U.S. Economy

demand for the government to provide more and better transportation

services, such as super highways and modern airports. As the population

increased and became more prosperous, demand grew for government-financed

universities, museums, parks, and arts programs. In other words, as

incomes rose in the United States, people became more willing to be taxed

to support more of the kinds of programs that government agencies

provide.

Social changes have also contributed to the growing role of government.

As the structure of U.S. families changed, the government has

increasingly taken over services that were once provided mainly by

families. For instance, in past times, families provided housing and

health care for their elderly. Today, extended families with several

generations living together are rare, partly because workers move more

often than they did in the past to take new jobs. Also the elderly live

longer today than they once did, and often require much more

sophisticated and expensive forms of medical care. Furthermore, once the

government began to provide more services, people began to look to the

government for more support, forming special interest groups to push

their demands.

Some people and groups in the United States favor further expansion of

government programs, while others favor sharp reductions in the current

size and scope of government. Reliance on a market system implies a

limited role for government and identifies fairly specific kinds of

things for the government to do in the economy. Private households and

businesses are expected to make most economic decisions. It is also true

that if taxes and other government revenues take too large a share of

personal income, incentives to work, save, and invest are diminished,

which hurts the overall performance of the economy. But these general

principles do not establish precise guidelines on how large or small a

role the government should play in a market economy. Judging the

effectiveness of any current or proposed government program requires a

careful analysis of the additional benefits and costs of the program. And

ultimately, of course, the size of government is something that U.S.

citizens decide through democratic elections.

IX IMPACT OF THE WORLD ECONOMY Today, virtually every country

in the world is affected by what happens in other countries. Some of

these effects are a result of political events, such as the overthrow of

one government in favor of another. But a great deal of the

interdependence among the nations is economic in nature, based on the

production and trading of goods and services.

One of the most rapidly growing and changing sectors of the U.S. economy

involves trade with other nations. In recent decades, the level of goods

and services imported from other countries by U.S. consumers, businesses,

and government agencies has increased dramatically. But so, too, has the

level of U.S. goods and services sold as exports to consumers,

businesses, and government agencies in other nations. This international

trade and the policies that encourage or restrict the growth of imports

and exports have wide-ranging effects on the U.S. economy.

As the nation with the world’s largest economy, the United States plays a

key role on the international political and economic stages. The United

States is also the largest trading nation in the world, exporting and

importing more goods and services than any other country.. Some people

worry that extensive levels of international trade may have hurt the U.S.

economy, and U.S. workers in particular. But while some firms and workers

have been hurt by international competition, in general economists view

international trade like any other kind of voluntary trade: Both parties

can gain, and usually do. International trade increases the total level

of production and consumption in the world, lowers the costs of

production and prices that consumers pay, and increases standards of

living. How does that happen?

All over the world, people specialize in producing particular goods and

services, then trade with others to get all of the other goods and

services they can afford to buy and consume. It is far more efficient for

some people to be lawyers and other people doctors, butchers, bakers, and

teachers than it is for each person to try to make or do all of the

things he or she consumes.

In earlier centuries, the majority of trade took place between

individuals living in the same town or city. Later, as transportation and

communications networks improved, individuals began to trade more

frequently with people in other places. The industrial revolution that

began in the 18th century greatly increased the volume of goods that

could be shipped to other cities and regions, and eventually to other

nations. As people became more prosperous, they also traveled more to

other countries and began to demand the new products they encountered

during their travels.

The basic motivation and benefits of international trade are actually no

different from those that lead to trade within a nation. But

international trade differs from trade within a nation in two major ways.

First, international trade involves at least two national currencies,

which must usually be exchanged before goods and services can be imported

or exported. Second, nations sometimes impose barriers on international

trade that they do not impose on trade that occurs entirely inside their

own country.

A U.S. Imports and Exports

U.S. exports are goods and services made in the United States that are

sold to people or businesses in other countries. Goods and services from

other countries that U.S. citizens or firms purchase are imports for the

United States. Like almost all of the other nations of the world, the

United States has seen a rapid increase in both its imports and exports

over the last several decades. In 1959 the combined value of U.S. imports

and exports amounted to less than 9 percent of the country’s gross

domestic product (GDP); by 1997 that figure had risen to 25 percent.

Clearly, the international trade sector has grown much more rapidly than

the overall economy.

Most of this trade occurs between industrialized, developed nations and

involves similar kinds of products as both imports and exports. While it

is true that the U.S. imports some things that are only found or grown in

other parts of the world, most trade involves products that could be made

in the United States or any other industrialized market economies. In

fact, some products that are now imported, such as clothing and textiles,

were once manufactured extensively in the United States. However,

economists note that just because things were or could be made in a

country does not mean that they should be made there.

Just as individuals can increase their standard of living by specializing

in the production of the things they do best, nations also specialize in

the products they can make most efficiently. The kinds of goods and

services that the United States can produce most competitively for export

are determined by its resources. The United States has a great deal of

fertile land, is the most technologically advanced nation in the world,

and has a highly educated and skilled labor force. That explains why U.S.

companies produce and export many agricultural products as well as

sophisticated machines, such as commercial jets and medical diagnostic

equipment.

Many other nations have lower labor costs than the United States, which

allows them to export goods that require a lot of labor, such as shoes,

clothing, and textiles. But even in trading with other industrialized

countries—whose workers are similarly well educated, trained, and highly

paid—the United States finds it advantageous to export some high-tech

products or professional services and to import others. For example, the

United States both imports and exports commercial airplanes, automobiles,

and various kinds of computer products. These trading patterns arise

because within these categories of goods, production is further

specialized into particular kinds of airplanes, automobiles, and computer

products. For example, automobile manufacturers in one nation may focus

production primarily on trucks and utility vehicles, while the automobile

industries in other countries may focus on sport cars or compact

vehicles.

Greater specialization allows producers to take full advantage of

economies of scale. Manufacturers can build large factories geared toward

production of specialized inventories, rather than spending extra

resources on factory equipment needed to produce a wide variety of goods.

Also, by selling more of their products to a greater number of consumers

in global markets, manufacturers can produce enough to make

specialization profitable.

The United States enjoyed a special advantage in the availability of

factories, machinery, and other capital goods after World War II ended in

1945. During the following decade or two, many of the other industrial

nations were recovering from the devastation of the war. But that

situation has largely disappeared, and the quality of the U.S. labor

force and the level of technological innovation in U.S. industry have

become more important in determining trade patterns and other

characteristics of the U.S. economy. A skilled labor force and the

ability of businesses to develop or adapt new technologies are the key to

high standards of living in modern global economies, particularly in

highly industrialized nations. Workers with low levels of education and

training will find it increasingly difficult to earn high wages and

salaries in any part of the world, including the United States.

B Barriers to Trade Despite the mutual advantages of global

trade, governments often adopt policies that reduce or eliminate

international trade in some markets. Historically, the most important

trade barriers have been tariffs (taxes on imports) and quotas (limits on

the number of products that can be imported into a country). In recent

decades, however, many countries have used product safety standards or

legal standards controlling the production or distribution of goods and

services to make it difficult for foreign businesses to sell in their

markets. For example, Russia recently used health standards to limit

imports of frozen chicken from the United States, and the United States

has frequently charged Japan with using legal restrictions and allowing

exclusive trade agreements among Japanese companies. These exclusive

agreements make it very difficult for U.S. banks and other firms to

operate or sell products in Japan.

While there are special reasons for limiting imports or exports of

certain kinds of products—such as products that are vital to a nation’s

national defense—economists generally view trade barriers as hurting both

importing and exporting nations. Although the trade barriers protect

workers and firms in industries competing with foreign firms, the costs

of this protection to consumers and other businesses are typically much

higher than the benefits to the protected workers and firms. And in the

long run it usually becomes prohibitively expensive to continue this kind

of protection. Instead it often makes more sense to end the trade barrier

and help workers in industries that are hurt by the increased imports to

relocate or retrain for jobs with firms that are competitive. In the

United States, trade adjustment assistance payments were provided to

steelworkers and autoworkers in the late 1970s, instead of imposing trade

barriers on imported cars. Since then, these direct cash payments have

been largely phased out in favor of retraining programs.

During recessions, when national unemployment rates are high or rising,

workers and firms facing competition from foreign companies usually want

the government to adopt trade barriers to protect their industries. But

again, historical experience with such policies shows that they do not

work. Perhaps the most famous example of these policies occurred during

the Great Depression of the 1930s. The United States raised its tariffs

and other trade barriers in legislation such as the Smoot-Hawley Act of

1930. Other nations imposed similar kinds of trade barriers, and the

overall result was to make the Great Depression even worse by reducing

world trade.

C World Trade Organization (WTO) and Its Predecessors

As World War II drew to a close, leaders in the United States and other

Western nations began working to promote freer trade for the post-war

world. They set up the International Monetary Fund (IMF) in 1944 to

stabilize exchange rates across member nations. The Marshall Plan,

developed by U.S. general and economist George Marshall, promoted free

trade. It gave U.S. aid to European nations rebuilding after the war,

provided those nations reduced tariffs and other trade barriers.

In 1947 the United States and many of its allies signed the General

Agreement on Tariffs and Trade (GATT), which was especially successful in

reducing tariffs over the next five decades. In 1995 the member nations

of the GATT founded the World Trade Organization (WTO), which set even

greater obligations on member countries to follow the rules established

under GATT. It also established procedures and organizations to deal with

disputes among member nations about the trading policies adopted by

individual nations.

In 1992 the United States also signed the North American Free Trade

Agreement (NAFTA) with its closest neighbors and major trading partners,

Canada and Mexico. The provisions of this agreement took effect in 1994.

Since then, studies by economists have found that NAFTA has benefited all

three nations, although greater competition has resulted in some

factories closing. As a percentage of national income, the benefits from

NAFTA have been greater in Canada and Mexico than in the United States,

because international trade represents a larger part of those economies.

While the United States is the largest trading nation in the world, it

has a very large and prosperous domestic economy; therefore international

trade is a much smaller percentage of the U.S. economy than it is in many

countries with much smaller domestic economies.

D Exchange Rates and the Balance of Payments

Currencies from different nations are traded in the foreign exchange

market, where the price of the U.S. dollar, for instance, rises and falls

against other currencies with changes in supply and demand. When firms in

the United States want to buy goods and services made in France, or when

U.S. tourists visit France, they have to trade dollars for French francs.

That creates a demand for French francs and a supply of dollars in the

foreign exchange market. When people or firms in France want to buy goods

and services made in the United States they supply French francs to the

foreign exchange market and create a demand for U.S. dollars.

Changes in people’s preferences for goods and services from other

countries result in changes in the supply and demand for different

national currencies. Other factors also affect the supply and demand for

a national currency. These include the prices of goods and services in a

country, the country’s national inflation rate, its interest rates, and

its investment opportunities. If people in other countries want to make

investments in the United States, they will demand more dollars. When the

demand for dollars increases faster than the supply of dollars on the

exchange markets, the price of the dollar will rise against other

national currencies. The dollar will fall, or depreciate, against other

currencies when the supply of dollars on the exchange market increases

faster than the demand.

All international transactions made by U.S. citizens, firms, and the

government are recorded in the U.S. annual balance of payments account.

This account has two basic sections. The first is the current account,

which records transactions involving the purchase (imports) and sale

(exports) of goods and services, interest payments paid to and received

from people and firms in other nations, and net transfers (gifts and aid)

paid to other nations. The second section is the capital account, which

records investments in the United States made by people and firms from

other countries, and investments that U.S. citizens and firms make in

other nations.

These two accounts must balance. When the United States runs a deficit on

its current account, often because it imports more that it exports, that

deficit must be offset by a surplus on its capital account. If foreign

investments in the United States do not create a large enough surplus to

cover the deficit on the current account, the U.S. government must

transfer currency and other financial reserves to the governments of the

countries that have the current account surplus. In recent decades, the

United States has usually had annual deficits in its current account,

with most of that deficit offset by a surplus of foreign investments in

the U.S. economy.

Economists offer divergent views on the persistent surpluses in the U.S.

capital account. Some analysts view these surpluses as evidence that the

United States must borrow from foreigners to pay for importing more than

it exports. Other analysts attribute the surpluses to a strong desire by

foreigners to invest their funds in the U.S. economy. Both

interpretations have some validity. But either way, it is clear that

foreign investors have a claim on future production and income generated

in the U.S. economy. Whether that situation is good or bad depends how

the foreign funds are used. If they are used mainly to finance current

consumption, they will prove detrimental to the long-term health of the

U.S. economy. On the other hand, their effect will be positive if they

are used primarily to fund investments that increase future levels of

U.S. output and income.

X CURRENT TRENDS AND ISSUES

In the early decades of the 21st century, many different social, economic

and technological changes in the United States and around the world will

affect the U.S. economy. The population of the United States will become

older and more racially and ethnically diverse. The world population is

expected to continue to grow at a rapid rate, while the U.S. population

will likely grow much more slowly. World trade will almost certainly

continue to expand rapidly if current trade policies and rates of

economic growth are maintained, which in turn will make competition in

the production of many goods and services increasingly global in scope.

Technological progress is likely to continue at least at current rates,

and perhaps faster. How will all of this affect U.S. consumers,

businesses, and government?

Over the next century, average standards of living in the United States

will almost certainly rise, so that on average, people living at the end

of the century are likely to be better off in material terms than people

are today. During the past century, the primary reasons for the increase

in living standards in the United States were technological progress,

business investments in capital goods, and people’s investments in

greater education and training (which were often subsidized by government

programs). There is no evident reason why these same factors will not

continue to be the most important reasons underlying changes in the

standard of living in the United States and other industrialized

economies. A comparatively small number of economists and scientists from

other fields argue that limited supplies of energy or of other natural

resources will eventually slow or stop economic growth. Most, however,

expect those limits to be offset by discoveries of new deposits or new

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