Unit 10 · The Nation and the World

Picture a tiny island with one bakery and one bike shop. In one year the bakery sells 1,000 loaves at $3 each (example prices). That is $3,000. The bike shop sells 20 bikes at $200 each. That is $4,000. Add them up. The island made $7,000 worth of goods that year.

That total is the island’s gross domestic product, or GDP. GDP is the market value of all final goods and services made inside a country in one year. Final means sold to the last user. We count the bread, not the flour the baker bought. Counting the flour too would count it twice.

The United States works the same way, just much bigger. Economists add up spending on houses, haircuts, trucks, doctor visits and much more. The Bureau of Economic Analysis, a federal agency, measures U.S. GDP. A bigger GDP usually means more goods, more services and more jobs.

Think of a town where factories hire more workers each year. Stores are busy. People buy new cars. This is growth. If GDP is $100 billion one year and $103 billion the next (example numbers), it grew by $3 billion. That is 3% growth.

Sometimes spending slows. Stores sell less, so they order less from factories. Factories cut hours and lay off workers. Those workers spend less, and the slowdown spreads. A widespread drop in economic activity that lasts more than a few months is called a recession.

Over many years, the economy moves up and down in waves. Economists call this the business cycle. It has an expansion, when things grow, then a peak, then a contraction, and then a low point called a trough. After the trough, growth starts again. A common mistake is thinking every dip is a recession. A short, small wobble usually is not.

Go back to the island. Last year it made 1,000 loaves at $3. This year it made the same 1,000 loaves, but the price rose to $4 (example prices). GDP in dollars went from $3,000 to $4,000. Did the island make more bread? No. It made the same bread. Only the price changed.

GDP measured in current prices is called nominal GDP. It can rise just because prices rose. Real GDP uses the prices of one fixed year for every year. Using last year’s $3 price, this year’s real GDP is still $3,000. Real GDP shows the true change in how much was made.

When news reports say the economy grew 2%, they almost always mean real GDP. Mixing the two is a common mistake. If nominal GDP rose 5% and prices rose 3%, real output grew only about 2%.

Imagine a snack basket: a sandwich, an apple and a juice. Last year it cost $10. This year the same basket costs $10.50 (example prices). Prices rose $0.50 on $10. That is 5%. When prices across the economy go up like this, it is called inflation.

Inflation shrinks what a dollar can buy. That buying power is called purchasing power. If your allowance stays at $10 but the basket costs $10.50, you can no longer buy the whole basket. Your dollars did not change. What they can buy did.

Inflation happens for different reasons. Sometimes people and businesses want to buy more than the economy can make, so prices get pushed up. Sometimes costs like fuel jump, and businesses pass them on. The Federal Reserve aims for inflation of about 2% a year over time. A little inflation is normal. Fast inflation makes planning hard.

No one can check every price in the country. So the Bureau of Labor Statistics, or BLS, uses a sample. Each month it checks prices on a large basket of goods and services, like food, rent, gas, clothes and doctor visits. The result is the Consumer Price Index, or CPI.

The CPI starts from a base period set to 100. Suppose the basket’s index is 100 in the base year and 110 later (example numbers). Prices rose 10% since the base. To find inflation between any two years, use percent change. From 110 to 121 is a rise of 11. Divide 11 by 110. That is 10%.

The CPI is not perfect. People change what they buy when prices change. New products appear. Quality gets better. Still, the CPI is the most used price measure. Governments use it to adjust things like Social Security payments so they keep up with prices.

Picture a street with 10 adults. Six have jobs. Two have no job and are sending out applications. One is retired. One is a full-time college student who is not looking for work. Who is unemployed? Only the two who are looking.

The labor force is everyone who is working or looking for work. On this street, that is 6 + 2 = 8 people. The unemployment rate is the unemployed divided by the labor force, times 100. Here that is 2 / 8 x 100 = 25%. The retiree and the student are not in the labor force at all.

A common mistake is dividing by all adults. That would give 2 / 10 = 20%, which is wrong. The BLS finds the real rate each month with a large survey of households. The rate was about 25% in the worst year of the Great Depression and about 10% in late 2009.

Jordan earns $500 from a summer job. Some of it goes to income tax, a tax on what people earn. Then Jordan buys $40 of shoes. The store adds a sales tax, a tax on things you buy. At a rate of 6% (example rate), that adds $2.40. The shoes cost $42.40.

Jordan’s family owns a house. Each year they pay property tax, a tax based on the value of land and buildings. Property taxes pay for much of the local public schools in Illinois, along with state money. Your town and county use them for roads, parks and police too.

Different levels of government lean on different taxes. The federal government collects mostly income and payroll taxes. States use income and sales taxes. Local governments use property taxes the most. Each tax makes something a little costlier, so every tax has trade-offs.

Imagine the federal government spends $100 (a pretend round number). Where would it go? In recent years, about $21 went to Social Security. About $26 went to health programs such as Medicare and Medicaid. About $13 went to national defense. About $13 went to interest on money the government borrowed.

That leaves about $27 for everything else. Everything else includes highways, food aid, veterans’ benefits, science, national parks and much more. When the government spends more than it collects in taxes in a year, the gap is a deficit. It borrows to cover it, and the total borrowed over time is the debt.

Congress and the President decide the budget. This is called fiscal policy: choices about government spending and taxes. People disagree about how big the budget should be. Some say more spending helps people and builds roads and schools. Others say lower spending and taxes leave more for families and businesses. Both sides weigh trade-offs.

Two neighbors each buy $1,000 of goods and pay a 5% sales tax (example rate). Both pay $50. One neighbor earns $20,000 a year. The other earns $100,000. For the first, $50 is 0.25% of income. For the second, it is 0.05%. The same tax takes a bigger share from the lower income.

A tax that takes a larger share from lower incomes is called regressive. A tax that takes a larger share from higher incomes is progressive. The U.S. federal income tax is progressive: rates rise in steps as income rises. A tax that takes the same share from everyone is proportional, sometimes called a flat tax.

People argue about which kind is fairest. Some say those who earn more can afford to pay a larger share. Others say everyone should pay the same share, and that high rates discourage work and investment. Economists study how each design affects work, saving and fairness.

Think of the economy like a car on a long road. Too fast, and prices rise too quickly. Too slow, and people lose jobs. The Federal Reserve, often called the Fed, is the nation’s central bank. Congress created it with the Federal Reserve Act of 1913.

Congress gave the Fed two main goals, often called the dual mandate: maximum employment and stable prices. The Fed has a board in Washington, D.C., and twelve regional Reserve Banks. One is the Federal Reserve Bank of Chicago, which serves Illinois and nearby states.

The Fed’s main tool is a key interest rate that banks charge each other for overnight loans. When the Fed raises it, loans for cars, homes and businesses tend to cost more, so spending slows and inflation can cool. When the Fed lowers it, borrowing gets cheaper and spending can pick up. This is monetary policy. It is separate from fiscal policy, which is spending and taxes.

An Illinois farmer grows soybeans. A buyer in another country purchases a shipload. For the United States, those soybeans are an export, a good or service sold to people in another country. Illinois is one of the top soybean-growing states, so soybeans are a big Illinois export.

Now think of a banana at a Chicago grocery. Bananas grow in warm places, so most of ours come from other countries. For the United States, that banana is an import, a good or service bought from another country. Services count too. When a tourist from abroad stays in a Chicago hotel, that is a U.S. service export.

Every import for one country is an export for another. Trade happens because people want goods they cannot make well at home, or cannot make as cheaply. The U.S. both imports and exports trillions of dollars of goods and services each year.

Picture a small country that sells $50 billion of goods to the world and buys $70 billion (example numbers). Its trade balance is exports minus imports: $50 billion - $70 billion = -$20 billion. When the balance is negative, the country has a trade deficit. When it is positive, it has a trade surplus.

The United States has run a trade deficit for many years. That means Americans buy more from other countries than they sell to them. In GDP, this shows up as net exports, the NX in C + I + G + NX. A negative NX pulls measured GDP down a little.

A common mistake is to think a trade deficit is like losing a game. It is not that simple. Buyers still got goods they wanted in return for their money, and money spent abroad often comes back as investment. Economists disagree about when a deficit is a worry. Some point to lost factory jobs. Others say it reflects strong spending and foreign investment.

Imagine two countries, Northland and Southland. In a day, a Northland worker can make 6 shirts or 3 radios. A Southland worker can make 2 shirts or 2 radios (example numbers). Northland is better at both. Does trade still help? Yes. Look at what each gives up.

In Northland, 1 radio costs 2 shirts, because making it means giving up 2 shirts. In Southland, 1 radio costs only 1 shirt. So Southland has the lower opportunity cost for radios. For shirts, Northland gives up half a radio per shirt, while Southland gives up a whole radio. Northland has the lower cost for shirts.

A comparative advantage means making a good at a lower opportunity cost than someone else. Northland should make shirts and Southland radios. If they trade at, say, 1.5 shirts for 1 radio, both get radios or shirts more cheaply than making them at home. A common mistake is to think only the country that is better at everything should make anything.

A bike made in another country sells in the U.S. for $200 (example price). The government puts a 25% tariff on imported bikes. A tariff is a tax on imports. It is paid to the U.S. government by the company that brings the bike in. That is $50 per bike.

Who really bears that cost? The importer may raise the price toward $250. Then American buyers pay more. Some of the cost may be absorbed by the foreign maker or the store. Studies of recent U.S. tariffs found that much of the cost was passed to U.S. buyers. A common mistake is to think the foreign country simply pays the tax.

Tariffs have trade-offs. They can protect jobs at American bike makers, who now face less competition. They can raise money for the government. But buyers pay higher prices, and other countries may answer with tariffs on U.S. exports, such as Illinois soybeans. Economists debate when, if ever, the protection is worth the cost.

Sofia’s family visits Mexico. In Mexico, prices are in pesos, not dollars. At the bank, suppose 1 U.S. dollar trades for 20 pesos (example rate). That number is the exchange rate, the price of one currency in terms of another. Currency is simply a country’s money.

Sofia sees a T-shirt for 300 pesos. How many dollars is that? Divide by the rate: 300 / 20 = $15. She changes $100 at the bank. She gets 100 x 20 = 2,000 pesos. Always ask which way the rate goes. Multiply dollars by 20 to get pesos. Divide pesos by 20 to get dollars.

Exchange rates change every day. Traders buy and sell currencies, so the price moves with supply and demand. If more people want dollars, the dollar’s price rises. That is why a trip can cost more one year and less the next, even when prices in the other country stay the same.

Say the rate moves from 1 dollar = 20 pesos to 1 dollar = 25 pesos (example rates). Each dollar now buys more pesos. The dollar has become stronger. Sofia’s 300-peso T-shirt now costs 300 / 25 = $12 instead of $15. Trips and imports from Mexico got cheaper for Americans.

Now flip it. A Mexican family wants to buy a U.S. product that costs $100. At 20 pesos per dollar, that is 2,000 pesos. At 25, it is 2,500 pesos. The strong dollar made U.S. goods more expensive for them. So a strong dollar tends to help U.S. shoppers and travelers but can hurt U.S. exporters.

A weaker dollar does the opposite. U.S. exports get cheaper for other countries, so farmers and factories may sell more abroad. But imports and foreign trips cost Americans more. A common mistake is to think a strong dollar is simply good. Whether it helps depends on whether you are buying from abroad or selling to it.

Follow a phone backward. Before the store, it rode in a truck. Before that, a ship or plane. Before that, a factory put it together. Before that, other factories made the chips, the screen and the battery. Before that, mines dug up metals. All these steps together make a supply chain.

Companies spread the steps across countries to lower costs and use special skills. One place may have expert chip makers. Another may have many trained assembly workers. Another may have the mines. Using each place for what it does best is comparative advantage at work. Linking the world’s economies this way is called globalization.

Long supply chains have a weak spot. If one step stops, everything waits. During the COVID-19 pandemic, closed factories and crowded ports delayed many goods, and some prices rose. Since then, some companies have moved steps closer to home or found more than one supplier. That can add safety but also add cost.

Picture two farms. On one, a family digs by hand and grows enough to eat. On the other, a trained farmer uses a tractor, good seed and weather data, and grows food for hundreds of people. The second farm has much higher productivity: more output per worker per hour.

Productivity is the main reason some countries are richer. It grows with human capital, the skills and health of workers, and with physical capital, like tools, machines and roads. It also grows with new technology. Economists often compare countries using GDP per person, which is GDP divided by population.

Institutions matter too. Institutions are the rules of the game: fair courts, protected property, honest government and stable money. When people trust that they can keep what they earn, they build and invest. Trade helps by opening bigger markets and new ideas. No single recipe fits every country, and economists still debate which steps matter most.

Look at a map of the Midwest. Chicago sits where the Great Lakes come close to rivers that lead to the Mississippi. In the 1800s, canals and then railroads linked the city to farms to the west and cities to the east. Grain, lumber and livestock poured in. Chicago grew fast.

In 1848, traders founded the Chicago Board of Trade. It became a place to buy and sell grain, and later contracts for grain to be delivered in the future. Farmers and buyers used it to set prices and manage risk. It is now part of CME Group, and its prices are watched around the world.

Today Chicago is still a crossroads. Many major railroads meet there, and O’Hare Airport handles large amounts of air cargo. Illinois farms send soybeans and corn abroad, and Illinois factories export machinery. When world trade rises or falls, Chicago feels it quickly.

You started this course with wants and needs. Now you can see the whole world economy. Through it all, a few ideas kept coming back. Resources are scarce, so every choice has an opportunity cost. People respond to incentives, like prices, wages and taxes.

Trade helps both sides when each does what it gives up the least to do. Markets use prices to share information. Governments set rules, collect taxes and provide some goods. The Fed tries to keep prices steady and jobs plentiful. Each step has trade-offs, and wise choices name them.

Try it on a real question. Should your town build a new park? Ask what it costs, what else that money could do, who gains, who pays, and how people’s behavior might change. That set of questions is the economic way of thinking. You can use it at the store, at work and when you vote.