# Financial Markets

## How Households Supply Financial Capital

The ways in which firms would prefer to raise funds are only half the story of financial markets. The other half is what those households and individuals who supply funds desire, and how they perceive the available choices. The focus of our discussion now shifts from firms on the demand side of financial capital markets to households on the supply side of those markets. We can divide the mechanisms for savings available to households into several categories: deposits in bank accounts; bonds; stocks; money market mutual funds; stock and bond mutual funds; and housing and other tangible assets like owning gold. We need to analyze each of these investments in terms of three factors: (1) the expected rate of return it will pay; (2) the risk that the return will be much lower or higher than expected; and (3) the investment's liquidity, which refers to how easily one can exchange money or financial assets for a good or service. We will do this analysis as we discuss each of these investments in the sections below. First, however, we need to understand the difference between expected rate of return, risk, and actual rate of return.

### Expected Rate of Return, Risk, and Actual Rate of Return

The expected rate of return refers to how much a project or an investment is expected to return to the investor, either in future interest payments, capital gains, or increased profitability. It is usually the average return over a period of time, usually in years or even decades. We normally measure it as a percentage rate. Risk measures the uncertainty of that project’s profitability. There are several types of risk, including default risk and interest rate risk. Default risk, as its name suggests, is the risk that the borrower fails to pay back the bond or loan. Interest rate risk is the danger that you might buy a long term bond at a 6% interest rate right before market rates suddenly rise, so had you waited, you could have received a similar bond that paid 9%. A high-risk investment is one for which a wide range of potential payoffs is reasonably probable. A low-risk investment may have actual returns that are fairly close to its expected rate of return year after year. A high-risk investment will have actual returns that are much higher than the expected rate of return in some months or years and much lower in other months or years. The actual rate of return refers to the total rate of return, including capital gains and interest paid on an investment at the end of a time period.

### Bank Accounts

An intermediary is one who stands between two other parties. For example, a person who arranges a blind date between two other people is one kind of intermediary. In financial capital markets, banks are an example of a financial intermediary—that is, an institution that operates between a saver who deposits funds in a bank and a borrower who receives a loan from that bank. When a bank serves as a financial intermediary, unlike the situation with a couple on a blind date, the saver and the borrower never meet. In fact, it is not even possible to make direct connections between those who deposit funds in banks and those who borrow from banks, because all deposited funds end up in one big pool, which the financial institution then lends out.
 illustrates the position of banks as a financial intermediary, with a pattern of deposits flowing into a bank and loans flowing out, and then repayment of the loans flowing back to the bank, with interest payments for the original savers.
Banks offer a range of accounts to serve different needs. A checking account typically pays little or no interest, but it facilitates transactions by giving you easy access to your money, either by writing a check or by using a debit card (that is, a card which works like a credit card, except that purchases are immediately deducted from your checking account rather than billed separately through a credit card company). A savings account typically pays some interest rate, but getting the money typically requires you to make a trip to the bank or an automatic teller machine (or you can access the funds electronically). The lines between checking and savings accounts have blurred in the last couple of decades, as many banks offer checking accounts that will pay an interest rate similar to a savings account if you keep a certain minimum amount in the account, or conversely, offer savings accounts that allow you to write at least a few checks per month.
Another way to deposit savings at a bank is to use a certificate of deposit (CD). With a CD, you agree to deposit a certain amount of money, often measured in thousands of dollars, in the account for a stated period of time, typically ranging from a few months to several years. In exchange, the bank agrees to pay a higher interest rate than for a regular savings account. While you can withdraw the money before the allotted time, as the advertisements for CDs always warn, there is “a substantial penalty for early withdrawal.”
 shows the annual rate of interest paid on a six-month, one-year, and five-year CD since 1984, as reported by Bankrate.com. The interest rates that savings accounts pay are typically a little lower than the CD rate, because financial investors need to receive a slightly higher rate of interest as compensation for promising to leave deposits untouched for a period of time in a CD, and thus forfeiting some liquidity.
The great advantages of bank accounts are that financial investors have very easy access to their money, and also money in bank accounts is extremely safe. In part, this safety arises because a bank account offers more security than keeping a few thousand dollars in the toe of a sock in your underwear drawer. In addition, the Federal Deposit Insurance Corporation (FDIC) protects the savings of the average person. Every bank is required by law to pay a fee to the FDIC, based on the size of its deposits. Then, if a bank should go bankrupt and not be able to repay depositors, the FDIC guarantees that all customers will receive their deposits back up to $250,000.
The bottom line on bank accounts looks like this: low risk means low rate of return but high liquidity.

### Bonds

An investor who buys a bond expects to receive a rate of return. However, bonds vary in the rates of return that they offer, according to the riskiness of the borrower. We always can divide an interest rate into three components (as we explained in Choice in a World of Scarcity): compensation for delaying consumption, an adjustment for an inflationary rise in the overall level of prices, and a risk premium that takes the borrower’s riskiness into account.
The U.S. government is an extremely safe borrower, so when the U.S. government issues Treasury bonds, it can pay a relatively low interest rate. Firms that appear to be safe borrowers, perhaps because of their sheer size or because they have consistently earned profits over time, will pay a higher interest rate than the U.S. government. Firms that appear to be riskier borrowers, perhaps because they are still growing or their businesses appear shaky, will pay the highest interest rates when they issue bonds. We call bonds that offer high interest rates to compensate for their relatively high chance of default high-yield bonds or junk bonds. A number of today’s well-known firms issued junk bonds in the 1980s when they were starting to grow, including Turner Broadcasting and Microsoft.
A bond issued by the U.S. government or a large corporation may seem to be relatively low risk: after all, the bond issuer has promised to make certain payments over time, and except for rare bankruptcy cases, these payments will occur. If a corporate bond issuer fails to make the payments that it owes to its bondholders, the bondholders can require that the company declare bankruptcy, sell off its assets, and pay them as much as it can. Even in the case of junk bonds, a wise investor can reduce the risk by purchasing bonds from a wide range of different companies since, even if a few firms go broke and do not pay, they are not all likely to go bankrupt.
As we noted before, bonds carry an interest rate risk. For example, imagine you decide to buy a 10-year bond for $1,000 that would pay an annual interest rate of 8%. Soon after you buy the bond, interest rates on bonds rise, so that now similar companies are paying an annual rate of 12%. Anyone who buys a $1,000 bond now can receive annual payments of $120 per year, but since your bond was issued at an interest rate of 8%, you have tied up $1,000 and receive payments of only $80 per year. In the meaningful sense of opportunity cost, you are missing out on the higher payments that you could have received. Furthermore, you can calculate the amount you should be willing to pay now for future payments. To place a present discounted value on a future payment, decide what you would need in the present to equal a certain amount in the
  future. This calculation will require an interest rate. For example, if the interest rate is 25%, then a payment of $125 a year from now will have a present discounted value of $100—that is, you could take $100 in the present and have $125 in the future. (We discuss this further in the appendix on Present Discounted Value.)
In financial terms, a bond has several parts. A bond is basically an “I owe you” note that an investor receives in exchange for capital (money). The bond has a face value. This is the amount the borrower agrees to pay the investor at maturity. The bond has a coupon rate or interest rate, which is usually semi-annual, but can be paid at different times throughout the year. (Bonds used to be paper documents with coupons that investors clipped and turned in to the bank to receive interest.) The bond has a maturity date when the borrower will pay back its face value as well as its last interest payment. Combining the bond’s face value, interest rate, and maturity date, and market interest rates, allows a buyer to compute a bond’s present value, which is the most that a buyer would be willing to pay for a given bond. This may or may not be the same as the face value.
The bond yield measures the rate of return a bond is expected to pay over time. Investors can buy bonds when they are issued and they can buy and sell them during their lifetimes. When buying a bond that has been around for a few years, investors should know that the interest rate printed on a bond is often not the same as the bond yield, even on new bonds. Read the next Work It Out feature to see how this happens.
 shows bond yield for two kinds of bonds: 10-year Treasury bonds (which are officially called “notes”) and corporate bonds issued by firms that have been given an AAA rating as relatively safe borrowers by Moody’s, an independent firm that publishes such ratings. Even though corporate bonds pay a higher interest rate, because firms are riskier borrowers than the federal government, the rates tend to rise and fall together. Treasury bonds typically pay more than bank accounts, and corporate bonds typically pay a higher interest rate than Treasury bonds.
The bottom line for bonds: rate of return—low to moderate, depending on the borrower's risk; risk—low to moderate, depending on whether interest rates in the economy change substantially after the bond is issued; liquidity—moderate, because the investor needs to sell the bond before the investor regains the cash.

### Stocks

As we stated earlier, the rate of return on a financial investment in a share of stock can come in two forms: as dividends paid by the firm and as a capital gain achieved by selling the stock for more than you paid. The range of possible returns from buying stock is mind-bending. Firms can decide to pay dividends or not. A stock price can rise to a multiple of its original price or sink all the way to zero. Even in short periods of time, well-established companies can see large movements in their stock prices. For example, on July 1, 2011, Netflix stock peaked at $295 per share; one year later, on July 30, 2012, it was at $53.91 per share; in 2022, it had recovered to $199. When Facebook went public, its shares of stock sold for around $40 per share, but in 2022, they were selling for slightly over $212.
We will discuss the reasons why stock prices fall and rise so abruptly below, but first you need to know how we measure stock market performance. There are a number of different ways to measure the overall performance of the stock market, based on averaging different subsets of companies' stock prices. Perhaps the best-known stock market measure is the Dow Jones Industrial Average, which is based on 30 large U.S. companies' stock prices. Another stock market performance gauge, the Standard & Poor’s 500, follows the stock prices of the 500 largest U.S. companies. The Wilshire 5000 tracks the stock prices of essentially all U.S. companies that have stock the public can buy and sell.
Other stock market measures focus on where stocks are traded. For example, the New York Stock Exchange monitors the performance of stocks that are traded on that exchange in New York City. The Nasdaq stock market includes about 3,600 stocks, with a concentration of technology stocks.  lists some of the most commonly cited measures of U.S. and international stock markets.
The trend in the stock market is generally up over time, but with some large dips along the way.  shows the path of the Standard & Poor’s 500 index (which is measured on the left-hand vertical axis) and the Dow Jones Index (which is measured on the right-hand vertical axis). Broad stock market measures, like the ones we list here, tend to move together. The S&P 500 Index is the weighted average market capitalization of the firms selected to be in the index. The Dow Jones Industrial Average is the price weighted average of 30 industrial stocks tracked on the New York Stock Exchange.
When the Dow Jones average rises from 5,000 to 10,000, you know that the average price of the stocks in that index has roughly doubled.  shows that stock prices did not rise much in the 1970s, but then started a steady climb in the 1980s. From 2000 to 2013, stock prices bounced up and down, but ended up at about the same level.
 shows the total annual rate of return an investor would have received from buying the stocks in the S&P 500 index over recent decades. The total return here includes both dividends paid by these companies and also capital gains arising from increases in the stock value. (For technical reasons related to how we calculate the numbers, the dividends and capital gains do not add exactly to the total return.) From the 1950s to the 1980s, the average firm paid annual dividends equal to about 4% of its stock value. Since the 1990s, dividends have dropped and now often provide a return closer to 1% to 2%. In the 1960s and 1970s, the gap between percent earned on capital gains and dividends was much closer than it has been since the 1980s. In the 1980s and 1990s, capital gains were far higher than dividends. In the 2000s, dividends remained low and, while stock prices fluctuated, they ended the decade roughly where they had started. In the 2010s, dividends remained low and stock prices increased, and this continued at the beginning of the 2020s.
The overall pattern is that stocks as a group have provided a high rate of return over extended periods of time, but this return comes with risks. The market value of individual companies can rise and fall substantially, both over short time periods and over the long run. During extended periods of time like the 1970s or the first decade of the 2000s, the overall stock market return can be quite modest. The stock market can sometimes fall sharply, as it did in 2008.
The bottom line on investing in stocks is that the rate of return over time will be high, but the risks are also high, especially in the short run. Liquidity is also high since one can sell stock in publicly held companies readily for spendable money.

### Mutual Funds

Buying stocks or bonds issued by a single company is always somewhat risky. An individual firm may find itself buffeted by unfavorable supply and demand conditions or hurt by unlucky or unwise managerial decisions. Thus, a standard recommendation from financial investors is diversification, which means buying stocks or bonds from a wide range of companies. A saver who diversifies is following the old proverb: “Don’t put all your eggs in one basket.” In any broad group of companies, some firms will do better than expected and some will do worse—but the diversification has a tendency to cancel out extreme increases and decreases in value.
Purchasing a diversified group of stocks or bonds has become easier in the internet age, but it remains something of a task. To simplify the process, companies offer mutual funds, which consist of a variety of stocks or bonds from different companies. The financial investor buys mutual fund shares, and then receives a return based on how the fund as a whole performs. In 2021, according to the Investment Company Factbook, just over 47% of U.S. households had a financial investment in a mutual fund—including many people who have their retirement savings or pension money invested in this way.
Mutual funds can focus in certain areas: one mutual fund might invest only in company stocks based in Indonesia, or only in bonds issued by large manufacturing companies, or only in biotechnology companies' stock. At the other end of the spectrum, a mutual fund might be quite broad. At the extreme, some mutual funds own a tiny share of every firm in the stock market, and thus the mutual fund's value will fluctuate with the overall stock market's average. We call a mutual fund that seeks only to mimic the market's overall performance an index fund.
Diversification can offset some of the risks of individual stocks rising or falling. Even investors who buy an indexed mutual fund designed to mimic some measure of the broad stock market, like the Standard & Poor’s 500, had better prepare against some ups and downs, like those the stock market experienced in the first decade of the 2000s. In 2008 average U.S. stock funds declined 38%, reducing individual and household wealth. This steep drop in value hit hardest those who were close to retirement and were counting on their stock funds to supplement retirement income.
The bottom line on investing in mutual funds is that the rate of return over time will be high. The risks are also high, but the risks and returns for an individual mutual fund will be lower than those for an individual stock. As with stocks, liquidity is also high provided the mutual fund or stock index fund is readily traded.

### Housing and Other Tangible Assets

Households can also seek a rate of return by purchasing tangible assets, especially housing. About two-thirds of U.S. households own their own home. An owner’s equity in a house is the monetary value the owner would have after selling the house and repaying any outstanding bank loans they used to buy the house. For example, imagine that you buy a house for $200,000, paying 10% of the price as a down payment and taking out a bank loan for the remaining $180,000. Over time, you pay off some of your bank loan, so that only $100,000 remains, and the house's value on the market rises to $250,000. At that point, your equity in the home is the value of the home minus the value of the loan outstanding, which is $150,000. For many middle-class Americans, home equity is their single greatest financial asset. The total value of all home equity held by U.S. households was $23.6 trillion as of the middle of 2021, according to Federal Reserve data.
Investment in a house is tangibly different from bank accounts, stocks, and bonds because a house offers both a financial and a nonfinancial return. If you buy a house to live in, part of the return on your investment occurs from your consumption of “housing services”—that is, having a place to live. (Of course, if you buy a home and rent it out, you receive rental payments for the housing services you provide, which would offer a financial return.) Buying a house to live in also offers the possibility of a capital gain from selling the house in the future for more than you paid for it. There can, however, be different outcomes, as the Clear It Up on the housing market shows.
Housing prices have usually risen steadily over time. For example, the median sales price for an existing one-family home was $122,900 in 1990, but 232,000 at the end of December 2016, according to FRED® Economic Data. Over these 24 years, home prices increased an average of 3.1% per year, which is an average financial return over this time.  shows U.S. Census data for the average sales price of a new home in the United States from 1965 to 2021.
However, the possible capital gains from rising housing prices are riskier than these national price averages. Certain regions of the country or metropolitan areas have seen drops in housing prices over time. The median housing price for the United States as a whole fell almost 7% in 2008 and again in 2009, dropping the median price from $247,900 to $216,700. As of 2016, home values had recovered and even exceeded their pre-recession levels, and they have continued to increase into the early 2020s.
Investors can also put money into other tangible assets such as gold, silver, and other precious metals, or in duller commodities like sugar, cocoa, coffee, orange juice, oil, and natural gas. The return on these investments derives from the saver’s hope of buying low, selling high, and receiving a capital gain. Investing in, say, gold or coffee offers relatively little in the way of nonfinancial benefits to the user (unless the investor likes to caress gold or gaze upon a warehouse full of coffee). Typically, investors in these commodities never even see the physical good. Instead, they sign a contract that takes ownership of a certain quantity of these commodities, which are stored in a warehouse, and later they sell the ownership to someone else. As one example, from 1981 to 2005, the gold prices generally fluctuated between about $300 and $500 per ounce, but then rose sharply to over $1,100 per ounce by early 2010. In January 2017, prices were hovering around $1,191 per ounce, and they have since increased, reaching over $1,900 by early 2022.
A final area of tangible assets consists of “collectibles” like paintings, fine wine, jewelry, antiques, or even baseball cards. Most collectibles provide returns both in the form of services or of a potentially higher selling price in the future. You can use paintings by hanging them on the wall; jewelry by wearing it; baseball cards by displaying them. You can also hope to sell them someday for more than you paid for them. However, the evidence on prices of collectibles, while scanty, is that while they may go through periods where prices skyrocket for a time, you should not expect to make a higher-than-average rate of return over a sustained period of time from investing in this way.
The bottom line on investing in tangible assets: rate of return—moderate, especially if you can receive nonfinancial benefits from, for example, living in the house; risk—moderate for housing or high if you buy gold or baseball cards; liquidity—low, because it often takes considerable time and energy to sell a house or a piece of fine art and turn your capital gain into cash. The next Clear It Up feature explains the issues in the recent U.S. housing market crisis.

### The Tradeoffs between Return and Risk

The discussion of financial investments has emphasized the expected rate of return, the risk, and the liquidity of each investment.  summarizes these characteristics.
The household investment choices listed here display a tradeoff between the expected return and the degree of risk involved. Bank accounts have very low risk and very low returns; bonds have higher risk but higher returns; and stocks are riskiest of all but have the potential for still higher returns. In effect, the higher average return compensates for the higher degree of risk. If risky assets like stocks did not also offer a higher average return, then few investors would want them.
This tradeoff between return and risk complicates the task of any financial investor: Is it better to invest safely or to take a risk and go for the high return? Ultimately, choices about risk and return will be based on personal preferences. However, it is often useful to examine risk and return in the context of different time frames.
The high returns of stock market investments refer to a high average return that we can expect over a period of several years or decades. The high risk of such investments refers to the fact that in shorter time frames, from months to a few years, the rate of return may fluctuate a great deal. Thus, a person near retirement age, who already owns a house, may prefer reduced risk and certainty about retirement income. For young workers, just starting to make a reasonably profitable living, it may make sense to put most of their savings for retirement in mutual funds. Mutual funds are able to take advantage of their buying and selling size and thereby reduce transaction costs for investors. Stocks are risky in the short term, to be sure, but when the worker can look forward to several decades during which stock market ups and downs can even out, stocks will typically pay a much higher return over that extended period than will bonds or bank accounts. Thus, one must consider tradeoffs between risk and return in the context of where the investor is in life.

### Key Concepts and Summary

We can categorize all investments according to three key characteristics: average expected return, degree of risk, and liquidity. To obtain a higher rate of return, an investor must typically accept either more risk or less liquidity. Banks are an example of a financial intermediary, an institution that operates to coordinate supply and demand in the financial capital market. Banks offer a range of accounts, including checking accounts, savings accounts, and certificates of deposit. Under the Federal Deposit Insurance Corporation (FDIC), banks purchase insurance against the risk of a bank failure.
A typical bond promises the financial investor a series of payments over time, based on the interest rate at the time the financial institution issues the bond, and when the borrower repays it. Bonds that offer a high rate of return but also a relatively high chance of defaulting on the payments are called high-yield or junk bonds. The bond yield is the rate of return that a bond promises to pay at the time of purchase. Even when bonds make payments based on a fixed interest rate, they are somewhat risky, because if interest rates rise for the economy as a whole, an investor who owns bonds issued at lower interest rates is now locked into the low rate and suffers a loss.
Changes in the stock price depend on changes in expectations about future profits. Investing in any individual firm is somewhat risky, so investors are wise to practice diversification, which means investing in a range of companies. A mutual fund purchases an array of stocks and/or bonds. An investor in the mutual fund then receives a return depending on the fund's overall performance as a whole. A mutual fund that seeks to imitate the overall behavior of the stock market is called an index fund.
We can also regard housing and other tangible assets as forms of financial investment, which pay a rate of return in the form of capital gains. Housing can also offer a nonfinancial return—specifically, you can live in it.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### Problems

### References

Howley, Kathleen M. Bloomberg. “Home Value Highest Since ’07 as U.S. Houses Make Cash.” Last modified March 26, 2013. http://www.bloomberg.com/news/2013-03-26/home-value-highest-since-07-as-u-s-houses-make-cash-mortgages.html.
NASDAQ.com. 2015. “Facebook, Inc. Historical Stock Prices.” Accessed March 28, 2015. http://www.nasdaq.com/symbol/fb/historical.
National Association of Realtors. 2015. “Existing-Home Sales: Latest News.” Accessed April 1, 2015. http://www.realtor.org/topics/existing-home-sales/data.
PricewaterhouseCoopers LLP. 2015. “Annual Venture Capital Investment Tops $48 Billion in 2014, Reaching Hightest Level in Over a Decade, According to the Moneytree Report.” Accessed April 1, 2015. http://www.pwc.com/us/en/press-releases/2015/annual-venture-capital-investment-tops-48-billion.jhtml.
Rooney, Ben. “Trading Program Sparked May ‘Flash Crash’.” CNN Money. Last modified October 1, 2010. http://money.cnn.com/2010/10/01/markets/SEC_CFTC_flash_crash/index.htm.
Investment Company Institute. “2013 Investment Company Fact Book, Chapter 6: Characteristics of Mutual Fund Owners.” http://icifactbook.org/fb_ch6.html.


# Financial Markets

## How to Accumulate Personal Wealth

Getting rich may seem straightforward enough. Figure out what companies are going to grow and earn high profits in the future, or figure out what companies are going to become popular for everyone else to buy. Those companies are the ones that will pay high dividends or whose stock price will climb in the future. Then, buy stock in those companies. Presto! Multiply your money!
Why is this path to riches not as easy as it sounds? This module first discusses the problems with picking stocks, and then discusses a more reliable but undeniably duller method of accumulating personal wealth.

### Why It Is Hard to Get Rich Quick: The Random Walk Theory

The chief problem with attempting to buy stock in companies that will have higher prices in the future is that many other financial investors are trying to do the same thing. Thus, in attempting to get rich in the stock market, it is no help to identify a company that is going to earn high profits if many other investors have already reached the same conclusion, because the stock price will already be high, based on the expected high level of future profits.
The idea that stock prices are based on expectations about the future has a powerful and unexpected implication. If expectations determine stock price, then shifts in expectations will determine shifts in the stock price. Thus, what matters for predicting whether the stock price of a company will do well is not whether the company will actually earn profits in the future. Instead, you must find a company that analysts widely believe at present to have poor prospects, but that will actually turn out to be a shining star. Brigades of stock market analysts and individual investors are carrying out such research 24 hours a day.
The fundamental problem with predicting future stock winners is that, by definition, no one can predict the future news that alters expectations about profits. Because stock prices will shift in response to unpredictable future news, these prices will tend to follow what mathematicians call a “random walk with a trend.” The “random walk” part means that, on any given day, stock prices are just as likely to rise as to fall. “With a trend” means that over time, the upward steps tend to be larger than the downward steps, so stocks do gradually climb.
If stocks follow a random walk, then not even financial professionals will be able to choose those that will beat the average consistently. While some investment advisers are better than average in any given year, and some even succeed for a number of years in a row, the majority of financial investors do not outguess the market. If we look back over time, it is typically true that half or two-thirds of the mutual funds that attempted to pick stocks which would rise more than the market average actually ended up performing worse than the market average. For the average investor who reads the newspaper business pages over a cup of coffee in the morning, the odds of doing better than full-time professionals is not very good at all. Trying to pick the stocks that will gain a great deal in the future is a risky and unlikely way to become rich.

### Getting Rich the Slow, Boring Way

Many U.S. citizens can accumulate a large amount of wealth during their lifetimes, if they make two key choices. The first is to complete additional education and training. In 2020, the Bureau of Labor Statistics reported median weekly usual earnings for full-time wage and salary workers age 25 and over that corresponded to annual income of $40,612 for those with a high school diploma, $48,776 for those with a two-year associate degree, and $67,860 for those with a four-year bachelor’s degree. Learning is not only good for you, but it pays off financially, too.
The second key choice is to start saving money early in life, and to give the power of compound interest a chance. Imagine that at age 25, you save $3,000 and place that money into an account that you do not touch. In the long run, it is not unreasonable to assume a 7% real annual rate of return (that is, 7% above the rate of inflation) on money invested in a well-diversified stock portfolio. After 40 years, using the formula for compound interest, the original $3,000 investment will have multiplied nearly fifteen fold:
Having $45,000 does not make you a millionaire. Notice, however, that this tidy sum is the result of saving $3,000 exactly once. Saving that amount every year for several decades—or saving more as income rises—will multiply the total considerably. This type of wealth will not rival the riches of Microsoft CEO Bill Gates, but remember that only half of Americans have any money in mutual funds at all. Accumulating hundreds of thousands of dollars by retirement is a perfectly achievable goal for a well-educated person who starts saving early in life—and that amount of accumulated wealth will put you at or near the top 10% of all American households. The following Work It Out feature shows the difference between simple and compound interest, and the power of compound interest.
Obtaining additional education and saving money early in life obviously will not make you rich overnight. Additional education typically means deferring earning income and living as a student for more years. Saving money often requires choices like driving an older or less expensive car, living in a smaller apartment or buying a smaller house, and making other day-to-day sacrifices. For most people, the tradeoffs for achieving substantial personal wealth will require effort, patience, and sacrifice.

### How Capital Markets Transform Financial Flows

Financial capital markets have the power to repackage money as it moves from those who supply financial capital to those who demand it. Banks accept checking account deposits and turn them into long-term loans to companies. Individual firms sell shares of stock and issue bonds to raise capital. Firms make and sell an astonishing array of goods and services, but an investor can receive a return on the company’s decisions by buying stock in that company. Financial investors sell and resell stocks and bonds to one another. Venture capitalists and angel investors search for promising small companies. Mutual funds combine the stocks and bonds—and thus, indirectly, the products and investments—of many different companies.
In this chapter, we discussed the basic mechanisms of financial markets. (A more advanced course in economics or finance will consider more sophisticated tools.) The fundamentals of those financial capital markets remain the same: Firms are trying to raise financial capital and households are looking for a desirable combination of rate of return, risk, and liquidity. Financial markets are society’s mechanisms for bringing together these forces of demand and supply.

### Key Concepts and Summary

It is extremely difficult, even for financial professionals, to predict changes in future expectations and thus to choose the stocks whose price will rise in the future. Most Americans can accumulate considerable financial wealth if they follow two rules: complete significant additional education and training after graduating from high school and start saving money early in life.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### Problems

### References

U.S. Department of Commerce: United States Census Bureau. “Income: Table H-13. Educational Attainment of Householder—Households with Householder 25 Years Old and Over by Median and Mean Income.” http://www.census.gov/hhes/www/income/data/historical/household/.
United States Department of Labor. Bureau of Labor Statistics. 2015. “Table 9. Quartiles and Selected Deciles of Usual Weekly Earnings of Full-Time Wage and Salary Workers by Selected Characteristics, 2014 Annual Averages.” Accessed April 1, 2015. http://www.bls.gov/news.release/wkyeng.t09.htm.


# Public Economy

## Introduction to Public Economy

As President Abraham Lincoln famously said in his 1863 Gettysburg Address, democratic governments are supposed to be “of the people, by the people, and for the people.” Can we rely on democratic governments to enact sensible economic policies? After all, they react to voters, not to analyses of demand and supply curves. The main focus of an economics course is, naturally enough, to analyze the characteristics of markets and purely economic institutions. However, political institutions also play a role in allocating society’s scarce resources, and economists have played an active role, along with other social scientists, in analyzing how such political institutions work.
Other chapters of this book discuss situations in which market forces can sometimes lead to undesirable results: monopoly, imperfect competition, and antitrust policy; negative and positive externalities; poverty and inequality of incomes; failures to provide insurance; and financial markets that may go from boom to bust. Many of these chapters suggest that the government's economic policies could address these issues.
However, just as markets can face issues and problems that lead to undesirable outcomes, a democratic system of government can also make mistakes, either by enacting policies that do not benefit society as a whole or by failing to enact policies that would have benefited society as a whole. This chapter discusses some practical difficulties of democracy from an economic point of view: we presume the actors in the political system follow their own self-interest, which is not necessarily the same as the public good. For example, many of those who are eligible to vote do not, which obviously raises questions about whether a democratic system will reflect everyone’s interests. Benefits or costs of government action are sometimes concentrated on small groups, which in some cases may organize and have a disproportionately large impact on politics and in other cases may fail to organize and end up neglected. A legislator who worries about support from voters in their district may focus on spending projects specific to the district without sufficient concern for whether this spending is in the nation's interest.
When more than two choices exist, the principle that the majority of voters should decide may not always make logical sense, because situations can arise where it becomes literally impossible to decide what the “majority” prefers. Government may also be slower than private firms to correct its mistakes, because government agencies do not face competition or the threat of new entry.


# Public Economy

## Voter Participation and Costs of Elections

In U.S. presidential elections over the last few decades, about 55% to 65% of voting-age citizens actually voted, according to the U.S. Census. In congressional elections when there is no presidential race, or in local elections, the turnout is typically lower, often less than half the eligible voters. In other countries, the share of adults who vote is often higher. For example, in national elections since the 1980s in Germany, Spain, and France, about 75% to 80% of those of voting age cast ballots. Even this total falls well short of 100%. Some countries have laws that require voting, among them Australia, Belgium, Italy, Greece, Turkey, Singapore, and most Latin American nations. At the time the United States was founded, voting was mandatory in Virginia, Maryland, Delaware, and Georgia. Even if the law can require people to vote, however, no law can require that each voter cast an informed or a thoughtful vote. Moreover, in the United States and in most countries around the world, the freedom to vote has also typically meant the freedom not to vote.
Why do people not vote? Perhaps they do not care too much about who wins, or they are uninformed about who is running, or they do not believe their vote will matter or change their lives in any way. These reasons are probably tied together, since people who do not believe their vote matters will not bother to become informed or care who wins. Economists have suggested why a utility-maximizing person might rationally decide not to vote or not to become informed about the election. While a single vote may decide a few elections in very small towns, in most elections of any size, the Board of Elections measures the margin of victory in hundreds, thousands, or even millions of votes. A rational voter will recognize that one vote is extremely unlikely to make a difference. This theory of rational ignorance holds that people will not vote if the costs of becoming informed and voting are too high, or they feel their vote will not be decisive in the election.
In a 1957 work, An Economic Theory of Democracy, the economist Anthony Downs stated the problem this way: “It seems probable that for a great many citizens in a democracy, rational behavior excludes any investment whatever in political information per se. No matter how significant a difference between parties is revealed to the rational citizen by his free information, or how uncertain he is about which party to support, he realizes that his vote has almost no chance of influencing the outcome… He will not even utilize all the free information available, since assimilating it takes time.” In his classic 1948 novel Walden Two, the psychologist B. F. Skinner puts the issue even more succinctly via one of his characters, who states: “The chance that one man’s vote will decide the issue in a national election…is less than the chance that he will be killed on his way to the polls.” The following Clear It Up feature explores another aspect of the election process: spending.
While many U.S. adults do not bother to vote in presidential elections, more than half do. What motivates them? Research on voting behavior has indicated that people who are more settled or more “connected” to society tend to vote more frequently. According to the Washington Post, more married people vote than single people. Those with a job vote more than the unemployed. Those who have lived longer in a neighborhood are more likely to vote than newcomers. Those who report that they know their neighbors and talk to them are more likely to vote than socially isolated people. Those with a higher income and level of education are also more likely to vote. These factors suggest that politicians are likely to focus more on the interests of married, employed, well-educated people with at least a middle-class level of income than on the interests of other groups. For example, those who vote may tend to be more supportive of financial assistance for the two-year and four-year colleges they expect their children to attend than they are of medical care or public school education aimed at families of unemployed people and those experiencing poverty.

There have been many proposals to encourage greater voter turnout: making it easier to register to vote, keeping the polls open for more hours, or even moving Election Day to the weekend, when fewer people need to worry about jobs or school commitments. However, such changes do not seem to have caused a long-term upward trend in the number of people voting. After all, casting an informed vote will always impose some costs of time and energy. It is not clear how to strengthen people’s feeling of connectedness to society in a way that will lead to a substantial increase in voter turnout. Without greater voter turnout, however, politicians elected by the votes of 60% or fewer of the population may not enact economic policy in the best interests of 100% of the population. Meanwhile, countering a long trend toward making voting easier, many states have recently enacted new voting laws that critics say are actually barriers to voting. States have passed laws reducing early voting, restricting groups who are organizing get-out-the-vote efforts, enacted strict photo ID laws, as well as laws that require showing proof of U.S. citizenship. The ACLU argues that while these laws profess to prevent voter fraud, they are in effect making it harder for individuals to cast their vote.

### Key Concepts and Summary

The theory of rational ignorance says voters will recognize that their single vote is extremely unlikely to influence the outcome of an election. As a consequence, they will choose to remain uninformed about issues and not vote. This theory helps explain why voter turnout is so low in the United States.

### Self-Check Questions

### Review Question

### Critical Thinking Questions

### References

Olson, Mancur. The Logic of Collective Action: Public Goods and the Theory of Groups, (Boston: Harvard University Press, 1965).
Downs, Anthony. An Economic Theory of Democracy. New York: Harper, 1957.
Skinner, B.F. Walden Two. Indianapolis: Hackett Publishing Company, Inc., 1948.
American Civil Liberties Union (ACLU).  "Voting Rights." https://www.aclu.org/voting-rights.
The New York Times. “The 2012 Money Race: Compare the Candidates.” http://elections.nytimes.com/2012/campaign-finance.
The Washington Post. “Exit Polls 2012: Where Americans Stood this Election.” Last modified November 7, 2012. http://www.washingtonpost.com/wp-srv/special/politics/2012-exit-polls/national-breakdown/.
Cornell University Law School: Legal Information Institute. “Citizens United v. Federal Election Committee (No. 08-205).” Last modified January 21, 2010. http://www.law.cornell.edu/supct/html/08-205.ZS.html.
U.S. Department of Commerce: United States Census Bureau. “Voting and Registration: Historical Time Series Tables; Table A-9: Reported Voting Rates in Presidential Election Years, by Selected Characteristics: November 1964 to 2012.” http://www.census.gov/hhes/www/socdemo/voting/publications/historical/index.html


# Public Economy

## Special Interest Politics

Many political issues are of intense interest to a relatively small group, as we noted above. For example, many U.S. drivers do not much care where their car tires were made—they just want good quality as inexpensively as possible. In September 2009, President Obama and Congress enacted a tariff (taxes added on imported goods) on tires imported from China that would increase the price by 35 percent in its first year, 30 percent in its second year, and 25 percent in its third year. Interestingly, the U.S. companies that make tires did not favor this step, because most of them also import tires from China and other countries. (See Globalization and Protectionism for more on tariffs.) However, the United Steelworkers union, which had seen jobs in the tire industry fall by 5,000 over the previous five years, lobbied fiercely for the tariff. With this tariff, the cost of all tires increased significantly. (See the closing Bring It Home feature at the end of this chapter for more information on the tire tariff.)
Special interest groups are groups that are small in number relative to the nation, but quite well organized and focused on a specific issue. A special interest group can pressure legislators to enact public policies that do not benefit society as a whole. Imagine an environmental rule to reduce air pollution that will cost 10 large companies $8 million each, for a total cost of $80 million. The social benefits from enacting this rule provide an average benefit of $10 for every person in the United States, for a total of about $3 trillion. Even though the benefits are far higher than the costs for society as a whole, the 10 companies are likely to lobby much more fiercely to avoid $8 million in costs than the average person is to argue for $10 worth of benefits.
As this example suggests, we can relate the problem of special interests in politics to an issue we raised in Environmental Protection and Negative Externalities about economic policy with respect to negative externalities and pollution—the problem called regulatory capture (which we defined in Monopoly and Antitrust Policy). In legislative bodies and agencies that write laws and regulations about how much corporations will pay in taxes, or rules for safety in the workplace, or instructions on how to satisfy environmental regulations, you can be sure the specific industry affected has lobbyists who study every word and every comma. They talk with the legislators who are writing the legislation and suggest alternative wording. They contribute to the campaigns of legislators on the key committees—and may even offer those legislators high-paying jobs after they have left office. As a result, it often turns out that those regulated can exercise considerable influence over the regulators.
In the early 2000s, about 40 million people in the United States were eligible for Medicare, a government program that provides health insurance for those 65 and older. On some issues, the elderly are a powerful interest group. They donate money and time to political campaigns, and in the 2020 presidential election, 76% of those ages 65–74 voted, while just 51% of those aged 18 to 24 cast a ballot, according to the U.S. Census.
In 2003, Congress passed and President George Bush signed into law a substantial expansion of Medicare that helped the elderly to pay for prescription drugs. The prescription drug benefit cost the federal government about $40 billion in 2006, and the Medicare system projected that the annual cost would rise to $121 billion by 2016. The political pressure to pass a prescription drug benefit for Medicare was apparently quite high, while the political pressure to assist the 40 million with no health insurance at all was considerably lower. One reason might be that the American Association for Retired People AARP, a well-funded and well-organized lobbying group represents senior citizens, while there is no umbrella organization to lobby for those without health insurance.
In the battle over passage of the 2010 Affordable Care Act (ACA), which became known as “Obamacare,” there was heavy lobbying on all sides by insurance companies and pharmaceutical companies. However, labor unions and community groups financed a lobby group, Health Care for America Now (HCAN), to offset corporate lobbying. HCAN, spending $60 million dollars, was successful in helping pass legislation which added new regulations on insurance companies and a mandate that all individuals will obtain health insurance by 2014. The following Work It Out feature further explains voter incentives and lobbyist influence.
Special interests may develop a close relationship with one political party, so their ability to influence legislation rises and falls as that party moves in or out of power. A special interest may even hurt a political party if it appears to a number of voters that the relationship is too cozy. In a close election, a small group that has been under-represented in the past may find that it can tip the election one way or another—so that group will suddenly receive considerable attention. Democratic institutions produce an ebb and flow of political parties and interests and thus offer both opportunities for special interests and ways of counterbalancing those interests over time.

### Identifiable Winners, Anonymous Losers

A number of economic policies produce gains whose beneficiaries are easily identifiable, but costs that are partly or entirely shared by a large number who remain anonymous. A democratic political system probably has a bias toward those who are identifiable.
For example, policies that impose price controls—like rent control—may look as if they benefit renters and impose costs only on landlords. However, when landlords then decide to reduce the number of rental units available in the area, a number of people who would have liked to rent an apartment end up living somewhere else because no units were available. These would-be renters have experienced a cost of rent control, but it is hard to identify who they are.
Similarly, policies that block imports will benefit the firms that would have competed with those imports—and workers at those firms—who are likely to be quite visible. Consumers who would have preferred to purchase the imported products, and who thus bear some costs of the protectionist policy, are much less visible.
Specific tax breaks and spending programs also have identifiable winners and impose costs on others who are hard to identify. Special interests are more likely to arise from a group that is easily identifiable, rather than from a group where some of those who suffer may not even recognize they are bearing costs.

### Pork Barrels and Logrolling

Politicians have an incentive to ensure that they spend government money in their home state or district, where it will benefit their constituents in a direct and obvious way. Thus, when legislators are negotiating over whether to support a piece of legislation, they commonly ask each other to include pork-barrel spending, legislation that benefits mainly a single political district. Pork-barrel spending is another case in which concentrated benefits and widely dispersed costs challenge democracy: the benefits of pork-barrel spending are obvious and direct to local voters, while the costs are spread over the entire country. Read the following Clear It Up feature for more information on pork-barrel spending.
The amount that government spends on individual pork-barrel projects is small, but many small projects can add up to a substantial total. A nonprofit watchdog organization, called Citizens against Government Waste, produces an annual report, the Pig Book that attempts to quantify the amount of pork-barrel spending, focusing on items that only one member of Congress requested, that were passed into law without any public hearings, or that serve only a local purpose. Whether any specific item qualifies as pork can be controversial. The 2021 Congressional Pig Book identified 285 earmarks in FY 2021, with a cost of $16.8 billion. Recent growth in earmarks and their cost is apparent: in FY 2017, there were 163 earmarks at a cost of $6.8 billion. Hence, in only four years, there was a 75% increase in the number of earmarks and a 147% increase in the cost of those earmarks.
Logrolling, an action in which all members of a group of legislators agree to vote for a package of otherwise unrelated laws that they individually favor, can encourage pork barrel spending. For example, if one member of the U.S. Congress suggests building a new bridge or hospital in their own congressional district, the other members might oppose it. However, if 51% of the legislators come together, they can pass a bill that includes a bridge or hospital for every one of their districts.
As a reflection of this interest of legislators in their own districts, the U.S. government has typically spread out its spending on military bases and weapons programs to congressional districts all across the country. In part, the government does this to help create a situation that encourages members of Congress to vote in support of defense spending.

### Key Concepts and Summary

Special interest politics arises when a relatively small group, called a special interest group, each of whose members has a large interest in a political outcome, devotes considerable time and energy to lobbying for the group’s preferred choice. Meanwhile, the large majority, each of whose members has only a small interest in this issue, pays no attention.
We define pork--barrel spending as legislation whose benefits are concentrated on a single district while the costs are spread widely over the country. Logrolling refers to a situation in which two or more legislators agree to vote for each other’s legislation, which can then encourage pork-barrel spending in many districts.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### Problems

### References

Roper Center Public Opinion Archives. “A Brief History of Public Opinion on the Government’s Role in Providing Health Care.” Last modified September 23, 2013.
U.S. Department of Commerce: United States Census Bureau. “Voting and Registration: Historical Time Series Tables; Table A-10: Reported Registration Rates in Presidential Election Years, by Selected Characteristics: November 1968 to 2012.” http://www.census.gov/hhes/www/socdemo/voting/publications/historical/index.html


# Public Economy

## Flaws in the Democratic System of Government

Most developed countries today have a democratic system of government: citizens express their opinions through votes and those votes affect the direction of the country. The advantage of democracy over other systems is that it allows everyone in a society an equal say and therefore may reduce the possibility of a small group of wealthy oligarchs oppressing the masses. There is no such thing as a perfect system, and democracy, for all its popularity, is not without its problems, a few of which we will examine here.
We sometimes sum up and oversimplify democracy in two words: “Majority rule.” When voters face three or more choices, however, then voting may not always be a useful way of determining what the majority prefers.
As one example, consider an election in a state where 60% of the population is liberal and 40% is conservative. If there are only two candidates, one from each side, and if liberals and conservatives vote in the same 60–40 proportions in which they are represented in the population, then the liberal will win. What if the election ends up including two liberal candidates and one conservative? It is possible that the liberal vote will split and victory will go to the minority party. In this case, the outcome does not reflect the majority’s preference.
Does the majority view prevail in the case of sugar quotas? Clearly there are more sugar consumers in the United States than sugar producers, but the U.S. domestic sugar lobby (www.sugarcane.org) has successfully argued for protection against imports since 1789. By law, therefore, U.S. cookie and candy makers must use 85% domestic sugar in their products. Meanwhile quotas on imported sugar restrict supply and keep the domestic sugar price up—raising prices for companies that use sugar in producing their goods and for consumers. The European Union allows sugar imports, and prices there are 40% lower than U.S. sugar prices. Sugar-producing countries in the Caribbean repeatedly protest the U.S. quotas at the World Trade Organization meetings, but each bite of cookie, at present, costs you more than if there were no sugar lobby. This case goes against the theory of the “median” voter in a democracy. The median voter theory argues that politicians will try to match policies to what pleases the median voter preferences. If we think of political positions along a spectrum from left to right, the median voter is in the middle of the spectrum. This theory argues that actual policy will reflect “middle of the road.” In the case of sugar lobby politics, the minority, not the median, dominates policy.
Sometimes it is not even clear how to define the majority opinion. Step aside from politics for a moment and think about a choice facing three families (the Ortegas, the Schmidts, and the Alexanders) who are planning to celebrate New Year’s Day together. They agree to vote on the menu, choosing from three entrees, and they agree that the majority vote wins. With three families, it seems reasonable that one producing choice will get a 2–1 majority. What if, however, their vote ends up looking like ?
Clearly, the three families disagree on their first choice. However, the problem goes even deeper. Instead of looking at all three choices at once, compare them two at a time. (See ) In a vote of turkey versus beef, turkey wins by 2–1. In a vote of beef versus lasagna, beef wins 2–1. If turkey beats beef, and beef beats lasagna, then it might seem only logical that turkey must also beat lasagna. However, with the preferences, lasagna is preferred to turkey by a 2–1 vote, as well. If lasagna is preferred to turkey, and turkey beats beef, then surely it must be that lasagna also beats beef? Actually, no. Beef beats lasagna. In other words, the majority view may not win. Clearly, as any car salesperson will tell you, the way one presents choices to us influences our decisions.
We call the situation in which Choice A is preferred by a majority over Choice B, Choice B is preferred by a majority over Choice C, and Choice C is preferred by a majority over Choice A a voting cycle. It is easy to imagine sets of government choices—say, perhaps the choice between increased defense spending, increased government spending on health care, and a tax cut—in which a voting cycle could occur. The result will be determined by the order in which interested parties present and vote on choices, not by majority rule, because every choice is both preferred to some alternative and also not preferred to another alternative.

### Where Is Government’s Self-Correcting Mechanism?

When a firm produces a product no one wants to buy or produces at a higher cost than its competitors, the firm is likely to suffer losses. If it cannot change its ways, it will go out of business. This self-correcting mechanism in the marketplace can have harsh effects on workers or on local economies, but it also puts pressure on firms for good performance.
Government agencies, however, do not sell their products in a market. They receive tax dollars instead. They are not challenged by competitors as are private-sector firms. If the U.S. Department of Education or the U.S. Department of Defense is performing poorly, citizens cannot purchase their services from another provider and drive the existing government agencies into bankruptcy. If you are upset that the Internal Revenue Service is slow in sending you a tax refund or seems unable to answer your questions, you cannot decide to pay your income taxes through a different organization. Of course, elected politicians can assign new leaders to government agencies and instruct them to reorganize or to emphasize a different mission. The pressure government faces, however, to change its bureaucracy, to seek greater efficiency, and to improve customer responsiveness is much milder than the threat of being put out of business altogether.
This insight suggests that when government provides goods or services directly, we might expect it to do so with less efficiency than private firms—except in certain cases where the government agency may compete directly with private firms. At the local level, for example, government can provide directly services like garbage collection, using private firms under contract to the government, or by a mix of government employees competing with private firms.

### A Balanced View of Markets and Government

The British statesman Sir Winston Churchill (1874–1965) once wrote: “No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of government except for all of the other forms which have been tried from time to time.” In that spirit, the theme of this discussion is certainly not that we should abandon democratic government. A practical student of public policy needs to recognize that in some cases, like the case of well-organized special interests or pork-barrel legislation, a democratic government may seek to enact economically unwise projects or programs. In other cases, by placing a low priority on the problems of those who are not well organized or who are less likely to vote, the government may fail to act when it could do some good. In these and other cases, there is no automatic reason to believe that government will necessarily make economically sensible choices.
 “The true test of a first-rate mind is the ability to hold two contradictory ideas at the same time,” wrote the American author F. Scott Fitzgerald (1896–1940). At this point in your study of microeconomics, you should be able to go one better than Fitzgerald and hold three somewhat contradictory ideas about the interrelationship between markets and government in your mind at the same time.
First, markets are extraordinarily useful and flexible institutions through which society can allocate its scarce resources. We introduced this idea with the subjects of international trade and demand and supply in other chapters and reinforced it in all the subsequent discussions of how households and firms make decisions.
Second, markets may sometimes produce unwanted results. A short list of the cases in which markets produce unwanted results includes monopoly and other cases of imperfect competition, pollution, poverty and inequality of incomes, discrimination, and failure to provide insurance.
Third, while government may play a useful role in addressing the problems of markets, government action is also imperfect and may not reflect majority views. Economists readily admit that, in settings like monopoly or negative externalities, a potential role exists for government intervention. However, in the real world, it is not enough to point out that government action might be a good idea. Instead, we must have some confidence that the government is likely to identify and carry out the appropriate public policy. To make sensible judgments about economic policy, we must see the strengths and weaknesses of both markets and government. We must not idealize or demonize either unregulated markets or government actions. Instead, consider the actual strengths and weaknesses of real-world markets and real-world governments.
These three insights seldom lead to simple or obvious political conclusions. As the famous British economist Joan Robinson wrote some decades ago: “[E]conomic theory, in itself, preaches no doctrines and cannot establish any universally valid laws. It is a method of ordering ideas and formulating questions.” The study of economics is neither politically conservative, nor moderate, nor liberal. There are economists who are Democrats, Republicans, libertarians, socialists, and members of every other political group you can name. Of course, conservatives may tend to emphasize the virtues of markets and the limitations of government, while liberals may tend to emphasize the shortcomings of markets and the need for government programs. Such differences only illustrate that the language and terminology of economics is not limited to one set of political beliefs, but can be used by all.

### Key Concepts and Summary

Majority votes can run into difficulties when more than two choices exist. A voting cycle occurs when, in a situation with at least three choices, choice A is preferred by a majority vote to choice B, choice B is preferred by a majority vote to choice C, and choice C is preferred by a majority vote to choice A. In such a situation, it is impossible to identify what the majority prefers. Another difficulty arises when the vote is so divided that no choice receives a majority.
A practical approach to microeconomic policy will need to take a realistic view of the specific strengths and weaknesses of markets as well as government, rather than making the easy but wrong assumption that either the market or government is always beneficial or always harmful.

### Self-Check Questions

### Review Questions

### Critical Thinking Questions

### References

Nixon, Ron. “American Candy Makers. Pinched by Inflated Sugar Prices. Look Abroad.” The New York Times. Last modified October 30, 2013. http://www.nytimes.com/2013/10/31/us/american-candy-makers-pinched-by-inflated-sugar-prices-look-abroad.html?_r=0.
Hufbauer, Gary Clyde, and Sean Lowry. “U.S. Tire Tariffs: Saving Few Jobs at High Cost (Policy Brief 12-9).” Peterson Institute for International Economics. Last modified April 2012.


# The Macroeconomic Perspective

## Introduction to the Macroeconomic Perspective

Macroeconomics focuses on the economy as a whole (or on whole economies as they interact). What causes recessions? What makes unemployment stay high when recessions are supposed to be over? Why do some countries grow faster than others? Why do some countries have higher standards of living than others? These are all questions that macroeconomics addresses. Macroeconomics involves adding up the economic activity of all households and all businesses in all markets to obtain the overall demand and supply in the economy. However, when we do that, something curious happens. It is not unusual that what results at the macro level is different from the sum of the microeconomic parts. What seems sensible from a microeconomic point of view can have unexpected or counterproductive results at the macroeconomic level. Imagine that you are sitting at an event with a large audience, like a live concert or a basketball game. A few people decide that they want a better view, and so they stand up. However, when these people stand up, they block the view for other people, and the others need to stand up as well if they wish to see. Eventually, nearly everyone is standing up, and as a result, no one can see much better than before. The rational decision of some individuals at the micro level—to stand up for a better view—ended up as self-defeating at the macro level. This is not macroeconomics, but it is an apt analogy.
Macroeconomics is a rather massive subject. How are we going to tackle it?  illustrates the structure we will use. We will study macroeconomics from three different perspectives:

### Goals

In thinking about the macroeconomy's overall health, it is useful to consider three primary goals: economic growth, low unemployment, and low inflation.

### Frameworks

As you learn in the micro part of this book, principal tools that economists use are theories and models (see Welcome to Economics! for more on this). In microeconomics, we used the theories of supply and demand. In macroeconomics, we use the theories of aggregate demand (AD) and aggregate supply (AS). This book presents two perspectives on macroeconomics: the Neoclassical perspective and the Keynesian perspective, each of which has its own version of AD and AS. Between the two perspectives, you will obtain a good understanding of what drives the macroeconomy.

### Policy Tools

National governments have two tools for influencing the macroeconomy. The first is monetary policy, which involves managing the money supply and interest rates. The second is fiscal policy, which involves changes in government spending/purchases and taxes.
We will explain each of the items in  in detail in one or more other chapters. As you learn these things, you will discover that the goals and the policy tools are in the news almost every day.


# The Macroeconomic Perspective

## Measuring the Size of the Economy: Gross Domestic Product

Macroeconomics is an empirical subject, so the first step toward understanding it is to measure the economy.
How large is the U.S. economy? Economists typically measure the size of a nation’s overall economy by its gross domestic product (GDP), which is the value of all final goods and services produced within a country in a given year. Measuring GDP involves counting the production of millions of different goods and services—smart phones, cars, music downloads, computers, steel, bananas, college educations, and all other new goods and services that a country produced in the current year—and summing them into a total dollar value. This task is straightforward: take the quantity of everything produced, multiply it by the price at which each product sold, and add up the total. In 2020, the U.S. GDP totaled $20.9 trillion, the largest GDP in the world.
Each of the market transactions that enter into GDP must involve both a buyer and a seller. We can measure an economy's GDP either by the total dollar value of what consumers purchase in the economy, or by the total dollar value of what is the country produces. There is even a third way, as we will explain later.

### GDP Measured by Components of Demand

Who buys all of this production? We can divide this demand into four main parts: consumer spending (consumption), business spending (investment), government spending on goods and services, and spending on net exports. (See the following Clear It Up feature to understand what we mean by investment.)  shows how these four components added up to the GDP in 2020,  (a) shows the levels of consumption, investment, and government purchases over time, expressed as a percentage of GDP, while  (b) shows the levels of exports and imports as a percentage of GDP over time. A few patterns about each of these components are worth noticing.  shows the components of GDP from the demand side.
Consumption expenditure by households is the largest component of GDP, accounting for about two-thirds of the GDP in any year. This tells us that consumers’ spending decisions are a major driver of the economy. However, consumer spending is a gentle elephant: when viewed over time, it does not jump around too much, and has increased modestly from about 60% of GDP in the 1960s and 1970s.
Investment expenditure refers to purchases of physical plant and equipment, primarily by businesses. If Starbucks builds a new store, or Amazon buys robots, they count these expenditures under business investment. Investment demand is far smaller than consumption demand, typically accounting for only about 15–18% of GDP, but it is very important for the economy because this is where jobs are created. However, it fluctuates more noticeably than consumption. Business investment is volatile. New technology or a new product can spur business investment, but then confidence can drop and business investment can pull back sharply.
If you have noticed any of the infrastructure projects (new bridges, highways, airports) launched during the 2009 recession, or if you received a stimulus check during the pandemic-induced recession of 2020–2021, you have seen how important government spending can be for the economy. Government expenditure in the United States is close to 20% of GDP, and includes spending by all three levels of government: federal, state, and local. The only part of government spending counted in demand is government purchases of goods or services produced in the economy. Examples include the government buying a new fighter jet for the Air Force (federal government spending), building a new highway (state government spending), or a new school (local government spending). A significant portion of government budgets consists of transfer payments, like unemployment benefits, veteran’s benefits, and Social Security payments to retirees. The government excludes these payments from GDP because it does not receive a new good or service in return or exchange. Instead they are transfers of income from taxpayers to others. If you are curious about the awesome undertaking of adding up GDP, read the following Clear It Up feature.
When thinking about the demand for domestically produced goods in a global economy, it is important to count spending on exports—domestically produced goods that a country sells abroad. Similarly, we must also subtract spending on imports—goods that a country produces in other countries that residents of this country purchase. The GDP net export component is equal to the dollar value of exports (X) minus the dollar value of imports (M), (X – M). We call the gap between exports and imports the trade balance. If a country’s exports are larger than its imports, then a country has a trade surplus. In the United States, exports typically exceeded imports in the 1960s and 1970s, as (b) shows.
Since the early 1980s, imports have typically exceeded exports, and so the United States has experienced a trade deficit in most years. The trade deficit grew quite large in the late 1990s and in the mid-2000s.  (b) also shows that imports and exports have both risen substantially in recent decades, even after the declines during the Great Recession between 2008 and 2009. As we noted before, if exports and imports are equal, foreign trade has no effect on total GDP. However, even if exports and imports are balanced overall, foreign trade might still have powerful effects on particular industries and workers by causing nations to shift workers and physical capital investment toward one industry rather than another.
Based on these four components of demand, we can measure GDP as:
Understanding how to measure GDP is important for analyzing connections in the macro economy and for thinking about macroeconomic policy tools.

### GDP Measured by What is Produced

Everything that we purchase somebody must first produce.  breaks down what a country produces into five categories: durable goods, nondurable goods, services, structures, and the change in inventories. Before going into detail about these categories, notice that total GDP measured according to what is produced is exactly the same as the GDP measured by looking at the five components of demand.  provides a visual representation of this information.
Since every market transaction must have both a buyer and a seller, GDP must be the same whether measured by what is demanded or by what is produced.  shows these components of what is produced, expressed as a percentage of GDP, since 1950.
In thinking about what is produced in the economy, many non-economists immediately focus on solid, long-lasting goods, like cars and computers. By far the largest part of GDP, however, is services. Moreover, services have been a growing share of GDP over time. A detailed breakdown of the leading service industries would include healthcare, education, and legal and financial services. It has been decades since most of the U.S. economy involved making solid objects. Instead, the most common jobs in a modern economy involve a worker looking at pieces of paper or a computer screen; meeting with co-workers, customers, or suppliers; or making phone calls.
Even within the overall category of goods, long-lasting durable goods like cars and refrigerators are about the same share of the economy as short-lived nondurable goods like food and clothing. The category of structures includes everything from homes, to office buildings, shopping malls, and factories. Inventories is a small category that refers to the goods that one business has produced but has not yet sold to consumers, and are still sitting in warehouses and on shelves. The amount of inventories sitting on shelves tends to decline if business is better than expected, or to rise if business is worse than expected.

### Another Way to Measure GDP: The National Income Approach

GDP is a measure of what is produced in a nation. The primary way GDP is estimated is with the Expenditure Approach we discussed above, but there is another way.  Everything a firm produces, when sold, becomes revenues to the firm. Businesses use revenues to pay their bills: Wages and salaries for labor, interest and dividends for capital, rent for land, profit to the entrepreneur, etc. So adding up all the income produced in a year provides a second way of measuring GDP. This is why the terms GDP and national income are sometimes used interchangeably. The total value of a nation’s output is equal to the total value of a nation’s income.

### The Problem of Double Counting

We define GDP as the current value of all final goods and services produced in a nation in a year. What are final goods? They are goods at the furthest stage of production at the end of a year. Statisticians who calculate GDP must avoid the mistake of double counting, in which they count output more than once as it travels through the production stages. For example, imagine what would happen if government statisticians first counted the value of tires that a tire manufacturer produces, and then counted the value of a new truck that an automaker sold that contains those tires. In this example, the statisticians would have counted the value of the tires twice-because the truck's price includes the value of the tires.
To avoid this problem, which would overstate the size of the economy considerably, government statisticians count just the value of final goods and services in the chain of production that are sold for consumption, investment, government, and trade purposes. Statisticians exclude intermediate  goods, which are goods that go into producing other goods, from GDP calculations. From the example above, they will only count the Ford truck's value. The value of what businesses provide to other businesses is captured in the final products at the end of the production chain.
The concept of GDP is fairly straightforward: it is just the dollar value of all final goods and services produced in the economy in a year. In our decentralized, market-oriented economy, actually calculating the more than $21 trillion-dollar U.S. GDP—along with how it is changing every few months—is a full-time job for a brigade of government statisticians.
Notice the items that are not counted into GDP, as   outlines. The sales of used goods are not included because they were produced in a previous year and are part of that year’s GDP. The entire underground economy of services paid “under the table” and illegal sales should be counted, but is not, because it is impossible to track these sales. In Friedrich Schneider's recent study of shadow economies, he estimated the underground economy in the United States to be 6.6% of GDP, or close to $2 trillion dollars in 2013 alone. Transfer payments, such as payment by the government to individuals, are not included, because they do not represent production. Also, production of some goods—such as home production as when you make your breakfast—is not counted because these goods are not sold in the marketplace.

### Other Ways to Measure the Economy

Besides GDP, there are several different but closely related ways of measuring the size of the economy. We mentioned above that we can think of GDP as total production and as total purchases. We can also think of it as total income since anything one produces and sells yields income.
One of the closest cousins of GDP is the gross national product (GNP). GDP includes only what country produces within its borders. GNP adds what domestic businesses and labor abroad produces, and subtracts any payments that foreign labor and businesses located in the United States send home to other countries. In other words, GNP is based more on what a country's citizens and firms produce, wherever they are located, and GDP is based on what happens within a certain county's geographic boundaries. For the United States, the gap between GDP and GNP is relatively small; in recent years, only about 0.2%. For small nations, which may have a substantial share of their population working abroad and sending money back home, the difference can be substantial.
We calculate net national product (NNP) by taking GNP and then subtracting the value of how much physical capital is worn out, or reduced in value because of aging, over the course of a year. The process by which capital ages and loses value is called depreciation. We can further subdivide NNP into national income, which includes all income to businesses and individuals, and personal income, which includes only income to people.
The gross national income (GNI) includes the value of all goods and services produced by people from a country—whether in the country or not. Unlike the other methods, GNI essentially measures the wealth of a nation because it focuses on income, not output. As you will see in the discussion regarding global economic diversity, the World Bank now uses GNI to classify nations according to economic status.
For practical purposes, it is not vital to memorize these definitions. However, it is important to be aware that these differences exist and to know what statistic you are examining, so that you do not accidentally compare, say, GDP in one year or for one country with GNP or NNP in another year or another country. To get an idea of how these calculations work, follow the steps in the following Work It Out feature.

### Key Concepts and Summary

Economists generally express the size of a nation’s economy as its gross domestic product (GDP), which measures the value of the output of all goods and services produced within the country in a year. Economists measure GDP by taking the quantities of all goods and services produced, multiplying them by their prices, and summing the total. Since GDP measures what is bought and sold in the economy, we can measure it either by the sum of what is purchased in the economy or what is produced.
We can divide demand into consumption, investment, government, exports, and imports. We can divide what is produced in the economy into durable goods, nondurable goods, services, structures, and inventories. To avoid double counting, GDP counts only final output of goods and services, not the production of intermediate goods or the value of labor in the chain of production.

### Self-Check Questions

### Review Questions

### Critical Thinking Question

### Problem

### References

U.S. Department of Commerce: Bureau of Economic Analysis. “National data: National Income and Product Accounts Tables.” http://bea.gov/iTable/iTable.cfm?ReqID=9&step=1.
U.S. Department of Commerce: United States Census Bureau. “Census of Governments: 2012 Census of Governments.”  http://www.census.gov/govs/cog/.
United States Department of Transportation. “About DOT.” Last modified March 2, 2012. http://www.dot.gov/about.
U.S. Department of Energy. “Energy.gov.” http://energy.gov/.
U.S. Department of Health & Human Services. “Agency for Healthcare Research and Quality.” http://www.ahrq.gov/.
United States Department of Agriculture. “USDA.” http://www.usda.gov/wps/portal/usda/usdahome.
Schneider, Friedrich. Department of Economics. “Size and Development of the Shadow Economy of 31 European and 5 other OECD Countries from 2003 to 2013: A Further Decline.” Johannes Kepler University. Last modified April 5, 2013. http://www.econ.jku.at/members/Schneider/files/publications/2013/ShadEcEurope31_Jan2013.pdf.


# The Macroeconomic Perspective

## Adjusting Nominal Values to Real Values

When examining economic statistics, there is a crucial distinction worth emphasizing. The distinction is between nominal and real measurements, which refer to whether or not inflation has distorted a given statistic. Looking at economic statistics without considering inflation is like looking through a pair of binoculars and trying to guess how close something is: unless you know how strong the lenses are, you cannot guess the distance very accurately. Similarly, if you do not know the inflation rate, it is difficult to figure out if a rise in GDP is due mainly to a rise in the overall level of prices or to a rise in quantities of goods produced. The nominal value of any economic statistic means that we measure the statistic in terms of actual prices that exist at the time. The real value refers to the same statistic after it has been adjusted for inflation. Generally, it is the real value that is more important.

### Converting Nominal to Real GDP

 shows U.S. GDP at five-year intervals since 1960 in nominal dollars; that is, GDP measured using the actual market prices prevailing in each stated year.  also reflects this data in a graph.
If an unwary analyst compared nominal GDP in 1960 to nominal GDP in 2010, it might appear that national output had risen by a factor of more than 38 over this time (that is, GDP of $20.9 trillion in 2020 divided by GDP of $543 billion in 1960 = 38). This conclusion would be highly misleading. Recall that we define nominal GDP as the quantity of every final good or service produced multiplied by the price at which it was sold, summed up for all goods and services. In order to see how much production has actually increased, we need to extract the effects of higher prices on nominal GDP. We can easily accomplish this using the GDP deflator.
The GDP deflator is a price index measuring the average prices of all final goods and services included in the economy. We explore price indices in detail and how we compute them in Inflation, but this definition will do in the context of this chapter.  provides the GDP deflator data and  shows it graphically.
 shows that the price level has risen dramatically since 1960. The price level in 2020 was seven times higher than in 1960 (the deflator for 2020 was 113 versus a level of 17 in 1960). Clearly, much of the growth in nominal GDP was due to inflation, not an actual change in the quantity of goods and services produced, in other words, not in real GDP. Recall that nominal GDP can rise for two reasons: an increase in output, and/or an increase in prices. What is needed is to extract the increase in prices from nominal GDP so as to measure only changes in output. After all, the dollars used to measure nominal GDP in 1960 are worth more than the inflated dollars of 2020—and the price index tells exactly how much more. This adjustment is easy to do if you understand that nominal measurements are in value terms, where
Let’s look at an example at the micro level. Suppose the t-shirt company, Coolshirts, sells 10 t-shirts at a price of $9 each.
Then,
In other words, when we compute “real” measurements we are trying to obtain actual quantities, in this case, 10 t-shirts.
With GDP, it is just a tiny bit more complicated. We start with the same formula as above:
For reasons that we will explain in more detail below, mathematically, a price index is a two-digit decimal number like 1.00 or 0.85 or 1.25. Because some people have trouble working with decimals, when the price index is published, it has traditionally been multiplied by 100 to get integer numbers like 100, 85, or 125. What this means is that when we “deflate” nominal figures to get real figures (by dividing the nominal by the price index). We also need to remember to divide the published price index by 100 to make the math work. Thus, the formula becomes:
Now read the following Work It Out feature for more practice calculating real GDP.
 shows the U.S. nominal and real GDP since 1960. Because 2005 is the base year, the nominal and real values are exactly the same in that year. However, over time, the rise in nominal GDP looks much larger than the rise in real GDP (that is, the nominal GDP line rises more steeply than the real GDP line), because the presence of inflation, especially in the 1970s exaggerates the rise in nominal GDP.
Let’s return to the question that we posed originally: How much did GDP increase in real terms? What was the real GDP growth rate from 1960 to 2012? To find the real growth rate, we apply the formula for percentage change:
In other words, the U.S. economy has increased real production of goods and services by nearly a factor of five since 1960. Of course, that understates the material improvement since it fails to capture improvements in the quality of products and the invention of new products.
There is a quicker way to answer this question approximately, using another math trick. Because:
Therefore, real GDP growth rate (% change in quantity) equals the growth rate in nominal GDP (% change in value) minus the inflation rate (% change in price).
Note that using this equation provides an approximation for small changes in the levels. For more accurate measures, one should use the first formula.

### Key Concepts and Summary

The nominal value of an economic statistic is the commonly announced value. The real value is the value after adjusting for changes in inflation. To convert nominal economic data from several different years into real, inflation-adjusted data, the starting point is to choose a base year arbitrarily and then use a price index to convert the measurements so that economists measure them in the money prevailing in the base year.

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# The Macroeconomic Perspective

## Tracking Real GDP over Time

When news reports indicate that “the economy grew 1.2% in the first quarter,” the reports are referring to the percentage change in real GDP. By convention, governments report GDP growth at an annualized rate: Whatever the calculated growth in real GDP was for the quarter, we multiply it by four when it is reported as if the economy were growing at that rate for a full year.
 shows the pattern of U.S. real GDP since 1930. Short term declines have regularly interrupted the generally upward long-term path of GDP. We call a significant decline in real GDP a recession. We call an especially lengthy and deep recession a depression. The severe drop in GDP that occurred during the 1930s Great Depression is clearly visible in the figure, as is the 2008–2009 Great Recession and the recession induced by COVID-19 in 2020.
Real GDP is important because it is highly correlated with other measures of economic activity, like employment and unemployment. When real GDP rises, so does employment.
The most significant human problem associated with recessions (and their larger, uglier cousins, depressions) is that a slowdown in production means that firms need to lay off or fire some of their workers. Losing a job imposes painful financial and personal costs on workers, and often on their extended families as well. In addition, even those who keep their jobs are likely to find that wage raises are scanty at best—or their employers may ask them to take pay cuts.
 lists the pattern of recessions and expansions in the U.S. economy since 1900. We call the highest point of the economy, before the recession begins, the peak. Conversely, the lowest point of a recession, before a recovery begins, is the trough. Thus, a recession lasts from peak to trough, and an economic upswing runs from trough to peak. We call the economy's movement from peak to trough and trough to peak the business cycle. It is intriguing to notice that the three longest trough-to-peak expansions of the twentieth century have happened since 1960. The most recent recession was caused by the COVID-19 pandemic. It started in February 2020 and ended formally in May 2020. This was the most severe recession since the 1930s Great Depression, but also the shortest. The previous recession, called the Great Recession, was also very severe and lasted about 18 months. The expansion starting in June 2009, the trough from the Great Recession, was the longest on record—ending 128 months with the pandemic-induced recession.
A private think tank, the National Bureau of Economic Research (NBER), tracks business cycles for the U.S. economy. However, the effects of a severe recession often linger after the official ending date assigned by the NBER.

### Key Concepts and Summary

Over the long term, U.S. real GDP have increased dramatically. At the same time, GDP has not increased the same amount each year. The speeding up and slowing down of GDP growth represents the business cycle. When GDP declines significantly, a recession occurs. A longer and deeper decline is a depression. Recessions begin at the business cycle's peak and end at the trough.

### Self-Check Questions

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### References

The National Bureau of Economic Research. “Information on Recessions and Recoveries, the NBER Business Cycle Dating Committee, and related topics.” http://www.nber.org/cycles/main.html.