U.S. Economy

circulation when commercial banks use their reserves to buy currency from

the Federal Reserve Bank.

Second, the regional Federal Reserve banks transfer funds for checks that

are deposited by a bank in one part of the country, but were written by

someone who has a checking account with a bank in another part of the

country. Millions of checks are processed this way every business day.

Third, the regional Federal Reserve Banks collect and analyze data on the

economic performance of their regions, and provide that information and

their analysis of it to the national Federal Reserve System. Each of the

12 regions served by the Federal Reserve banks has its own economic

characteristics. Some of these regional economies are concerned more with

agricultural issues than others; some with different types of

manufacturing and industries; some with international trade; and some

with financial markets and firms. After reviewing the reports from all

different parts of the country, the national Federal Reserve System then

adopts policies that have major effects on the entire U.S. economy.

By far the most important function of the Federal Reserve System is

controlling the nation’s money supply and the overall availability of

credit in the economy. If the Federal Reserve System wants to put more

money in the economy, it does not ask the Treasury to print more dollar

bills. Remember, much more money is held in checking and savings accounts

than as currency, and it is through those deposit accounts that the

Federal Reserve System most directly controls the money supply. The

Federal Reserve affects deposit accounts in one of three ways.

First, it can allow banks to hold a smaller percentage of their deposits

as reserves at the Federal Reserve System. A lower reserve requirement

allows banks to make more loans and earn more money from the interest

paid on those loans. Banks making more loans increase the money supply.

Conversely, a higher reserve requirement reduces the amount of loans

banks can make, which reduces or tightens the money supply.

The second way the Federal Reserve System can put more money into the

economy is by lowering the rate it charges banks when they borrow money

from the Federal Reserve System. This particular interest rate is known

as the discount rate. When the discount rate goes down, it is more likely

that banks will borrow money from the Federal Reserve System, to cover

their reserve requirements and support more loans to borrowers. Once

again, those loans will increase the nation’s money supply. Therefore, a

decrease in the discount rate can increase the money supply, while an

increase in the discount rate can decrease the money supply.

In practice, however, banks rarely borrow money from the Federal Reserve,

so changes in the discount rate are more important as a signal of whether

the Federal Reserve wants to increase or decrease the money supply. For

example, raising the discount rate may alert banks that the Federal

Reserve might take other actions, such as increasing the reserve

requirement. That signal can lead banks to reduce the amount of loans

they are making.

The third way the Federal Reserve System can adjust the supply of money

and the availability of credit in the economy is through its open market

operations—the buying or selling of government bonds. Open market

operations are actually the tool that the Federal Reserve uses most often

to change the money supply. These open-market operations take place in

the market for government securities. The U.S. government borrows money

by issuing bonds that are regularly auctioned on the bond market in New

York. The Federal Reserve System is one of the largest purchasers of

those bonds, and the bank changes the amount of money in the economy when

it buys or sells bonds.

Government bonds are not money, because they are not generally accepted

as final payment for goods and services. (Just try paying for a hamburger

with a government savings bond.) But when the Federal Reserve System pays

for a federal government bond with a check, that check is new

money—specifically, it represents a loan to the government. This loan

creates a higher balance in the government’s own checking account after

the funds have been transferred from the privately owned Federal Reserve

Bank to the government. That new money is put into the economy as soon as

the government spends the funds. On the other hand, if the Federal

Reserve sells government bonds, it collects money that is taken out of

circulation, since the bonds that the Federal Reserve sells to banks,

firms, or households cannot be used as money until they are redeemed at a

later date.

The Wall Street Journal and other financial media regularly report on

purchases of bonds made by the Federal Reserve and other buyers at

auctions of U.S. government bonds. The Federal Reserve System itself also

publishes a record of its buying and selling in the bond market. In

practice, since the U.S. economy is growing and the money supply must

grow with it to keep prices stable, the Federal Reserve is almost always

buying bonds, not selling them. What changes over time is how fast the

Federal Reserve wants the money supply to grow, and how many dollars

worth of bonds it purchases from month to month.

To summarize the Federal Reserve System’s tools of monetary policy: It

can increase the supply of money and the availability of credit by

lowering the percentage of deposits that banks must hold as reserves at

the Federal Reserve System, by lowering the discount rate, or by

purchasing government bonds through open market operations. The Federal

Reserve System can decrease the supply of money and the availability of

credit by raising reserve ratios, raising the discount rate, or by

selling government bonds.

The Federal Reserve System increases the money supply when it wants to

encourage more spending in the economy, and especially when it is

concerned about high levels of unemployment. Increasing the money supply

usually decreases interest rates—which are the price of money paid by

those who borrow funds to those who save and lend them. Lower interest

rates encourage more investment spending by businesses, and more spending

by households for houses, automobiles, and other “big ticket” items that

are often financed by borrowing money. That additional spending increases

national levels of production, employment, and income. However, the

Federal Reserve Bank must be very careful when increasing the money

supply. If it does so when the economy is already operating close to full

employment, the additional spending will increase only prices, not output

and employment.

Effect of Monetary Policies on the U.S. Economy

The monetary policies adopted by the Federal Reserve System can have

dramatic effects on the national economy and, in particular, on financial

markets. Most directly, of course, when the Federal Reserve System

increases the money supply and expands the availability of credit, then

the interest rate, which determines the amount of money that borrowers

pay for loans, is likely to decrease. Lower interest rates, in turn, will

encourage businesses to borrow more money to invest in capital goods, and

will stimulate households to borrow more money to purchase housing,

automobiles, and other goods.

But the Federal Reserve System can go too far in expanding the money

supply. If the supply of money and credit grows much faster than the

production of goods and services in the economy, then prices will

increase, and the rate of inflation will rise. Inflation is a serious

problem for those who live on fixed incomes, since the income of those

individuals remains constant while the amount of goods and services they

can purchase with their income decreases. Inflation may also hurt banks

and other financial institutions that lend money, as well as savers. In a

period of unanticipated inflation, as the value of money decreases in

terms of what it will purchase, loans are repaid with dollars that are

worth less. The funds that people have saved are worth less, too.

When banks and savers anticipate higher inflation, they will try to

protect themselves by demanding higher interest rates on loans and

savings accounts. This will be especially true on long-term loans and

savings deposits, if the higher inflation is considered likely to

continue for many years. But higher interest rates create problems for

borrowers and those who want to invest in capital goods.

If the supply of money and credit grows too slowly, however, then

interest rates are again likely to rise, leading to decreased spending

for capital investments and consumer durable goods (products designed for

long-term use, such as television sets, refrigerators, and personal

computers). Such decreased spending will hurt many businesses and may

lead to a recession, an economic slowdown in which the national output of

goods and services falls. When that happens, wages and salaries paid to

individual workers will fall or grow more slowly, and some workers will

be laid off, facing possibly long periods of unemployment.

For all of these reasons, bankers and other financial experts watch the

Federal Reserve’s actions with monetary policy very closely. There are

regular reports in the media about policy changes made by the Federal

Reserve System, and even about statements made by Federal Reserve

officials that may indicate that the Federal Reserve is going to change

the supply of money and interest rates. The chairman of the Federal

Reserve System is widely considered to be one of the most influential

people in the world because what the Federal Reserve does so dramatically

affects the U.S. and world economies, especially financial markets.

LABOR AND LABOR MARKETS

Labor includes work done for employers and work done in a person’s own

household, but labor markets deal only with work that is done for some

form of financial compensation. Labor markets include all the means by

which workers find jobs and by which employers locate workers to staff

their businesses. A number of factors influence labor and labor markets

in the United States, including immigration, discrimination, labor

unions, unemployment, and income inequality between the rich and poor.

The official definition of the U.S. labor force includes people who are

at least 16 years old and either working, waiting to be recalled from a

layoff, or actively looking for work within the past 30 days. In 1998 the

U.S. labor force included nearly 138 million people, most of them working

in full-time or part-time jobs.

Most people in the United States receive their income as wages and

salaries paid by firms that have hired individuals to work as their

employees. Those wages and salaries are the prices they receive for the

labor services they provide to their employers. Like other prices, wages

and salaries are determined primarily by market forces.

Labor Supply and Demand

The wages and salaries that U.S. workers earn vary from occupation to

occupation, across geographic regions, and according to workers’ levels

of education, training, experience, and skill. As with goods and services

purchased by consumers, labor is traded in markets that reflect both

supply and demand. In general, higher wages and salaries are paid in

occupations where labor is more scarce—that is, in jobs where the demand

for workers is relatively high and the supply of workers with the

qualifications and ability to do that work is relatively low. The demand

for workers in particular occupations depends largely on how much the

work they do adds to a firm’s revenues. In other words, workers who

create more products or higher-priced products will be worth more to

employers than workers who make fewer or less valuable products. The

supply of workers in any occupation is affected by the amount of time and

effort required to enter that occupation compared to other things workers

might do.

Workers seeking higher wages often learn skills that will increase the

likelihood of finding a higher-paying job. The knowledge, skills, and

experience a worker has acquired are the worker’s human capital.

Education and training can clearly increase workers’ human capital and

productivity, which makes them more valuable to employers. In general,

more educated individuals make more money at their jobs. However, a

greater level of education does not always guarantee higher wages.

Certain professions that demand a high level of education, such as

teaching elementary and secondary school, are not high-paying. Such

situations arise when the number of people with the training to do that

job is relatively large compared with the number of people that employers

want to hire. Of course this situation can change over time if, for

example, fewer young people choose to train for the profession.

Supply and demand factors change in labor markets, just as they do in

markets for goods and services. As a result, occupations that paid high

wages and salaries in the past sometimes become outdated, while entirely

new occupations are created as a result of technological change or

changes in the goods and services consumers demand. For example,

blacksmiths were once among the most skilled workers in the United

States; today, computer programmers and software developers are in great

demand.

The process of creative destruction carries over from product markets to

labor markets because the demand for particular goods and services

creates a demand for the labor to produce them. Conversely, when the

demand for particular goods or services decreases, the demand for labor

to produce them will also fall. Similarly, when new technologies create

new products or new ways of producing existing products, some workers

will have new job opportunities, but other workers might have to retrain,

relocate, or take new jobs.

Factors Affecting Labor Markets

Changes in society and in the makeup of the population also affect labor

markets. For example, starting in the 1960s it became more common for

married women to work outside the home. Unprecedented numbers of

women—many with little previous job experience and training—entered the

labor markets for the first time during the 1970s. As a result, wages for

entry-level jobs were pushed down and did not rise as rapidly as they had

in the past. This decline in entry-level wages was further fueled by huge

numbers of teens who were also entering the labor market for the first

time. These young people were the children of the baby boom of 1946 to

1964, a period in which the birth rate increased dramatically in the

United States. So, two changes—one affecting women’s roles in the labor

market, the other in the makeup of the age of the workforce—combined to

affect the labor market.

The baby boomers’ effects have continued to reverberate through the U.S.

economy. For example, starting salaries for people with college degrees

became depressed when large numbers of baby boomers started graduating

from college. And as workers born during the boom have aged, the work

force in the United States has grown progressively older, with the

percentage of workers under the age of 25 falling from 20.3 percent in

1980 to 14.3 percent in 1997.

By the 1990s, the women and baby boomers who first entered the job market

in the 1970s had acquired more experience and training. Therefore, the

aging of the labor force was not affecting entry-level jobs as it once

did, and starting salaries for college graduates were rising rapidly

again. There will be, however, other kinds of labor market and public

policy issues to face when the baby boomers begin to retire in the early

decades of the 21st century.

Immigration

Labor markets in the United States have also been significantly affected

by the immigration of families and workers from other nations. Most

families and workers in the United States can trace their heritage to

immigrants. In fact, before the 20th century, while the United States was

trying to settle its frontiers, it allowed essentially unlimited

immigration. see Immigration: A Nation of Immigrants. In these periods

the U.S. economy had more land and other natural resources than it was

able to use, because labor was so scarce. Immigration served as one of

the main remedies for this shortage of labor.

Generally, immigration raises national output and income levels. These

changes occur because immigration increases the number of workers in the

economy, which allows employers to produce more goods and services.

Capital resources in the economy may also become more valuable as

immigration increases. The number of workers available to work with

machines and tools increases, as does the number of consumers who want to

buy goods and services. However, wages for jobs that are filled by large

numbers of immigrants may decrease. This wage decline stems from greater

competition for these jobs and from the fact that many immigrants are

willing to work for lower wages than other U.S. workers.

Immigration into the United States is now regulated by a system of quotas

that limits the number of immigrants who can legally enter the country

each year. In 1964 Congress changed immigration policies to give

preference to those with families already in the United States, to

refugees facing political persecution, and to individuals with other

humanitarian concerns. Before that time, more weight had been placed on

immigrants’ labor-market skills. Although this change in policy helped

reunite families, it also increased the supply of unskilled labor in the

nation, especially in the states of California, Florida, and New York. In

1990 Congress modified the immigration legislation to set a separate

annual quota for immigrants with job skills needed in the United States.

But people with family members who are already U.S. citizens remain the

largest category of immigrants, and U.S. immigration law still puts less

focus on job skills than do immigration laws in many other market

economies, including Canada and many of the nations of Western Europe.

Discrimination

Women and many minorities have long faced discrimination in U.S. labor

markets. Employed women earn less, on average, than men with similar

levels of education. In part this wage disparity reflects different

educational choices that women and men have made. In the past, women have

been less likely to study engineering, sciences, and other technical

fields that generally pay more. In part, the wage differences result from

women leaving the job market for a period of years to raise children.

Another reason for the disparity in wages between men and women is that

there is still a considerable degree of occupational segregation between

males and females—for example, nurses are much more likely to be females

and dentists males. But even after allowing for those factors, studies

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