Changes

*Perform labor to earn wages.  This is how most people make most of their money.

*Perform labor to earn wages.  This is how most people make most of their money.

*Invest capital to earn interest.  This is what you can do once you save up some money.

*Invest capital to earn returns on the investment (usually in the form of interest on the money).  This is what you can do once you save up some money.

*Allow someone to use your land in exchange for rent.

*Allow someone to use your land in exchange for rent.

*Start a new business to earn profits.  But watch out here: 9 out of 10 new businesses fail!

*Start a new business to earn profits.  But watch out here: 9 out of 10 new businesses fail!

Sounds simple enough, right?  Look around you, and you’ll see people earning money each of the four above ways.  Mostly, you’ll see the first way: get a job and earn some wages.  That entails the least risk and is the easiest for most people.  Adults and teenagers often follow the path of least resistance, and often imitate others.  In economics, that means getting a job to work for a company.  It’s great until the economy goes through a downturn and you get "laid off" (fired), or the job becomes tiresome and tedious, or the boss fires you because he did not like something you said.  Then it’s not so great anymore.  But as a teenager you can earn money from someone else while you are learning how business works.  You need experience and savings before you can even try to make money the other three ways.

Sounds simple enough, right?  Look around you, and you’ll see people earning money each of the four above ways.  Mostly, you’ll see the first way: get a job and earn some wages.  That entails the least risk and is the easiest for most people.  Adults and teenagers often follow the path of least resistance, and often imitate others.  In economics, that means getting a job to work for a company.  It’s great until the economy goes through a downturn and you get "laid off" (fired), or the job becomes tiresome and tedious, or the boss fires you because he did not like something you said.  Then it’s not so great anymore.  But as a teenager you can earn money from someone else while you are learning how business works.  You may need experience and savings before you make money the other three ways.

Economists have their own terminology which, as you’ve seen in this course, is often different from common usage.  In economics, the basic terms of wages, interest, rent and profit are all redefined.  Here we go:

Economists have their own terminology which, as you’ve seen in this course, is often different from common usage.  In economics, the basic terms of wages, interest, rent and profit are all redefined.  Here we go:

“'''''[[Economic wages]]'''''” are payments for the worker’s opportunity cost of time.  When a student earns $7 per hour working for a dry cleaners, those wages are payments for his opportunity cost of time.  He could be working someone else making money.  The market rate of $7 implies that his time is worth that much at this stage in his life.

“'''''[[Economic wages]]'''''” are payments for the worker’s opportunity cost of time.  When a student earns $7 per hour working for a dry cleaners, those wages are payments for his opportunity cost of time.  He could be working someone else making money.

“'''''[[Economic rent]]'''''” is the payment for a perfectly inelastic input.  If increasing the payment does not increase the supply of the input, then this extra amount above cost is a “rent”.  It is similar, but not identical, to rent paid on scarce land.  Increasing the rent does not increase the supply the land.  The supply is fixed.  Don’t worry if you don’t understand this yet.  We’ll spend more time on it below.

“'''''[[Economic rent]]'''''” is the payment for a perfectly inelastic input.  If increasing the payment does not increase the supply of the input, then this extra amount above cost is a “rent”.  It is similar, but not identical, to rent paid on scarce land.  Increasing the rent does not increase the supply the land.  The supply is limited.

“'''''[[Interest]]'''''” is straightforward: it is the cost of the use of money over time.  If you borrow $10,000 for your business, then you have to pay interest (say 5% per year) for using that money.  The person who lent you the money wants something for it.  He’s not going to give it to you for free.

“'''''[[Interest]]'''''” is straightforward: it is the cost of the use of money over time.  If you borrow $10,000 for your business, then you have to pay interest (say 5% per year) for using that money.  The person who lent you the money wants something for it.  He’s not going to give it to you for free.

The opposite of "compounded" interest is "simple" interest.  In the above example, the total amount due the second year is $1000 plus 5% of $1000 (for the first year) plus another 5% of only the original $1000 (for the second year), for a total of $1100.  Notice how the total amount under compounded interest is always larger than the total amount using simple interest.

The opposite of "compounded" interest is "simple" interest.  In the above example, the total amount due the second year is $1000 plus 5% of $1000 (for the first year) plus another 5% of only the original $1000 (for the second year), for a total of $1100.  Notice how the total amount under compounded interest is always larger than the total amount using simple interest.

If you are saving money, then you want as much compounding of the interest as possible.  Ideally, you would like the interest on the money you save to be "compounded daily," such that each day's interest is on a total amount that includes all the interest that has accumulated for prior days.

If you are saving money, then you want as much compounding of the interest as possible.  Ideally, you would like the interest on the money you save to be "compounded daily," such that each day's interest is on a total amount that includes the interest that should have accumulated for the prior day too.

Sometimes people repay money all at once, rather than with interest payments.  Suppose I gave you $1000 and you promised to pay me back $1500 in 10 years.  Then economists ask, what is the “rate of return” or “yield” on that investment?

Sometimes people repay money all at once, rather than with interest payments.  Suppose I gave you $1000 and you promised to pay me back $1500 in 10 years.  Then economists ask, what is the “rate of return” or “yield” on that investment?

So $100 to be paid five years from now is the same thing as receiving only $78.35 today.  That’s due to the effect of the time value of money.

So $100 to be paid five years from now is the same thing as receiving only $78.35 today.  That’s due to the effect of the time value of money.

==Investment Decisions==

==Investment Decisions==

Ask yourself what the time value of the added income is.  It equals:

Ask yourself what the time value of the added income is.  It equals:

:($2000/1.10) + ($2000/(1.10x1.10)) = $1818.18 + $1652.89 = 3471.07

:($2000/1.10) + ($2000/(1.10x1.10)) = $1818.18 + $1652.89 = $3471.07

Look again at its cost.  What is your best decision?  Don’t buy it.

Look again at the cost of the new machine ($3500).  What is your best decision?  Don’t buy it, because it would bring in less money than it costs.

== Banking and the Federal Reserve System ==

== Banking and the Federal Reserve System ==

Long ago the economy relied on "commodity monies," which consisted of a commodity (such as silver or gold) serving the function of money.  To buy food or pay rent, someone would pay with silver or gold pieces.  But now we use "bank-debt money," such as paper dollars.  Special markings on each dollar bill signify which of the 12 Federal Reserve banks issued that dollar bill.

Long ago the economy relied on "commodity monies," which consisted of a commodity (such as silver or gold) serving the function of money.  To buy food or pay rent, someone would pay with silver or gold pieces.  But now we use "bank-debt money," such as paper dollars.  Special markings on each dollar bill signify which of the 12 Federal Reserve banks issued that dollar bill.

The Federal Reserve is supposed to protect the banking system against collapse, while also managing the system in an optimal manner.  It has three basic tools for doing this.  First, the "Fed" can modify the required percentage of deposits that banks must hold in reserves, in case many depositors wanted to withdraw their money at the same time.  This may surprise you but banks ordinarily keep only a small percentage of customer deposits on hand; the vast majority of the deposits are loaned by banks to other people at a higher interest rate than what they are paying the depositors.  This is how a bank makes money and can still pay interest to depositors.  To guard against a "run on the bank" (when many depositors panic and demand to withdraw all their money at once), the Federal Reserve (the "Fed") can increase the percentage that banks must keep on reserves.  Such an increase has the effect of "tightening the money supply," or making money more scarce.

The Federal Reserve is supposed to protect the banking system against collapse, while also managing the system in an optimal manner.  It has three basic tools for doing this.  First, the "Fed" can modify the required percentage of deposits that banks must hold in reserves, in case many depositors wanted to withdraw their money at the same time.  This may surprise you: banks ordinarily keep only a small percentage of customer deposits on hand.  The vast majority of the deposits are loaned by banks to other people at a higher interest rate than what they are paying the depositors.  This is how a bank makes money and can still pay interest to depositors.  To guard against a "run on the bank" (when many depositors panic and demand to withdraw all their money at once), the Federal Reserve (the "Fed") can increase the percentage that banks must keep on reserves.  Such an increase has the effect of "tightening the money supply," or making money more scarce.

The second policy tool -- and the one that attracts the most attention -- is when the Fed changes the interest rate it charges (its "discount rate") to banks.  The higher that rate, the higher the interest becomes for many other types of borrowing, from mortgages to deposit rates.  Increasing interest rates also reduces the supply of money, making it harder to obtain mortgages and business loans.

The second policy tool -- and the one that attracts the most attention -- is when the Fed changes the interest rate it charges (its "discount rate") to banks.  The higher that rate, the higher the interest becomes for many other types of borrowing, from mortgages to deposit rates.  Increasing interest rates also reduces the supply of money, making it harder to obtain mortgages and business loans.