Economics for Educators Revised Edition Lessons 13 & 14 and 5E Model
Robert F. Hodgin, Ph.D. Texas Council on Economic Education
ii Economics for Educators, Revised
Copyright © 2012 Texas Council on Economic Education All Rights Reserved
Texas Council on Economic Education
75 Economics for Educators, Revised
Lesson 13: Money and Prices Money Imagine a long-ago time where money as we know it did not exist. Consider a desert scene where two haggling nomads try to barter one ox for an equivalent value in food and clothing. Then multiply that vision times every transaction in the land. Money’s invention as a medium of exchange was destined to occur as a solution to inefficient bartering. Yet, that “solution” is not perfect. True coinage in the form of imprinted metal, commonly silver or gold pieces of predetermined weight, is first attributed to the kings of Lydia around the 8th century B.C. From that era forward, the means of exchange became more efficient as money’s use lowered the barriers of barter. Coinage, with all the benefits of dramatically reduced transaction costs in economic exchanges, also carries with it the scourge of fraud and debasement. As a practical matter, money’s use as a medium of exchange is validated when parties accept as payment coins and currency they believe others will honor.
Roles of Money � Medium of exchange—permits commodity values to be easily divided � Measure of value—a standard way to meter value � Store of value—easily kept for later use � Means of deferred payment—recognized as valid for future payment
Characteristics of Money � Stable in value Durable � Portable Uniform in unit size � Divisible into units Recognizable
Measuring Inflation In a barter economy, where the mutual exchange of goods occurs in the absence of an accepted money form, it is logically impossible for general prices to rise. There can be no inflation in a barter economy because each transaction involves commodity exchange equivalents uniquely defined by the parties in each transaction. Absent a common money form as a measure of value, a good’s worth in one exchange has no effect on other barter transactions.
Texas Council on Economic Education
In advanced economies like the US, the dollar as designated currency meets all requirements to qualify as money. Checkable accounts in banks also have emerged as a large component of the US money supply over the past 100 years. The wide acceptance of checks as payment makes them money. Currency and coins comprise about 50 percent of what is defined and accepted as money. Checking deposits in commercial banks made up the 50 percent remainder of the US money supply of $1,832.42 billion in
76 Economics for Educators, Revised
2010. In 1913, the US centralized control of the US money supply control through the Federal Reserve Act. Since that time, it has been the prime responsibility of the Federal Reserve System (the Fed) leadership to manage the volume of money in circulation. Inflation often can be traced to a common source—excess money compared to the quantity of money households hold to purchase goods and services in an economy. To the extent that is true, if the central monetary authority successfully controls the money supply, it can strongly influence the overall level of prices and interest rates in an economy.
Inflation–a rise in the average level of prices; equivalently, a fall in the value of the money supply. As long as the purchasing power of the money held by the public changes so slowly that it does not alter perceptions of the future, the economy functions effectively. But when prices begin to increase at a rate that is unanticipated and too rapidly erodes the currency’s purchasing power, citizens begin to panic as institutional processes falter. The difficulty with unanticipated inflation is that it assaults our usual protections against it. For example, if you open a savings account making annual deposits that earn 5 percent toward the expected cost of sending your child to college and average consumer prices begin rising unexpectedly at 10 percent annually, your prior expectations of affording those future college-related expenses evaporate.
US Consumer Price Index [CPI] Year US CPI-U Percentage Price Change 2009 to 2010
1982-1984 100.02009 217.22010 220.3
(220.3 – 217.2) X 100 = 0.47%
217.2 Source: www.BLS.gov
The US Bureau of Labor Statistics is charged with the task of measuring inflation. Among several related measures is the popular consumer price index (CPI). The BLS also tracks other price indexes like the producer price index, the wholesale price index and the GDP deflator, the broadest of the inflation measures.
Consumer Price Index (CPI)–a measure of the average change in prices over time, paid by urban consumers for a market basket of goods and services.
The idea behind the CPI is to measure consistently the price of representative consumer purchases in a particular year compared to prices for the same items prevailing in a “base” year. The CPI market basket contains 200 goods and services in 8 major groups. From the table above, in 2009, average consumer prices were 117.2% higher than in 1982-1984. As a consequence, to have the same purchasing power in 2009 as in 1982-1984, your income would need to more than double over that same period. Between 2009 and 2010, average consumer prices rose less than one-half of one percent (see table above). The “base” year choice for a given price index series is arbitrary and does not alter the results.
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US Gross Domestic Product Deflator
Year Current GDP (Billions)
GDP Deflator(2005 = 100%)
Real GDP(Billions)
2009Q4 $14,277.3 1.09665 $14,277.3 / 1.09665 = $13,019.0
2010Q4 $14,870.4 1.11118 $14,870.4 / 1.11118 = $13,382.6
Source: www.BEA.gov The CPI adjusts for prices in a consumer’s market basket of goods. A different index (see the table above), the GDP Deflator is used to adjust prices for all goods and services produced. A base year, currently 2005, is selected and subsequent year’s GDP output is valued using the 2005 base year prices. Using that technique allows the government to measure real GDP—actual goods and services produced, without the effect of price changes. Inspect the “GDP Deflator” column in the table to see that 2010 4th quarter prices are 11.1% greater than in the 2005 base period. To adjust the 2010Q4 current dollar value GDP figure (where both output and prices have changed from 2005) divide the 2010Q4 deflator value into the current GDP of $14,870.4 to get $13,382.6 billion in real GDP. Hence, between 2009 and 2010 fourth quarters, US real GDP grew by $363.6 billion ($13,382.6 minus $13,019.0). Inflation’s Winners and Losers While it is easy to typecast inflation as evil, in moderation—about 2 or 3 percent per year—it has beneficial economic effects. Entrepreneurs like modest inflation when they decide to invest, because they expect higher prices for their company’s product in the future. Some leading economists credibly claim that moderate expected inflation helps stimulate economic growth. The difficulty with inflation is its drain on purchasing power and wealth among citizens and institutions in the economy. There are recognizable groups who lose and other groups who gain from inflation. Persons on fixed incomes, or whose incomes increase much less rapidly than the inflation rate, lose relative purchasing power through time. Creditors also can fall into the category of inaccurate inflation forecasters. If a bank or mortgage company lends funds at 5 percent per year and the inflation rate over time turns out to be 5 percent annually, the lender will be paid back a fixed quantity of money with the same purchasing power as was loaned. But if future inflation is greater than 5 percent, the lender is paid back in dollars of lesser purchasing power. Taxpayers can also lose during inflationary times in a more subtle way. An inflated personal income level can fall into higher tax bracket, making the tax filer pay more federal tax dollars.
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Inflation’s winners appear as debtors who can pay off loans in less valuable dollars, especially if their own incomes are among those keeping pace with the inflation rate. Owners of inflation-sensitive assets often win during inflationary times when they sell the price-inflated asset. Landowners and homeowners may see the value of their homes rise, though their property taxes also may increase.
78 Economics for Educators, Revised
Taxing authorities may gain from inflation, for example, through property taxes based on current appraised valuations, if the taxation method does not adjust for inflation’s effect. Controlling Inflation Moderate and relatively steady inflation of a few percentage points per year does not appear to be detrimental and can help stimulate economic growth. But at what point does a relatively benign inflation rate become worrisome or destructive? The US record during the 1970s shows that inflation rates above 10 percent per year cause significant resource dislocations, arbitrary redistributions of wealth and general unrest. Labor unions during that time discovered that attempts to neutralize inflation’s effects by holding out for wage increases equal to expected inflation will ultimately fail if future prices rise faster than the newly bargained wages. Two serious risks for government policy makers are that the inflation will become institutionalized, so strongly built-in to contracts, interest rates and expectations that reducing inflation becomes extremely difficult, or reach uncontrollable levels that literally exhaust the economy as citizens rush about making hasty transactions and seeking shelter from exploding prices. World events for other countries have shown that hyperinflation episodes, where annual inflation rates crest 100 percent or more, destroy confidence in the government as businesses, citizens and institutions fail to cope. An excessively high inflation rate must be addressed via an equally heavy “cure”. The economic and political costs of getting prices under control can be large, yet not taking action can be ruinous. The government faces the dilemma of launching a credible anti-inflationary program when they are perceived as most responsible for the inflationary spiral. Fundamentally, the central monetary authority must consistently reduce the volume of money in the economy. Unfortunately, the economic price of a restrictive money policy usually is a recession, perhaps a deep one. Harsh and sustained reductions in the money supply make nominal GDP fall as companies lay off workers due to uncertainty about future economic adjustments and the central bank’s will to sustain its anti-inflationary stance. More, the policy-induced poor business outlook makes investment fall even as inflation-padded interest rates remain stubbornly high. The recession’s length and depth will directly reflect how long it takes people and institutions to dismantle the inflationary protections they erected during the period of rising prices and to, once again, regain their pre-inflation level of social trust.
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In Sum
� Money is denoted by the government as legal tender and the public validates it by honoring it in transactions.� Money fulfills its role as a useful medium of exchange as long as its value does not change rapidly.� Inflation cannot manifest in a barter economy because each transaction involves different commodities and different people.� Inflation is a rise in the general level of prices over time.� Consumer goods inflation is measured by the Consumer Price Index (CPI) as the change in value from a given base year for
a market basket of typical goods.� The GDP Deflator is used to adjust all of a given year’s GDP to the prices prevailing in another year.� Inflation’s “winners” and “losers”
o “Winners” include debtors, tax collectors, holders of inflating real assetso “Losers” include creditors, fixed income earners, income tax payers
� Inflation nearly always owes its origin to prior increases in the money supply.� “Curing” inflation requires systematic and consistent reduction in the money supply, which can cause a recession.
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� “Hyper-inflation” is particularly damaging because it is very difficult to break and overwhelms economic institutions.
80 Economics for Educators, Revised
Lesson 14: Money and Interest Rates
Money’s Official Definitions The US government officially denotes the dollar as currency to be legal tender and society validates that designation by accepting it in exchange for goods and services. With the rise of banking as an institution, checks—legal instruments accepted for payment called demand deposits—have found their way into the operational definition of money. Printing physical currency and stamping coins is the responsibility of the US Treasury. Accommodating the volume of money the economy needs is the duty of the Federal Reserve System, the US central bank. The difficulty in defining and controlling money in the economic system is due to the many creative ways people can use cash or “near” cash. Demand deposits (checking accounts) pass as a medium of exchange. It is less clear how to interpret “checkable” savings deposits that earn some nominal interest rate. The discerning question becomes at what point is money closer to an illiquid asset versus easily accessible cash? These and related questions compel economists to adopt more than one money definition.
M1 = (coins & currency) + demand deposits = $1,832.2 billion, held by the general public in January 2010. M2 = M1 + savings accounts and checkable time deposits, held by the general public = $8,816.4 billion in January 2010.
Money is Not Credit
Many Americans seem to think that credit cards are money. The truth is they are not. Credit cards are short-term promissory notes permitting the holder a line of credit for a fee called interest. The monthly balance on the credit card is paid using money, commonly a personal check drawn against the cardholder’s bank account, a demand deposit. The credit card balance, a short-term loan, can for a while, run ahead of the cardholder’s ability to pay the total balance in money—check or cash. Over time, either the cardholder’s credit balance is paid in full or the consequences range from card cancellation to personal bankruptcy. Indiscriminate credit card users also pay higher interest rates. Money’s Scarcity Preserves Its Value Goods and services satisfy basic human needs. Money is merely a means to economic ends. If the central monetary authority were to increase the money supply so that each citizen could fill their pockets and purses with it, then prices for goods would rise dramatically as shop owners witnessed a mad rush of cash-laden customers scrambling to outbid their neighbors for available goods. Ruinous inflation would inevitably result.
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The practical objective of the central monetary authority is to supply the economy with a quantity of money that satisfies the needs of commerce, and no more. As average prices rise, the value of the dollar falls, and the opposite is true. Preserving a currency’s value and moderating average prices, requires the monetary authority to maintain a relatively constant ratio between the volume of goods and services produced and the quantity of money in circulation. So why is this objective so difficult to achieve? Market economies are dynamic, leaky and fickle. First, business momentum can bring unanticipated swings in overall activity. Second, money leaks outside of the economy through international transactions, especially when the US buys more from other countries than it sells to them. Perhaps most vexing of all, the amount of money businesses and households hold—the demand for liquidity—to meet transactions needs and uncertainty is entirely up to them. Changes in the quantity of money held can be unexpected, swift and large. These three forces: economic shifts, currency leakages and changes in money demand, make knowing how much money the economy needs difficult to predict and to accommodate. Time’s Value is the Interest Rate The interest rate is the measure that links the value of an economic good tomorrow to its value today. In normal economic times the rate is positive, indicating that if we choose to wait for a future good, we insist on some reward for doing so. At the personal level, it makes sense to keep a certain amount of our income in a checking account where the money is immediately accessible but earns little or no interest. It is also prudent to keep some money in a savings account, where funds are somehow restricted but earn a higher interest return. Savings accounts offer a positive interest rate to entice savers to deposit funds into financial institutions. We each carry a personal interest rate with us and it shows up in our current consumption-to-saving behavior. If we consistently spent all of our income today, we would be showing little preference for the future. Then by implication, our personal interest rate must be higher than the market savings rate. If, instead, we engage in a steady savings plan with some of our after-tax income that earns 4% in a certificate of deposit, then our personal interest rate for short-term savings must be less than 4 percent. The interest rate similarly serves to allocate business investment spending. Before making an investment, business decision-makers analyze the proposition by estimating the expected future dollar profit returns as a percentage of the total investment cost in today’s dollars. They then compare that rate of return to the interest rate cost of borrowing. If the anticipated investment rate of return exceeds the cost of borrowing, the investment may be a good one. To the extent that an investment pays a return above all costs including the cost of borrowing, today’s income gets converted into tomorrow’s wealth.
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Funds for investment come from household savings, business savings (as undistributed corporate profits). Without savings somewhere in the economy, investment is not possible. The prevailing interest rate represents the macro trade-off between consumption today and consumption tomorrow. From the saver’s view, it is the reward for postponing consumption today. From the borrower’s view, it is the cost of gaining command over resources today rather than waiting until tomorrow. In the financial marketplace, as net savers supply funds and net borrowers demand funds—the market rate of interest is determined.
82 Economics for Educators, Revised
Banks and financial markets exist to permit the orderly transfer of funds from holders of excess income to borrowers with a deficit of available funds. Interest rates, as a cost of credit and as a reward for not consuming, are determined in financial markets by the interplay between demanders of loanable funds and the suppliers of loanable funds. In Sum � M1, the official money supply definition equals coin + currency in circulation, bank vault cash plus demand deposits in commercial
banks.� Credit cards are not money. Credit cards are short-term financial contracts mandating repayment with interest.� The central bank’s main objective is to preserve the value of the currency by providing only that amount necessary to meet the
needs of commerce as it helps the economy achieve full employment.� As average prices rise, the value of the currency falls and as average prices fall, the value of the currency rises.� The interest rate simultaneously is a reward for saving and a cost of borrowing to invest. � The orderly interaction of savers and borrowers through the financial system determines the interest rate.
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� Leakages of money out of the economic system, swings in economic activity and changing demands to hold money make controlling the money supply difficult for the central monetary authority.
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Page
| 41
Less
on 1
3M
oney
an
d P
rice
s, p
age
& L
esso
n 1
4 M
oney
an
d I
nte
rest
Rat
es,
pag
e 8
0
Eng
age
Bef
ore
clas
s, p
repa
re 1
00 “
mon
opol
y m
oney
” si
zed
$1 b
ills.
You
will
use
exa
ctly
50
at a
tim
e. (
Kee
p th
em for
use
in a
ll cl
asse
s.)
Als
o ac
quire
two
iden
tical
obj
ects
th
at m
ight
cos
t ab
out
$1.0
0, t
hat
stud
ents
sho
uld
wan
t (p
en,
mec
hani
cal p
enci
l, ca
ndy
bar
etc.
).
Ask
the
cla
ss if
any
one
thin
ks,
in g
ener
al,
they
eve
r ha
ve “
enou
gh”
mon
ey?
Then
pas
s ou
t H
ALF
of
the
$1 b
ills
(exa
ctly
hal
f—50
of th
em)
rand
omly
to
stud
ents
. Som
e ge
t no
ne o
r 1,
som
e ge
t 2
or 3
(th
at’s
life
!).
Then
hav
e th
e st
uden
ts “
bid”
on
the
obje
ct b
ased
on
the
(fak
e) m
oney
the
y ha
ve in
th
eir
hand
s. H
owev
er,
NO
“po
olin
g” o
f fu
nds
betw
een
stud
ents
is a
llow
ed.
Aw
ard
the
obje
ct t
o th
e hi
ghes
t bi
dder
and
TAKE
the
bidd
er’s
mon
ey.
The
n w
rite
the
PR
ICE
for
whi
ch t
he o
bjec
t so
ld o
n th
e bo
ard.
Of
cou
rse,
th
e an
swer
is “
no.
”
Exp
lore
Now
han
d ou
t th
e ot
her
HALF
of
the
$1 b
ills,
by
givi
ng e
ach
stud
ent
who
hol
ds o
ne
or m
ore
bills
DO
UBLE
the
am
ount
the
y ha
ve (
less
the
price
pai
d fo
r th
e fir
st o
bjec
t)
Then
rev
eal t
he s
econ
d (a
nd id
entic
al)
obje
ct a
nd a
uctio
n it
off as
bef
ore.
Ask
the
cla
ss w
hy t
his
occu
rred
and
list
the
ir r
espo
nse(
s).
The
win
nin
g b
id p
rice
WIL
L b
e h
igh
er t
han
th
e p
rio
r w
inn
ing
bid
! W
rite
it o
n
the
bo
ard
.
Of
cou
rse,
th
e am
ou
nt
of
mon
ey d
oub
led
so
the
pri
ce w
ent
up
. I
f th
at
occ
urr
ed f
or
all g
oo
ds
in t
he
eco
no
my,
we
wo
uld
cal
l it
infl
atio
n.
Be
sure
to
lin
k th
at d
edu
ctio
n d
irec
tly
to t
he
volu
me
of
mo
ney
in c
ircu
lati
on
!
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770
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Fax
: (71
3)65
5-16
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ail:
tcee
@ec
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| 42
Exp
lain
Ask
the
stu
dent
s to
write
dow
n w
hat
they
saw
hap
peni
ng.
Ask
the
m if
the
pro
duct
had
cha
nged
in a
ny w
ay,
shap
e or
for
m?
W
hy h
ad t
he
pric
e ch
ange
d?
Ask
the
stu
dent
s w
hat
this
cha
nge
was
cal
led?
Ask
whe
n th
e va
lue
of m
oney
was
gre
ater
-the
first
rou
nd o
r th
e se
cond
and
why
.
Then
mak
e th
e p
oin
t th
at I
F p
eop
le r
ecei
ve m
ore
mo
ney
th
an t
hey
per
ceiv
e th
ey n
eed
, th
ey w
ill t
ry t
o s
pen
d it
: ei
ther
by
mak
ing
mo
re p
urc
has
es o
r m
akin
g m
ore
inve
stm
ents
; in
eit
her
cas
e th
at a
ctio
n d
rive
s u
p t
he
pri
ce o
f th
e g
ood
.
So,
wh
ile a
sin
gle
per
son
MA
Y b
e ab
le t
o sp
end
th
eir
exce
ss c
ash
wit
ho
ut
con
seq
uen
ces
(a r
ise
in p
rice
s);
all
peo
ple
in
th
e ec
on
om
y ca
nn
ot
do
so
. T
his
is
th
e p
arad
ox
of in
flat
ion
!
The
valu
e o
f m
on
ey w
as g
reat
er t
he
firs
t ro
un
d b
ecau
se t
he
stu
den
ts c
ou
ld
bu
y th
e o
bje
ct f
or
hal
f th
e am
ou
nt
of
the
seco
nd
ro
un
d.
Exte
nd
So
then
ask
the
cla
ss “
how
muc
h” m
oney
rea
lly I
S e
noug
h to
hav
e in
an
econ
omy?
[L
ist
resp
onse
s on
the
boa
rd.]
Use
the
MV =
PQ
exp
ress
ion
to d
emon
stra
te t
he g
ener
al r
elat
ions
hip
usin
g th
e ta
ble
belo
w.
Rec
all f
rom
thi
s Le
sson
tha
t V is
rel
ativ
ely
cons
tant
. A
lso
let
the
clas
s kn
ow y
ou w
ill a
ssum
e th
e ec
onom
y is
alrea
dy a
t FU
LL e
mpl
oym
ent
(Q =
Rea
l GD
P =
500
), s
o Q
will
cha
nge
from
tha
t le
vel.
Sol
ve f
or P
in e
ach
period
and
not
ice
the
upw
ard
Pric
e tr
end
from
Per
iod
1.
Period
M X
V
=
P X
Q
= N
omin
al G
DP
1
$100
5
?
$500
=
$
500
(B
ase
year
)2
$150
5
?
$500
=
$
750
3 $2
00
5
? $5
00
= $
1,00
0
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5-16
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ail:
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@ec
onom
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exas
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icst
exas
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The
real
ity
is t
hat
it is
no
t so
mu
ch t
he
shee
r vo
lum
e o
f m
on
ey,
bu
t th
e ra
te o
f it
s in
crea
se (
cau
sin
g i
nfl
atio
n)
ove
r ti
me
or
the
rate
of
dec
reas
e (c
ausi
ng
a
rece
ssio
n)
ove
r ti
me
that
is im
po
rtan
t.
Hen
ce,
the
mo
net
ary
auth
ori
ties
mu
st
man
age
the
mo
ney
su
pp
ly s
o t
hat
bu
sin
ess
nee
ds
are
met
bu
t n
o m
ore
(an
d
no
less
).
Page
| 43
Sol
uti
on
s fo
r P
are
:
Per
iod
P
1
1
.0 B
ase
year
2
1.5
[In
flat
ion
= (
$7
50
- $
50
0)
/ $
50
0 X
10
0 =
$2
50
/$
50
0 X
10
0 =
5
0%
]3
2.0
[In
flat
ion
= (
$1
,00
0 -
$5
00
) /
$5
00
X 1
00
= $
50
0/
$5
00
X 1
00
=
10
0%
]
So
th
e re
sult
of
an i
ncr
easi
ng
mo
ney
su
pp
ly w
hen
th
e ec
on
om
y is
at
full
emp
loym
ent
(Rea
l GD
P =
$5
00
in P
erio
d 1
) is
hig
her
ave
rag
e p
rice
leve
l (P
),
i.e.
infl
atio
n.
Eval
uat
e
We
bega
n th
e cl
ass
with
the
que
stio
n: d
o yo
u ev
er h
ave
“eno
ugh”
mon
ey?
How
do
you
ans
wer
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The Texas Council on Economic Education (TCEE) thanks the Council for Economic Education and the Department of Education Office of Innovation and Improvement for awarding the Replication of Best Practices Program grant that allowed Economics for Educators, Revised Edition to be written and published.
The Texas Council on Economic Education also thanks six of its major partners whose support allows TCEE to provide the staff development that utilizes content and skills provided in Economics for Educators.
Helping young people learn to think & make better economic & financial choices in a global economy.
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