The Wall Street Journal Guide to Understanding Money & Investing by Kenneth M. Morris, Virginia B. Morris, Alan M. Siegel

From the Publisher

The Wall Street Journal Guide to Understanding Money & Investing initiates you into the mysteries of the financial pages -- buying stocks, bonds, mutual funds, futures and options, spotting trends and evaluating companies. For those who are curious but intimidated by everyday financial jargon, this guide offers a literate, forthright and lively alternative.

Product Details

• Table of Contents
• Forewords & Introductions
• Read an Excerpt
• Read a Sample Chapter

Table of Contents

Forewords & Introductions

When The Wall Street Journal Guide to Understanding Money & Investing first appeared in 1993, we thought that the book, with its colorful graphics and clear language, would appeal to people who wanted to know about the often-baffling world of the financial markets.

But we had no idea that it would become an indispensable resource in brokerage firms, banks, financial advisors' offices and school classrooms, or that there would be over a million copies in print. Nor did we ever dream it would be recast for the Asian markets and translated into Chinese.

As popular as the guide remains, we felt it was time for the revised edition that recognizes the monumental changes in the financial markets in the 1990s: the increasing number of people who are investing, the longest bull market in history, the sometimes dizzying speed with which records have been smashed and the explosion of electronic trading fueled by access to the World Wide Web.

In updated Money & Investing we haven't lost sight of our original mission: to unravel the mysteries of the financial markets -- the language, the players, the strategies and, above all, the risks and rewards of investing -- in a straightforward but lighthearted way. We show (and tell) how the markets work, why money gains and loses value, and what you need to know to make the right investments and measure their performance.

Read an Excerpt

The History of Money

Most money doesn't have any value of its own. It's worth what it can buy at any given time.

The history of money begins with people learning to trade the things they had for the things they wanted. If they wanted an ax, they had to find someone who had one and was willing to exchange it for something of theirs. The system works the same way today, with one variation: now you can give the seller money in exchange for the item you want, and the seller can use the money to buy something else.

IN THE BEGINNING WAS BARTER

Our earliest ancestors were self-sufficient, providing their own food, clothing and shelter from their surroundings. There was rarely anything extra -- and nothing much to trade it for.

But as communities formed, hunting and gathering became more efficient. Occasionally there were surpluses of one commodity or another. A people with extra animal skins but not enough grain could exchange its surplus with another people with plenty of food but no skins. Barter was born.

As societies grew more complex, barter flourished. The most famous example may be Peter Minuit's swap in 1626 of $24 in beads and trinkets for the island of Manhattan. Its property value in 1998 was assessed at $23.4 billion.

MONEY FILLS THE BILL

It takes time and energy to find someone with exactly what you want who's also willing to take what you have to offer. And it isn't always easy to agree on what things are worth. How many skins is a basket of grain worth? What happens if the plow you want is worth a cow and a half?.

As trade flourished, money came into use. Once buyers and sellers agreed what was acceptable as a means of payment, they could establish a system that assigned different values to coins or other durable and easily transportable items. The term currency, another word for money, means anything that's actually used as a means of exchange.

Using money also meant that buying and selling didn't have to happen at the same time. Sellers could wait until they were ready to make a purchase to spend the money they had received. What's more, they could accumulate money from a number of sales to give them more buying power.

Money has taken many different forms over the years. In Rome, for example, soldiers were often paid with sacks of salt -- that's sal in Latin, the root of salary -- and salt was also used in ancient China to pay for small purchases.

METAL BECOMES THE STANDARD

As early as 2500 B.C. various precious metals -- gold, silver and copper -- were used to pay for goods and services in Egypt and Asia Minor. By 700 B.C. the kingdom of Lydia was minting coins made of electrum, a pale yellow alloy of gold and silver. The coins were valuable, durable and portable. Better yet, they couldn't die or rot on the way to market. In addition, using coins permitted payments by tale, or counting out the right amount, rather than weighing it. That simplified the exchange process even more. For a long time, the relative value of currencies was usually gold or silver. That's where terms like pound sterling and gold standard originated. In modern times, though, national economies have moved away from basing their currency on metal reserves. Gold hasn't been a universal yardstick since 1971, when the U.S. stopped redeeming its paper currency with gold.

MONEY BY FIAT

When money was made of gold or silver -- or could he exchanged for one of them -- it was commodity currency. But money that has no intrinsic value and can't be redeemed for precious metal is fiat currency. Most currency circulating today is fiat money, created and authorized by various governments as their official currency.

Paper Money

Bills come in different sizes, colors and denominations, but their real value is based on the economic strength of the country that issues them.

THE ORIGINS OF PAPER MONEY

Although the idea of paper money can be found in bills and receipts recorded by the Babylonians as early as 2500 B.C., the earliest bills can be traced to China. In 1282, Kubla Khan issued paper notes made of mulberry bark bearing his seal and his treasurers' signatures. The Kuan is the oldest surviving paper money. The currency -- about 8 1/2 x 11 inches -- was issued in China by the Ming dynasty between 1368 and 1399.

The first European bank notes were printed in Sweden in 1661, and France put paper money into wide circulation in the 18th century.

The first paper money in the British Empire was in the form of promissory notes given to Massachusetts soldiers in 1690, when their siege of Quebec failed and there was no booty to pay them with. The idea became popular with the other colonies, if not with the soldiers who were paid that way.

THE U.S. DOLLAR

The American dollar comes from a silver coin called the Joachimsthaler minted in 1519 in the valley (thal) of St. Joachim in Bohemia (Jachymov in Czech Republic). The coin was widely circulated and called the daalder in Holland, the daler in Scandinavia and the dollar in England. More than two dozen countries besides the U.S. call their currency dollars.

The U.S. dollar's early history was chaotic until the National Banking Act of 1863 established a uniform currency. Before that, banks used paper money (called scrip), but they couldn't always meet their customers' demands for hard currency (gold or silver coins, or specie). Often the dollar could be exchanged for just a fraction of its stated value.

Dollars were once backed by gold and silver reserves. Until 1963, U.S. bills were called silver certificates. Today they are Federal Reserve notes, backed only by the economic integrity of the U.S. You can't exchange them for specie.

THE UPS AND DOWNS OF PAPER MONEY

Paper money has had its ups and downs because its value changes so quickly with changing economic conditions. When there's lots of money in circulation, prices go up and paper money buys less. That's known as inflation.

For example, during the American Revolution paper money dropped in value from $1 to just 2 1/2¢. In Germany in 1923, you needed 726,000,000 marks to buy what you'd been able to get for 1 mark in 1918.

MAKING PAPER MONEY

The Bureau of Engraving and Printing prints money at plants in Washington, D.C., and Fort Worth, Texas. The money is printed in large sheets, stacked into piles of 100 and cut into bills that are bundled into bricks for shipping. The engraved plates, which can be used to produce up to three million impressions before they have to be replaced, are designed with intricate patterns of lines and curves to make the money hard to copy. As an added security measure, several different engravers work on each plate.

The Bureau makes the slightly magnetic ink itself from secret formulas. Special paper, made by Crane and Company, has been used for all U.S. currency since 1879.

The content of the paper is a closely guarded secret, although we know the sheets are now about 75% cotton and 25% linen and contain small, faintly colored nylon threads.

You can get back the full value of a torn bill from the Bureau of Engraving and Printing in Washington, D.C. -- as long as you turn in at least 51% of the ripped one.

The U.S. Dollar

In 1862, the U.S. government issued its first paper money. The bills were called greenbacks because the backs were printed in green ink -- to distinguish them from gold certificates.

Each U.S. banknote has a distinctively marked green-, black- and cream-colored face. On the dollar bill, a letter within a seal to the left of the portrait identifies the Federal Reserve bank that issued the bill. In this case, it's B for New York. A corresponding number -- New York's is 2 -- appears four times on the face. On the redesigned bills, the seal of the Federal Reserve system itself appears.

The back of each denomination is different. On the dollar, it's the Great Seal of the United States. Its reverse side, on the right of the bill, features the American eagle and the number 13, representing the country as a whole and the original 13 states. Symbols include: 13 stripes on the eagle's shield, the 13-star constellation above the eagle's head, 13 warlike arrows grasped in one of the eagle's claws the olive branch of peace, with 13 leaves and 13 olives, grasped in the other.

Greenbacks are created in three steps. The black front is printed the first day from the engraved plates. Then the green back is is printed the second day, giving the ink time to dry. Finally, the green serial numbers and Treasury seal are added to the front using a process called COPE, or currency overprinting and processing equipment.

The front of the seal has a 13-letter Latin motto, ANNUIT COEPTIS, which means "He has favored our undertaking," a reference to the blessing of an all-seeing deity whose eye is at the apex of the pyramid. The pyramid itself suggests a strong base for future growth. Underneath, in Roman numerals, is the date 1776, the year the Declaration of Independence was signed. The second motto, NOVUS ORDO SECLORUM, means "New order of the ages."

Legal tender is money a government creates that must -- by law -- be accepted as payment of debt. A $100 bill is legal tender, for example, but a $100 check isn't. That's because the check is issued by a bank, not the government.

Bills are numbered two ways. The eight-digit serial number is printed on the top right and lower left on the front. The number of every bill of the same denomination in the same series is different. The number begins with a letter (here B) identifying the issuing Federal Reserve Bank.

Each bill also has a series identification number engraved between the portrait and the signature of the Secretary of the Treasury. It gives the year the note's design was introduced, usually when a new Secretary or a new U.S. Treasurer has been appointed.

The Money Cycle

Money is a permanent fixture of modern society, but the bills and coins we use have a limited lifespan.

A major redesign of U.S. currency is underway. The first new bill, the $100, was introduced in 1996, followed by the $50 in 1997 and the $20 in 1998, with the others slated to follow. Their most noticeable features are larger, off-center portraits and even more intricate border designs -- both calculated to make the bills more difficult to copy in an era of increasingly sophisticated computer and photocopying equipment.

Since paper bills wear out from changing hands, replacements are printed regularly to maintain a steady supply. Not surprisingly, dollar bills have the shortest life span, about 13 to 18 months. Other countries have successfully introduced durable coins with lifespans of 30 to 40 years to replace their small bills, though so far that approach hasn't worked in the U.S. A new $1 coin is scheduled for release in 2000 to replace the unpopular Susan B. Anthony dollar. Its design should resolve one of the existing coin's major drawbacks: It looks and feels so like the quarter that it's easy to confuse them.

VANISHING AMERICANS

In 1969, bills over $100 in value were eliminated as currency because of declining demand. The faces that disappeared were McKinley on the $500, Cleveland on the $1,000, Madison on the $5,000, Chase on the $10,000 and Wilson on the largest of them all, the $100,000.

HOW COINS COME TO LIFE

In the U.S., new coins are struck at three Bureau of the Mint branches, and each coin carries the mark of the branch where it was minted: D for Denver, S for San Francisco, and P (or no mark at all) for Philadelphia. The process of making coins is called minting, from the Latin word moneta.

The whole process is a modest profitmaker. For example, it costs about 9/10 of a cent to make a penny. That difference -- about a dollar for every thousand pennies -- is profit. The Mint prefers the term seigniorage. But whatever you call it, it amounts to more than $400 million annually.

Other Forms of Money

Money doesn't always change hands. It's often transferred from one account to another by written or electronic instructions.

Technology has revolutionized the way we use money. The form we're most familiar with -- bills and coins -- represents only about 8% of the trillions of dollars that circulate in the U.S. economy.

Before 1945, most people paid with cash. By 1990, about $30 trillion was transferred annually by check. Electronic transfers have increased the volume dramatically. In 1998, an average of $1.3 trillion was moved electronically every day through the Federal Reserve System.

NOT CASHLESS -- YET

A society that gets along without cash still seems a long way off.

We haven't yet abandoned our pennies, let alone our bills. On the other hand, the money we move with a checkbook, an ATM card, a credit card and a debit card -- or a program on a personal computer -- suggests that the story of money is still being written.

Increasingly sophisticated smart cards, whose dollar value is imbedded in a microchip that can be debited and replenished electronically, are likely to be part of that tale. For example, they're already replacing tickets and tokens to pay for mass transit, highway and bridge tolls.

HOW CHECKS MOVE MONEY

High-speed electronic equipment reads the sorting and payment instructions, called MICR (Magnetic Image Character Recognition) codes, printed in magnetic ink along the bottom of the check. The money is then debited (subtracted) from the writer's account and credited (added) to the receiver's.

Your bank account number, beginning with the branch number, identifies the account that money will be taken from to pay the check.

The check routing number identifies the bank, its location, and its Federal Reserve district and branch. The coded information explains the arrangement for collecting payment from the bank. The same information, in different format, appears in the upper right of the check, under the check number.

The check number and the amount of the check are printed by the first bank to receive the check when it is deposited or cashed. When you actually write the check, the space under your name is blank.

Information written and stamped on the back of the check shows the account the dollar value was credited to, the bank where it was cashed or deposited and the date, plus the payment stamp from your bank.

MAKING THE MOST OF CREDIT

In 1998, an estimated 70% of all U.S. households had one or more credit cards. And the majority used their cards regularly. But based an the number who pay their bills in full every month -- about 86%, according to Veribanc -- most people are taking advantage of credit to consolidate payment for their purchases or limit the amount of cash they have to carry around. Most sellers are happy to accept credit, too, despite the fee they pay the card issuer, because people tend to spend more when they're using a card than they do when they're laying out cash.

MONEY 'ROUND THE CLOCK

With a personal identification number (PIN) or personal identification code (PIC) and a bank ATM card linked to one or more of your accounts, you can withdraw or deposit money, find out how much you have in an account, pay bills or choose from a growing list of other services -- without ever entering a bank.

The chief attraction is convenience. Most banks are part of regional, national and even international systems that give you direct access to your accounts almost anywhere.

The card number is linked to your bank account, though it is not the same as your account number. The magnetic strip on the back identifies the bank and account when the card is inserted in a machine. The PIN number doesn't appear anywhere, for security reasons.

Details of your transactions are printed on the receipt the ATM provides. The date and location of the ATM branch may be important if you question certain transactions. Cameras often record the activity at an ATM and can provide evidence in unresolved disputes. There's rarely a limit on the number of transactions you can make on any one visit, though there may be a daily limit on the total amount you can withdraw in one day.

ELECTRONIC TRANSFERS

You can use a telephone or computer to authorize movement of funds among your own accounts or to transfer amounts out of your accounts to pay bills. Other examples of electronic transfers are the direct deposit of paychecks and Social Security payments. Increasingly, mutual funds, brokerage firms, banks, utility companies and retail businesses are expanding your electronic options.

DEBIT AND CREDIT CARDS

Debit cards and credit cards look alike, but work differently. Credit cards let you charge a purchase and pay for it later because you've got a credit arrangement with a bank or other financial institution. Debit cards subtract the amount of your purchase directly from your bank account and credit it to the seller's account.

Usually you sign a credit card receipt after it's been verified by the seller's security system. When you use a debit card, you enter your PIN (or PIC) to authorize the transaction.

The Federal Reserve System

The Federal Reserve System is the guardian of the nation's money -- banker, regulator, controller and watchdog all rolled into one.

Like other countries, the U.S. has a national bank to oversee its economic and monetary policies. But the Federal Reserve System, known informally as the Fed, isn't one bank. It's 12 separate district banks, with 25 regional branches, spread across the country, so that no one state, region or business group can exert too much control.

Each district bank has a president and board of directors, and the system itself is run by a seven-member board of governors. In addition, there's an Open Market Committee, whose responsibility is guiding day-to-day monetary decisions.

HOW THE FED WORKS

Technically a corporation owned by banks, the Fed works more like a government agency than a business. Under the direction of its chairman, it sets economic policy, supervises banking operations and has become a major factor in shaping the economy.

The governors are appointed to 14-year terms by the president and confirmed by Congress, which insulates them from political pressure to some extent. One term expires every two years. However, the chairman serves a four-year term and is often chosen by the president to achieve specific economic goals.

MEMBER BANKS

About half of all the banks in the country are members of the Federal Reserve System. All national banks must belong, and state-chartered banks are eligible if they meet the financial standards the Fed has established.

The Federal Reserve's Many Roles

The Fed plays many roles as part of its responsibility to keep the economy healthy.

The Fed handles the day-to-day banking business of the U.S. government. It gets deposits of corporate taxes for unemployment, withholding and income, and also of federal excise taxes on liquor, tobacco, gasoline and regulated services like phone systems. It also authorizes payment of government bills like Social Security and Medicare as well as interest payments on Treasury bills, notes and bonds.

REGULATOR

By authorizing buying and selling of government securities, the Fed tries to balance the money in circulation. When the economy is stable, the demand for goods and services is fairly constant, and so are prices. Achieving that stability supports the Fed's goals of keeping the economy healthy and maintaining the value of the dollar.

BANKER

The Fed maintains bank accounts for the U.S. Treasury and many government and quasi-government agencies. It deposits and withdraws funds the way you do at your own bank, but in bigger volume: Over 80 million Treasury checks are written every year.

LENDER

If a bank needs to borrow money, it can turn to a Federal Reserve bank. The interest the Fed charges banks is called the discount rate. Bankers don't like to borrow from the Fed, since it may suggest they have problems. And they can often borrow more cheaply from other banks.

AUDITOR

The Fed monitors the business affairs and audits the records of all of the banks in its system. Its particular concerns are compliance with banking rules and the quality of loans.

CONTROLLER

When currency wears out or gets damaged, the Fed takes it out of circulation and authorizes its replacement. Then the Treasury has new bills printed and new coins minted.

GUARDIAN

Gold stored in the U.S. by foreign governments is held in the vault at the New York Federal Reserve Bank -- some 10,000 tons of it. That's more gold in one place than anywhere else in the world, as far as anyone knows. Among its many tasks, the Fed administers the exchange of bullion between countries.

ADMINISTRATOR

The Fed is also the national clearing house for checks. It facilitates quick and accurate transfer of funds in mare than 15 billion transactions a year.

Controlling the Money Flow

The money that powers our economy is created essentially out of nothing by the Federal Reserve.

Keeping a modern economy running smoothly requires a pilot who'll keep it from stalling or overaccelerating.

The U.S., like most other countries, tries to control the amount of money in circulation. The process of injecting or withdrawing money reflects the monetary policy that the Federal Reserve adopts to regulate the economy.

Monetary policy isn't a fixed ideology. It's a constant juggling act to keep enough money in the economy so that it flourishes without growing too fast.

HOW IT WORKS

The Fed's Open Market Committee meets about every six weeks to evaluate the economy.

Then it tells the Federal Reserve Bank of New York -- the city where the nation's biggest banks and brokerage firms have their headquarters -- whether to speed up or slow down the creation of new money.

About 11:15 a.m. every day, the New York Fed decides whether to buy or sell government securities in order to implement the Open Market Committee's policy decisions.

REGULATION IS A TOUGH JOB

It isn't easy to regulate the money supply or control the rate of growth. That's because the economy doesn't always respond quickly or precisely when the Fed acts. Typically, it takes about six months for significant policy changes to affect the economy directly.

ADJUSTING THE RATE

Among the tools the Fed uses when it wants the economy to change direction is increasing or decreasing the discount rate, the rate it charges banks to borrow money. If the discount rate is increased, the banks tend to borrow less and have less money available to make loans to their clients. If the rate is decreased, banks tend to borrow more freely and lend money to their clients at attractive rates. The result is that changes in the discount rate have a ripple effect throughout the economy. And if the Fed isn't satisfied with the response, it can lower or raise the rate a second time or even a third.

CHANGING THE SUPPLY

The Fed regularly influences the amount of money in circulation when it chooses to buy or sell government securities in the open market.

To slow down an economy where too much money is in circulation, the New York Fed sells government securities, taking in the cash that would otherwise be available for lending. And to give the economy a shot in the arm, it creates money by buying securities.

For all practical purposes, there isn't any limit on the amount of money the Fed can create. The $100 million in the example to the right is only a modest increase in the money supply. In a typical month the Fed might pump as much as $4 billion or as little as $1 billion into the economy.

CREATING MONEY

To create money, the New York Fed buys government securities from banks and brokerage houses. The money that pays for the securities hasn't existed before, but it has value, or worth, because the securities the Fed has bought with it are valuable.

More new money is created when the banks and brokerages lend the money they receive from selling the securities to clients who spend it on goods and services. These simplified steps illustrate how the process works.

0. The Fed writes a check for $100 million to buy the securities from a brokerage house. The brokerage house deposits the check in its own bank (A), increasing the bank's cash.

1. Bank A can lend its customers $90 million of that deposit after setting aside 10%. The Fed requires all banks to hold 10% of their deposits (in this example, $10 million) in reserve. A young couple borrows $100,000 from Bank A to buy a new house. The sellers deposit the money in their bank (B).

2. Now Bank B has $90,000 (the deposit minus the required reserve) to lend that it didn't have before. A woman borrows $10,000 from Bank B to buy a car, and the dealer deposits her check in Bank C.

3. Bank C can now loan $9,000.

This one series of transactions has created $190,099,000 in just four steps. Through a repetition of the loan process involving a wide range of banks and their customers, the $100 million that the Fed initially added to the money supply could theoretically become almost $900 million in new money.

HOW FAST MONEY GOES

Money's velocity is the speed at which it changes hands. If a $1 bill is used by 20 different people in a year, its velocity is 20. An increase in either the quantity of money in circulation or its velocity makes prices go up -- though if both increase they can cancel each other's effect.

The Money Supply

There's no ideal money supply. The Fed's goal is to keep the economy running smoothly by keeping an eye on the money that people have to spend.

The money supply measures the amount of money that people have available to spend -- including cash on hand and funds that can be liquidated, or turned into cash.

When the Federal Reserve is following an easy money policy -- increasing the money supply -- the economy tends to grow quickly, companies hire more workers and consumer confidence tends to increase, boosting spending. But if the Fed adopts a tight money policy -- slowing the money supply to combat inflation -- the economy can bog down, unemployment may increase and spending typically slows.

In a strong economy, demand for currency increases without Federal Reserve intervention, and the amount of money in circulation goes up. In the 1990s, for example, the supply of dollars has grown steadily, reflecting demand both in the U.S. and overseas.

MEASURING THE MONEY SUPPLY

If you keep careful track of your personal money supply, you know, for instance, how much cash you have in your wallet and how much money is in your checking account. You also know how much salary is coming in and which investments, such as savings accounts and certificates of deposit (CDs), can be turned into cash quickly.

Similarly, economists and policy-makers keep careful track of the public money supply using measures called M1, M2, M3 and L.

The three Ms are monetary aggregates, or ways to group assets that people use in roughly the same way. M1, for instance, counts liquid assets, like cash. The object is to separate money that's being saved from money that's being spent in order to predict impending changes in the economy.

L is a measure of other highly liquid assets, and adds a number of short-term bonds, commercial paper and savings bonds, for example, to M3.

READING THE CHARTS

The Federal Reserve reports the financial details of the money supply every week. It's tracked in several different time periods to show both short-term changes and long-term trends. The average daily amounts -- in billions of dollars -- are provided for each component, M1, M2 and M3, and printed in The Wall Street Journal as Monetary Aggregates. The M3 figure, the most inclusive, is always the largest and the M1 the smallest. In addition, a summary of Reserve Aggregates appears every two weeks, providing additional financial statistics.

Seasonally adjusted (sa) amounts are always computed and compared with non-adjusted numbers (nsa). Seasonal adjustments reflect the varying flow of money into and out of bank accounts. In the spring, for instance, tax refunds tend to swell checking accounts that were depleted in the winter as consumers paid off holiday bills.

CHANGING YARDSTICK

In the early 1990s, the Federal Reserve stopped using its long-standing yardstick for measuring the economy -- growth in the M2 money supply. Because people increasingly keep their cash in mutual fund money market accounts, which aren't included in M2, the Fed found that the figure wasn't a reliable indicator of economic growth.

So, instead of adjusting interest rates to control the money supply as a reaction to changes in M2, the new method is to set short-term real interest rates (the current interest rates minus the rate of inflation) at a level that the Fed believes will produce growth without inflation.

Measuring Economic Health

Economists keep their fingers on the pulse of the economy at all times, determined to cure what ails it.

Intensive care is a 24-hour business. Doctors and nurses measure vital signs, record changes in temperature and physical functions, conduct test after test. That gives you an idea of how thousands of experts -- and countless more interested amateurs -- watch the economy.

The biggest differences? The vigil never stops -- even when the economy seems healthy. And there are usually multiple causes for any sign of weakness, often including a number that can't be cured by treating the U.S. economy alone.

Unemployment Figures

New unemployment claims for state unemployment insurance give a sense of the number of people losing their jobs. A falling number is a sign the economy is growing. The chart here reports that initial claims fell dramatically in early 1999.

The flip side of low unemployment, however, is the fear of increasing inflation. In the past, at least, employers have increased wages to attract new workers when competition was tight. Whether that pattern will persist in what many experts consider a new economic environment remains unanswered.

The Index of Leading Economic Indicators is released every month by The Conference Board, a business research group. The numbers rarely surprise the experts, since many of the components are reported separately before the Index is released. But it does provide a simple way to keep an eye on the economy's overall health. Generally, three consecutive rises in the Index are considered a sign that the economy is growing -- and three drops, a sign of decline and potential recession.

Ten leading indicators are averaged to produce the Index, with some carrying more weight than others. Taken together, they're designed to predict short-term economic conditions. Among them are the spread between the 10-year Treasury and the federal funds rate, the M2 money supply, the S&P 500-stock index and the four shown below.

Consumer Confidence

Consumers' attitudes toward the health of the economy are influenced by what they hear. And their confidence -- or lack of it -- affects how the economy fares.

If consumers feel good about their current situation and about the future, they tend to spend more freely, which boosts economic growth. If they're worried about things like job security, they tend to save more and spend less, slowing economic growth and the economy itself.

Consumers often respond slowly to news of an economic recovery if they don't see an immediate, positive financial impact on their own lives. Their reluctance to start spending helps keep the recovery slow.

The graphs shown on these pages illustrate how the complex information on the state of the economy that the government compiles each month is presented in The Wall Street Journal.

MEASURING EMOTIONS

Consumer sentiment is measured in several different ways. Three of the principal guides that economists use are the monthly surveys done by the University of Michigan Institute for Social Research, the Conference Board and Sindlinger & Co. The results are intended for specific audiences, but it's only a matter of minutes before Wall Street's information networks make survey results public knowledge.

The surveys can produce different results because the organizations ask different questions.

* Michigan's poll asks if consumers are confident enough to take on debt for such big-ticket items as cars and appliances.

* The Conference Board focuses on consumer worries about job security.

* The Sindlinger Report measures consumers' income, sense of job security and business conditions.

The Sindlinger Report also looks at whether household income has risen or fallen in the past six months, and what consumers expect in the next six.

The Consumer Price Index

The Consumer Price Index (CPI) looks at the economy from your perspective: it reports what it costs to pay for food, housing and other basics.

The Consumer Price Index (CPI) serves the double role of reflecting economic trends and influencing economic policy decisions. Though its accuracy as well as its urban bias are sometimes questioned,it's the most widely used measure of inflation -- and the basis for figuring adjustments to Social Security payments as well as determining cost-of-living increases in wages and pensions.

HOW THE CPI IS FIGURED

The Bureau of Labor Statistics compiles the CPI every month by recording prices for 80,000 goods and services that reflect the current lifestyle of the typical urban American consumer. It includes food, housing, clothing, transpoort also looks at whether household income has risen or fallen in the past six months, and what consumers expect in the next six.

The Consumer Price Index

The Consumer Price Index (CPI) looks at the economy from your perspective: it reports what it costs to pay for food, housing and other basics.

The Consumer Price Index (CPI) serves the double role of reflecting economic trends and influencing economic policy decisions. Though its accuracy as well as its urban bias are sometimes questioned,it's the most widely used measure of inflation -- and the basis for figuring adjustments to Social Security payments as well as determining cost-of-living increases in wages and pensions.

HOW THE CPI IS FIGURED

The Bureau of Labor Statistics compiles the CPI every month by recording prices for 80,000 goods and services that reflect the current lifestyle of the typical urban American consumer. It includes food, housing, clothing, transportation, health care, recreation and education as well as a catchall category called other. The Bureau reports changes from month to month and year to year, using the period 1982-1984 as the basis, or starting point, against which the numbers are measured.

The CPI components are adjusted periodically to reflect changes in lifestyle and in the relative cost of living.

The Economic Cycle

Inflation and recession are recurring phases of a continuous economic cycle. Experts work hard to predict their timing and control their effects.

Inflation occurs when prices rise because there's too much money in circulation and not enough goods and services to spend it on. When prices go higher than people can -- or will -- pay, demand decreases and a downturn begins.

THE INFLATION STRUGGLE

Since inflation typically occurs in a growing economy that's creating jobs and reducing unemployment, politicians are willing to risk its problems. But the Federal Reserve prefers to cool down a potentially inflationary economy before it gets out of hand. So it sells government securities, which has the effect of raising interest rates and slowing borrowing. But since it also wants to prevent a long-term slowdown, it typically reverses its policy when the economy seems likely to shrink.

CONTROLLING THE CYCLE

Most developed economies try not to let the economic cycle run unchecked because the consequences could be a major worldwide depression like the one that followed the stock market crash of 1929. In a depression, money is so tight that the economy virtually grinds to a halt, unemployment escalates, businesses collapse and the general mood is grim.

Instead, most central banks adjust their monetary policy at the first sign of a slowdown, or recession, to ward off more trouble.

EASY MONEY SPURS GROWTH -- AND INFLATION

In a recession, the Fed can create new money to make borrowing easier. As the economy picks up, sellers sense rising demand for their products or services and begin to raise prices.

The rule of 72 is a reliable guide to the impact of inflation. Its formula has you divide 72 by the annual inflation rate to find out the number of years it will take prices to double. For example, when inflation is at 10%, prices will double in seven years (72÷10=7) and when it's 3%, they will double in 24 years (72÷3=24).

INFLATION DESTROYS VALUE

Most economists agree that inflation isn't good for the economy because, over time, it destroys value, including the value of money. If inflation is running at a 10% annual rate, for example, the book that cost $10 one year would cost $20 just seven years later. For comparison's sake, if inflation averaged 3% a year, the same book wouldn't cost $20 for 24 years.

Inflation may also prompt investors to buy things they can resell at huge profits -- like art or real estate -- rather than putting their money into companies that can create new products and jobs.

WHO GETS HURT?

The people hit the hardest by inflation are those living on fixed incomes. For example, if you're retired and have a pension that was determined by a salary you earned in less inflationary times, your income will buy less of what you need to live comfortably. Workers whose wages don't keep pace with inflation can also find their lifestyle slipping.

But inflation isn't bad for everyone. Debtors love it because the money they repay each year is worth less than it was when they borrowed it. If their own income keeps pace with inflation, the money they repay is also an increasingly smaller percentage of their budget.

WHEN THERE's NO INFLATION

When the rate of inflation slows, it's described as disinflation. Several years of 1% annual increases in the cost of living are disinflationary after a period of more rapid growth. Employment and output can continue to be strong, and the economy can continue to grow.

Deflation, though, is a widespread decline in the prices of goods and services. But instead of stimulating employment and production, deflation has the potential to undermine them. As the economy contracts and people are out of work, they can't afford to buy even at cheaper prices.

The World of Money

Currencies are floated against each other to measure their worth in the global marketplace.

A currency's value in the world marketplace reflects whether individuals and governments are interested in using it to make purchases or investments, or in holding it as a source of long-term security. If demand is high, its value increases in relation to the value of other currencies. If it's low, the reverse occurs.

Some currencies, like the U.S. dollar and the Swiss franc, are relatively stable in price, reflecting an underlying financial and political stability. Most experts expect the euro, introduced in 1999 as the currency of the European Union, to join that group of strong currencies.

Some other currencies experience wild or rapid changes in value, the sign of economies in turmoil as the result of runaway inflation, deflation, defaults on loan agreements, serious balance-of-trade deficits or economic policies that seem unlikely to resolve the problems.

NOTHING IS FIXED

Currency values of even the most stable economies change over time as traders are willing to pay more -- or less -- for dollars or pounds or euros or yen. For example, great demand for a nation's products means great demand for the currency needed to pay for those products.

If there's a big demand for the stocks or bonds of a particular country, its currency's value is likely to rise as overseas investors buy it to make investments. Similarly, a low inflation rate can boost a currency's value, since investors believe that the value of long-term purchases in that country won't erode over time.

HOW CURRENCY VALUES ARE SET

Between 1944 and 1971, major trading nations had a fixed, official rate of exchange fied to the U.S. dollar, which could be redeemed for gold at $35 on ounce. Since 1971, when the gold standard was abandoned, currencies have floated against each other, influenced by supply and demand and by various governments' efforts to manage their currency. Some countries, for example, have sought stability by pegging, or linking, their currency to the value of the U.S. dollar. In Europe, the European Union established the euro as a common currency for 11 participating member nations. At year's end, 1998, their currencies were permanently aligned with one another.

STABILITY IS A GOAL

Governments usually want their currency to be stable, maintaining a constant relative worth with the currencies of their major trading partners. Sometimes they interfere with market forces -- buying up large amounts of their own currency or agreeing with trading partners to lower interest rates -- to achieve that goal.

If interest rates are lowered, however, fewer foreign investors will want to put money in the country's banks. They'll look for better return elsewhere.

Other times, a currency is deliberately devalued if a government decides to lower the value of its currency against those of other countries, often to make its exports more competitive.

CURRENCY CROSS RATES

Currency cross rates, reported as the late New York trading price of the basic units of 11 major currencies, including the euro, in relation to each other, are published daily in The Wall Street Journal. Since these exchange rates apply to bank trades of $1 million or more, they usually reflect a higher unit of foreign currency per dollar than you would get in a retail transaction, such as changing money at a bank.

To find the current exchange rate between two currencies, you find the place on the chart where one country's name (listed alphabetically in the vertical column) intersects with the other's currency value (in the horizontal column). Here, for example, the Mexican peso is trading at 9.7920 to the dollar.

The values of the U.S. dollar and the euro appear first and second, in recognition of the primary roles they play in international transactions. The chart has a global perspective, however, providing exchange information for a number of trading partners whose transactions may not be handled in dollars or euros -- Japanese yen and U.K. pounds, for example, or yen and Canadian dollars.

The Value of Money

Exchanging dollars for euros, pounds for yen, or rupees for rubles is big business -- to the tune of $1.5 trillion a day.

Some currencies are more widely traded than others, dominating world markets and setting standards of value. The U.S. dollar has held that position in recent years, along with the Japanese yen and the German mark. The euro, the currency of the European Union, is widely expected to be a major force in the world economy.

CURRENCY TRADING

Money flows across national borders all the time, so foreign exchange -- changing one currency for another -- flourishes. But there is no actual physical marketplace where the world's currencies are traded. The global foreign exchange market, or forex, is a network of interconnected telephones and computers that operate virtually around the clock. Traders working for big banks and other financial institutions buy and sell currencies in what is by far the largest single financial market in the world. On a typical day, roughly $1.5 trillion in currencies is traded electronically around the world.

TRADING FOR BUSINESS

Corporations that do business in more than one country depend on foreign exchange. If a corporation knows it needs Japanese yen to pay for a shipment of electronic equipment, it asks its bank to buy Japanese currency at the best exchange rate possible.

On a smaller scale, when a New York retailer buys sweaters from a Norwegian company, the New Yorker tells his bank to pay his bill. The bank either dips into its own reserves of kroners or buys them in the currency market. Then the bank calculates the current exchange rate between dollars and kroners, deducts the dollars from its client's account, and instructs the Norwegian company's bank in Oslo to credit the seller's account with the appropriate number of kroners.

Trading Money

Everybody wants to do business at the best possible exchange rates.

You're unlikely to be involved in having to negotiate what a dollar is worth, since currency exchange is a huge business, handled by traders working for large commercial banks or through electronic brokering systems. But you are directly affected by the fact that its value is constantly changing, whether you're traveling abroad or buying imported goods. Basically, a strong dollar means more buying power.

WHAT A DOLLAR's WORTH

A survey of the approximate rates of exchange for the U.S. dollar against various world currencies is reported every week in The Wall Street Journal. The figures give the amount of foreign currency a dollar would buy. Here, for example, a dollar was worth 1.79 Aruban florins and 35.8896 Belgian francs. A few countries with close tourist or political ties to the U.S., like Bermuda, set the value of their currency permanently at $1.

MONEY AWAY FROM HOME

Travelers exchanging money are very minor players in the currency market. But if they're savvy, they can benefit from banks' and credit card companies large-volume trading. The key is to get the most local currency for their own currency by exchanging where the rate is the best and the commission, or charge for the transaction, is the lowest.

YOUR MONEY ABROAD

The near-universal popularity of credit cards and the growing use of globally linked electronic banking systems has made it easier to handle money matters when you travel.

In most places, you can pay for goods and services with a credit card. When the bills appear on your statement, the value of the transactions is converted to dollars, ususally at favorable rates because the credit card companies do such a huge volume of international business.

With an ATM, American Express or Diner's Club card, you can withdraw cash in local currency directly from your checking account. There's a fee, typically $1 to $2 for each transaction, but the exchange rate is usually the best that you can get anywhere.

BIG DEALS

Large-scale currency trading is done by telephone or electronically through a network controlled by banks or other financial institutions, in what's known as an over-the-counter market. The trades can be handled three different ways, as
* Spot transactions
* Forward transactions
* Swap contracts

TRADING ON THE SPOT

Spot transactions, in which the currency trade occurs immediately and is settled within two days, are big money deals, with minimum trades of $1 million. Trading goes on around the clock, through what is known as the global trading day, which begins when the New Zealand market opens and runs through the end of New York trading.

Exchange rates are updated constantly, and traders must pay careful attention, as a good deal typically depends on split-second timing and small price differences.

FORWARDS AND SWAPS

Companies doing business in more than one country need to protect themselves against sudden or dramatic changes in the relative value of currencies, so they hedge commitments to invest, sell or borrow with agreements that have predetermined forex, or foreign-exchange, rates. Conventional deals are described as plain vanilla, while others are complex, customized transactions.

Basically, swaps involve converting a cash flow or interest rate in one currency to a cash flow or interest rate in another. Forward transactions mean agreeing on an exchange rate that will apply when currency is traded on a set date in the future.

Copyright © 1999 by Lightbulb Press, Inc. and Dow Jones & Co. Inc.

Read a Sample Chapter

Money

The History of Money

Most money doesn't have any value of its own. It's worth what it can buy at any given time.

The history of money begins with people learning to trade the things they had for the things they wanted. If they wanted an ax, they had to find someone who had one and was willing to exchange it for something of theirs. The system works the same way today, with one variation: now you can give the seller money in exchange for the item you want, and the seller can use the money to buy something else.

IN THE BEGINNING WAS BARTER

Our earliest ancestors were self-sufficient, providing their own food, clothing and shelter from their surroundings. There was rarely anything extra -- and nothing much to trade it for.

But as communities formed, hunting and gathering became more efficient. Occasionally there were surpluses of one commodity or another. A people with extra animal skins but not enough grain could exchange its surplus with another people with plenty of food but no skins. Barter was born.

As societies grew more complex, barter flourished. The most famous example may be Peter Minuit's swap in 1626 of $24 in beads and trinkets for the island of Manhattan. Its property value in 1998 was assessed at $23.4 billion.

MONEY FILLS THE BILL

It takes time and energy to find someone with exactly what you want who's also willing to take what you have to offer. And it isn't always easy to agree on what things are worth. How many skins is a basket of grain worth? What happens if the plow you want is worth a cow and a half?.

As trade flourished, money came into use. Once buyers and sellers agreed what was acceB>MONEY BY FIAT

When money was made of gold or silver -- or could he exchanged for one of them -- it was commodity currency. But money that has no intrinsic value and can't be redeemed for precious metal is fiat currency. Most currency circulating today is fiat money, created and authorized by various governments as their official currency.

Paper Money

Bills come in different sizes, colors and denominations, but their real value is based on the economic strength of the country that issues them.

THE ORIGINS OF PAPER MONEY

Although the idea of paper money can be found in bills and receipts recorded by the Babylonians as early as 2500 B.C., the earliest bills can be traced to China. In 1282, Kubla Khan issued paper notes made of mulberry bark bearing his seal and his treasurers' signatures. The Kuan is the oldest surviving paper money. The currency -- about 8 1/2 x 11 inches -- was issued in China by the Ming dynasty between 1368 and 1399.

The first European bank notes were printed in Sweden in 1661, and France put paper money into wide circulation in the 18th century.

The first paper money in the British Empire was in the form of promissory notes given to Massachusetts soldiers in 1690, when their siege of Quebec failed and there was no booty to pay them with. The idea became popular with the other colonies, if not with the soldiers who were paid that way.

THE U.S. DOLLAR

The American dollar comes from a silver coin called the Joachimsthaler minted in 1519 in the valley (thal) of St. Joachim in Bohemia (Jachymov in Czech Republic). The coin was widely circulated and called the daalder in Holland, the daler in Scandinavia and the dollar in England. More than two dozen countries besides the U.S. call their currency dollars.

The U.S. dollar's early history was chaotic until the National Banking Act of 1863 established a uniform currency. Before that, banks used paper money (called scrip), but they couldn't always meet their customers' demands for hard currency (gold or silver coins, or specie). Often the dollar could be exchanged for just a fraction of its stated value.

Dollars were once backed by gold and silver reserves. Until 1963, U.S. bills were called silver certificates. Today they are Federal Reserve notes, backed only by the economic integrity of the U.S. You can't exchange them for specie.

THE UPS AND DOWNS OF PAPER MONEY

Paper money has had its ups and downs because its value changes so quickly with changing economic conditions. When there's lots of money in circulation, prices go up and paper money buys less. That's known as inflation.

For example, during the American Revolution paper money dropped in value from $1 to just 2 1/2¢. In Germany in 1923, you needed 726,000,000 marks to buy what you'd been able to get for 1 mark in 1918.

MAKING PAPER MONEY

The Bureau of Engraving and Printing prints money at plants in Washington, D.C., and Fort Worth, Texas. The money is printed in large sheets, stacked into piles of 100 and cut into bills that are bundled into bricks for shipping. The engraved plates, which can be used to produce up to three million impressions before they have to be replaced, are designed with intricate patterns of lines and curves to make the money hard to copy. As an added security measure, several different engravers work on each plate.

The Bureau makes the slightly magnetic ink itself from secret formulas. Special paper, made by Crane and Company, has been used for all U.S. currency since 1879.

The content of the paper is a closely guarded secret, although we know the sheets are now about 75% cotton and 25% linen and contain small, faintly colored nylon threads.

You can get back the full value of a torn bill from the Bureau of Engraving and Printing in Washington, D.C. -- as long as you turn in at least 51% of the ripped one.

The U.S. Dollar

In 1862, the U.S. government issued its first paper money. The bills were called greenbacks because the backs were printed in green ink -- to distinguish them from gold certificates.

Each U.S. banknote has a distinctively marked green-, black- and cream-colored face. On the dollar bill, a letter within a seal to the left of the portrait identifies the Federal Reserve bank that issued the bill. In this case, it's B for New York. A corresponding number -- New York's is 2 -- appears four times on the face. On the redesigned bills, the seal of the Federal Reserve system itself appears.

The back of each denomination is different. On the dollar, it's the Great Seal of the United States. Its reverse side, on the right of the bill, features the American eagle and the number 13, representing the country as a whole and the original 13 states. Symbols include: 13 stripes on the eagle's shield, the 13-star constellation above the eagle's head, 13 warlike arrows grasped in one of the eagle's claws the olive branch of peace, with 13 leaves and 13 olives, grasped in the othe r.

Greenbacks are created in three steps. The black front is printed the first day from the engraved plates. Then the green back is is printed the second day, giving the ink time to dry. Finally, the green serial numbers and Treasury seal are added to the front using a process called COPE, or currency overprinting and processing equipment.

The front of the seal has a 13-letter Latin motto, ANNUIT COEPTIS, which means "He has favored our undertaking," a reference to the blessing of an all-seeing deity whose eye is at the apex of the pyramid. The pyramid itself suggests a strong base for future growth. Underneath, in Roman numerals, is the date 1776, the year the Declaration of Independence was signed. The second motto, NOVUS ORDO SECLORUM, means "New order of the ages."

Legal tender is money a government creates that must -- by law -- be accepted as payment of debt. A $100 bill is legal tender, for example, but a $100 check isn't. That's because the check is issued by a bank, not the government.

Bills are numbered two ways. The eight-digit serial number is printed on the top right and lower left on the front. The number of every bill of the same denomination in the same series is different. The number begins with a letter (here B) identifying the issuing Federal Reserve Bank.

Each bill also has a series identification number engraved between the portrait and the signature of the Secretary of the Treasury. It gives the year the note's design was introduced, usually when a new Secretary or a new U.S. Treasurer has been appointed.

The Money Cycle

Money is a permanent fixture of modern society, but the bills and coins we use have a limited lifespan.

A major redesign of U.S. currency is underway. The first new bill, the $100, was introduced in 1996, followed by the $50 in 1997 and the $20 in 1998, with the others slated to follow. Their most noticeable features are larger, off-center portraits and even more intricate border designs -- both calculated to make the bills more difficult to copy in an era of increasingly sophisticated computer and photocopying equipment.

Since paper bills wear out from changing hands, replacements are printed regularly to maintain a steady supply. Not surprisingly, dollar bills have the shortest life span, about 13 to 18 months. Other countries have successfully introduced durable coins with lifespans of 30 to 40 years to replace their small bills, though so far that approach hasn't worked in the U.S. A new $1 coin is scheduled for release in 2000 to replace the unpopular Susan B. Anthony dollar. Its design should resolve one of the existing coin's major drawbacks: It looks and feels so like the quarter that it's easy to confuse them.

VANISHING AMERICANS

In 1969, bills over $100 in value were eliminated as currency because of declining demand. The faces that disappeared were McKinley on the $500, Cleveland on the $1,000, Madison on the $5,000, Chase on the $10,000 and Wilson on the largest of them all, the $100,000.

HOW COINS COME TO LIFE

In the U.S., new coins are struck at three Bureau of the Mint branches, and each coin carries the mark of the branch where it was minted: D for Denver, S for San Francisco, and P (or no mark at all) for Philadelphia. The process of making coins is called minting, from the Latin word moneta .

The whole process is a modest profitmaker. For example, it costs about 9/10 of a cent to make a penny. That difference -- about a dollar for every thousand pennies -- is profit. The Mint prefers the term seigniorage. But whatever you call it, it amounts to more than $400 million annually.

Other Forms of Money

Money doesn't always change hands. It's often transferred from one account to another by written or electronic instructions.

Technology has revolutionized the way we use money. The form we're most familiar with -- bills and coins -- represents only about 8% of the trillions of dollars that circulate in the U.S. economy.

Before 1945, most people paid with cash. By 1990, about $30 trillion was transferred annually by check. Electronic transfers have increased the volume dramatically. In 1998, an average of $1.3 trillion was moved electronically every day through the Federal Reserve System.

NOT CASHLESS -- YET

A society that gets along without cash still seems a long way off.

We haven't yet abandoned our pennies, let alone our bills. On the other hand, the money we move with a checkbook, an ATM card, a credit card and a debit card -- or a program on a personal computer -- suggests that the story of money is still being written.

Increasingly sophisticated smart cards, whose dollar value is imbedded in a microchip that can be debited and replenished electronically, are likely to be part of that tale. For example, they're already replacing tickets and tokens to pay for mass transit, highway and bridge tolls.

HOW CHECKS MOVE MONEY

High-speed electronic equipment reads the sorting and payment instructions, call ed MICR (Magnetic Image Character Recognition) codes, printed in magnetic ink along the bottom of the check. The money is then debited (subtracted) from the writer's account and credited (added) to the receiver's.

Your bank account number, beginning with the branch number, identifies the account that money will be taken from to pay the check.

The check routing number identifies the bank, its location, and its Federal Reserve district and branch. The coded information explains the arrangement for collecting payment from the bank. The same information, in different format, appears in the upper right of the check, under the check number.

The check number and the amount of the check are printed by the first bank to receive the check when it is deposited or cashed. When you actually write the check, the space under your name is blank.

Information written and stamped on the back of the check shows the account the dollar value was credited to, the bank where it was cashed or deposited and the date, plus the payment stamp from your bank.

MAKING THE MOST OF CREDIT

In 1998, an estimated 70% of all U.S. households had one or more credit cards. And the majority used their cards regularly. But based an the number who pay their bills in full every month -- about 86%, according to Veribanc -- most people are taking advantage of credit to consolidate payment for their purchases or limit the amount of cash they have to carry around. Most sellers are happy to accept credit, too, despite the fee they pay the card issuer, because people tend to spend more when they're using a card than they do when they're laying out cash.

MONEY 'ROUND THE CLOCK

Wi th a personal identification number (PIN) or personal identification code (PIC) and a bank ATM card linked to one or more of your accounts, you can withdraw or deposit money, find out how much you have in an account, pay bills or choose from a growing list of other services -- without ever entering a bank.

The chief attraction is convenience. Most banks are part of regional, national and even international systems that give you direct access to your accounts almost anywhere.

The card number is linked to your bank account, though it is not the same as your account number. The magnetic strip on the back identifies the bank and account when the card is inserted in a machine. The PIN number doesn't appear anywhere, for security reasons.

Details of your transactions are printed on the receipt the ATM provides. The date and location of the ATM branch may be important if you question certain transactions. Cameras often record the activity at an ATM and can provide evidence in unresolved disputes. There's rarely a limit on the number of transactions you can make on any one visit, though there may be a daily limit on the total amount you can withdraw in one day.

ELECTRONIC TRANSFERS

You can use a telephone or computer to authorize movement of funds among your own accounts or to transfer amounts out of your accounts to pay bills. Other examples of electronic transfers are the direct deposit of paychecks and Social Security payments. Increasingly, mutual funds, brokerage firms, banks, utility companies and retail businesses are expanding your electronic options.

DEBIT AND CREDIT CARDS

Debit cards and credit cards look alike, but work differently. Credit c ards let you charge a purchase and pay for it later because you've got a credit arrangement with a bank or other financial institution. Debit cards subtract the amount of your purchase directly from your bank account and credit it to the seller's account.

Usually you sign a credit card receipt after it's been verified by the seller's security system. When you use a debit card, you enter your PIN (or PIC) to authorize the transaction.

The Federal Reserve System

The Federal Reserve System is the guardian of the nation's money -- banker, regulator, controller and watchdog all rolled into one.

Like other countries, the U.S. has a national bank to oversee its economic and monetary policies. But the Federal Reserve System, known informally as the Fed, isn't one bank. It's 12 separate district banks, with 25 regional branches, spread across the country, so that no one state, region or business group can exert too much control.

Each district bank has a president and board of directors, and the system itself is run by a seven-member board of governors. In addition, there's an Open Market Committee, whose responsibility is guiding day-to-day monetary decisions.

HOW THE FED WORKS

Technically a corporation owned by banks, the Fed works more like a government agency than a business. Under the direction of its chairman, it sets economic policy, supervises banking operations and has become a major factor in shaping the economy.

The governors are appointed to 14-year terms by the president and confirmed by Congress, which insulates them from political pressure to some extent. One term expires every two years. However, the chairman serves a four-year term and is o ften chosen by the president to achieve specific economic goals.

MEMBER BANKS

About half of all the banks in the country are members of the Federal Reserve System. All national banks must belong, and state-chartered banks are eligible if they meet the financial standards the Fed has established.

The Federal Reserve's Many Roles

The Fed plays many roles as part of its responsibility to keep the economy healthy.

The Fed handles the day-to-day banking business of the U.S. government. It gets deposits of corporate taxes for unemployment, withholding and income, and also of federal excise taxes on liquor, tobacco, gasoline and regulated services like phone systems. It also authorizes payment of government bills like Social Security and Medicare as well as interest payments on Treasury bills, notes and bonds.

REGULATOR

By authorizing buying and selling of government securities, the Fed tries to balance the money in circulation. When the economy is stable, the demand for goods and services is fairly constant, and so are prices. Achieving that stability supports the Fed's goals of keeping the economy healthy and maintaining the value of the dollar.

BANKER

The Fed maintains bank accounts for the U.S. Treasury and many government and quasi-government agencies. It deposits and withdraws funds the way you do at your own bank, but in bigger volume: Over 80 million Treasury checks are written every year.

LENDER

If a bank needs to borrow money, it can turn to a Federal Reserve bank. The interest the Fed charges banks is called the discount rate. Bankers don't like to borrow from the Fed, since it may suggest they have problems. And they can often borrow more cheaply from other banks.

AUDITOR

The Fed monitors the business affairs and audits the records of all of the banks in its system. Its particular concerns are compliance with banking rules and the quality of loans.

CONTROLLER

When currency wears out or gets damaged, the Fed takes it out of circulation and authorizes its replacement. Then the Treasury has new bills printed and new coins minted.

GUARDIAN

Gold stored in the U.S. by foreign governments is held in the vault at the New York Federal Reserve Bank -- some 10,000 tons of it. That's more gold in one place than anywhere else in the world, as far as anyone knows. Among its many tasks, the Fed administers the exchange of bullion between countries.

ADMINISTRATOR

The Fed is also the national clearing house for checks. It facilitates quick and accurate transfer of funds in mare than 15 billion transactions a year.

Controlling the Money Flow

The money that powers our economy is created essentially out of nothing by the Federal Reserve.

Keeping a modern economy running smoothly requires a pilot who'll keep it from stalling or overaccelerating.

The U.S., like most other countries, tries to control the amount of money in circulation. The process of injecting or withdrawing money reflects the monetary policy that the Federal Reserve adopts to regulate the economy.

Monetary policy isn't a fixed ideology. It's a constant juggling act to keep enough money in the economy so that it flourishes without growing too fast.

HOW IT WORKS

The Fed's Open Market Committee meets about every six weeks to evaluate the economy.

Then it tells the Federal Reserve Bank of New York -- the city where the nation's biggest banks and brokerage firms have their headquarters -- whether to speed up or slow down the creation of new money.

About 11:15 a.m. every day, the New York Fed decides whether to buy or sell government securities in order to implement the Open Market Committee's policy decisions.

REGULATION IS A TOUGH JOB

It isn't easy to regulate the money supply or control the rate of growth. That's because the economy doesn't always respond quickly or precisely when the Fed acts. Typically, it takes about six months for significant policy changes to affect the economy directly.

ADJUSTING THE RATE

Among the tools the Fed uses when it wants the economy to change direction is increasing or decreasing the discount rate, the rate it charges banks to borrow money. If the discount rate is increased, the banks tend to borrow less and have less money available to make loans to their clients. If the rate is decreased, banks tend to borrow more freely and lend money to their clients at attractive rates. The result is that changes in the discount rate have a ripple effect throughout the economy. And if the Fed isn't satisfied with the response, it can lower or raise the rate a second time or even a third.

CHANGING THE SUPPLY

The Fed regularly influences the amount of money in circulation when it chooses to buy or sell government securities in the open market.

To slow down an economy where too much money is in circulation, the New York Fed sells government securities, taking in the cash that would otherwise be available for lending. And to give the economy a shot in the arm, it creates money by buying securities.

For all practical purpose s, there isn't any limit on the amount of money the Fed can create. The $100 million in the example to the right is only a modest increase in the money supply. In a typical month the Fed might pump as much as $4 billion or as little as $1 billion into the economy.

CREATING MONEY

To create money, the New York Fed buys government securities from banks and brokerage houses. The money that pays for the securities hasn't existed before, but it has value, or worth, because the securities the Fed has bought with it are valuable.

More new money is created when the banks and brokerages lend the money they receive from selling the securities to clients who spend it on goods and services. These simplified steps illustrate how the process works.

0. The Fed writes a check for $100 million to buy the securities from a brokerage house. The brokerage house deposits the check in its own bank (A), increasing the bank's cash.

1. Bank A can lend its customers $90 million of that deposit after setting aside 10%. The Fed requires all banks to hold 10% of their deposits (in this example, $10 million) in reserve. A young couple borrows $100,000 from Bank A to buy a new house. The sellers deposit the money in their bank (B).

2. Now Bank B has $90,000 (the deposit minus the required reserve) to lend that it didn't have before. A woman borrows $10,000 from Bank B to buy a car, and the dealer deposits her check in Bank C.

3. Bank C can now loan $9,000.

This one series of transactions has created $190,099,000 in just four steps. Through a repetition of the loan process involving a wide range of banks and their customers, the $100 million that the Fed initiall y added to the money supply could theoretically become almost $900 million in new money.

HOW FAST MONEY GOES

Money's velocity is the speed at which it changes hands. If a $1 bill is used by 20 different people in a year, its velocity is 20. An increase in either the quantity of money in circulation or its velocity makes prices go up -- though if both increase they can cancel each other's effect.

The Money Supply

There's no ideal money supply. The Fed's goal is to keep the economy running smoothly by keeping an eye on the money that people have to spend.

The money supply measures the amount of money that people have available to spend -- including cash on hand and funds that can be liquidated, or turned into cash.

When the Federal Reserve is following an easy money policy -- increasing the money supply -- the economy tends to grow quickly, companies hire more workers and consumer confidence tends to increase, boosting spending. But if the Fed adopts a tight money policy -- slowing the money supply to combat inflation -- the economy can bog down, unemployment may increase and spending typically slows.

In a strong economy, demand for currency increases without Federal Reserve intervention, and the amount of money in circulation goes up. In the 1990s, for example, the supply of dollars has grown steadily, reflecting demand both in the U.S. and overseas.

MEASURING THE MONEY SUPPLY

If you keep careful track of your personal money supply, you know, for instance, how much cash you have in your wallet and how much money is in your checking account. You also know how much salary is coming in and which investments, such as savings accounts an d certificates of deposit (CDs), can be turned into cash quickly.

Similarly, economists and policy-makers keep careful track of the public money supply using measures called M1, M2, M3 and L.

The three Ms are monetary aggregates, or ways to group assets that people use in roughly the same way. M1, for instance, counts liquid assets, like cash. The object is to separate money that's being saved from money that's being spent in order to predict impending changes in the economy.

L is a measure of other highly liquid assets, and adds a number of short-term bonds, commercial paper and savings bonds, for example, to M3.

READING THE CHARTS

The Federal Reserve reports the financial details of the money supply every week. It's tracked in several different time periods to show both short-term changes and long-term trends. The average daily amounts -- in billions of dollars -- are provided for each component, M1, M2 and M3, and printed in The Wall Street Journal as Monetary Aggregates. The M3 figure, the most inclusive, is always the largest and the M1 the smallest. In addition, a summary of Reserve Aggregates appears every two weeks, providing additional financial statistics.

Seasonally adjusted (sa) amounts are always computed and compared with non-adjusted numbers (nsa). Seasonal adjustments reflect the varying flow of money into and out of bank accounts. In the spring, for instance, tax refunds tend to swell checking accounts that were depleted in the winter as consumers paid off holiday bills.

CHANGING YARDSTICK

In the early 1990s, the Federal Reserve stopped using its long-standing yardstick for measuring the economy -- growth in the M2 money supply. Bec ause people increasingly keep their cash in mutual fund money market accounts, which aren't included in M2, the Fed found that the figure wasn't a reliable indicator of economic growth.

So, instead of adjusting interest rates to control the money supply as a reaction to changes in M2, the new method is to set short-term real interest rates (the current interest rates minus the rate of inflation) at a level that the Fed believes will produce growth without inflation.

Measuring Economic Health

Economists keep their fingers on the pulse of the economy at all times, determined to cure what ails it.

Intensive care is a 24-hour business. Doctors and nurses measure vital signs, record changes in temperature and physical functions, conduct test after test. That gives you an idea of how thousands of experts -- and countless more interested amateurs -- watch the economy.

The biggest differences? The vigil never stops -- even when the economy seems healthy. And there are usually multiple causes for any sign of weakness, often including a number that can't be cured by treating the U.S. economy alone.

Unemployment Figures

New unemployment claims for state unemployment insurance give a sense of the number of people losing their jobs. A falling number is a sign the economy is growing. The chart here reports that initial claims fell dramatically in early 1999.

The flip side of low unemployment, however, is the fear of increasing inflation. In the past, at least, employers have increased wages to attract new workers when competition was tight. Whether that pattern will persist in what many experts consider a new economic environment remains unanswered.

The In dex of Leading Economic Indicators is released every month by The Conference Board, a business research group. The numbers rarely surprise the experts, since many of the components are reported separately before the Index is released. But it does provide a simple way to keep an eye on the economy's overall health. Generally, three consecutive rises in the Index are considered a sign that the economy is growing -- and three drops, a sign of decline and potential recession.

Ten leading indicators are averaged to produce the Index, with some carrying more weight than others. Taken together, they're designed to predict short-term economic conditions. Among them are the spread between the 10-year Treasury and the federal funds rate, the M2 money supply, the S&P 500-stock index and the four shown below.

Consumer Confidence

Consumers' attitudes toward the health of the economy are influenced by what they hear. And their confidence -- or lack of it -- affects how the economy fares.

If consumers feel good about their current situation and about the future, they tend to spend more freely, which boosts economic growth. If they're worried about things like job security, they tend to save more and spend less, slowing economic growth and the economy itself.

Consumers often respond slowly to news of an economic recovery if they don't see an immediate, positive financial impact on their own lives. Their reluctance to start spending helps keep the recovery slow.

The graphs shown on these pages illustrate how the complex information on the state of the economy that the government compiles each month is presented in The Wall Street Journal.

MEASURING EMOTIONS

Co nsumer sentiment is measured in several different ways. Three of the principal guides that economists use are the monthly surveys done by the University of Michigan Institute for Social Research, the Conference Board and Sindlinger & Co. The results are intended for specific audiences, but it's only a matter of minutes before Wall Street's information networks make survey results public knowledge.

The surveys can produce different results because the organizations ask different questions.

* Michigan's poll asks if consumers are confident enough to take on debt for such big-ticket items as cars and appliances.

* The Conference Board focuses on consumer worries about job security.

* The Sindlinger Report measures consumers' income, sense of job security and business conditions.

The Sindlinger Report also looks at whether household income has risen or fallen in the past six months, and what consumers expect in the next six.

The Consumer Price Index

The Consumer Price Index (CPI) looks at the economy from your perspective: it reports what it costs to pay for food, housing and other basics.

The Consumer Price Index (CPI) serves the double role of reflecting economic trends and influencing economic policy decisions. Though its accuracy as well as its urban bias are sometimes questioned,it's the most widely used measure of inflation -- and the basis for figuring adjustments to Social Security payments as well as determining cost-of-living increases in wages and pensions.

HOW THE CPI IS FIGURED

The Bureau of Labor Statistics compiles the CPI every month by recording prices for 80,000 goods and services that reflect the curr ent lifestyle of the typical urban American consumer. It includes food, housing, clothing, transportation, health care, recreation and education as well as a catchall category called other. The Bureau reports changes from month to month and year to year, using the period 1982-1984 as the basis, or starting point, against which the numbers are measured.

The CPI components are adjusted periodically to reflect changes in lifestyle and in the relative cost of living.

The Economic Cycle

Inflation and recession are recurring phases of a continuous economic cycle. Experts work hard to predict their timing and control their effects.

Inflation occurs when prices rise because there's too much money in circulation and not enough goods and services to spend it on. When prices go higher than people can -- or will -- pay, demand decreases and a downturn begins.

THE INFLATION STRUGGLE

Since inflation typically occurs in a growing economy that's creating jobs and reducing unemployment, politicians are willing to risk its problems. But the Federal Reserve prefers to cool down a potentially inflationary economy before it gets out of hand. So it sells government securities, which has the effect of raising interest rates and slowing borrowing. But since it also wants to prevent a long-term slowdown, it typically reverses its policy when the economy seems likely to shrink.

CONTROLLING THE CYCLE

Most developed economies try not to let the economic cycle run unchecked because the consequences could be a major worldwide depression like the one that followed the stock market crash of 1929. In a depression, money is so tight that the economy virtually grinds to a halt, unemployment escalates, businesses collapse and the general mood is grim.

Instead, most central banks adjust their monetary policy at the first sign of a slowdown, or recession, to ward off more trouble.

EASY MONEY SPURS GROWTH -- AND INFLATION

In a recession, the Fed can create new money to make borrowing easier. As the economy picks up, sellers sense rising demand for their products or services and begin to raise prices.

The rule of 72 is a reliable guide to the impact of inflation. Its formula has you divide 72 by the annual inflation rate to find out the number of years it will take prices to double. For example, when inflation is at 10%, prices will double in seven years (72÷10=7) and when it's 3%, they will double in 24 years (72÷3=24).

INFLATION DESTROYS VALUE

Most economists agree that inflation isn't good for the economy because, over time, it destroys value, including the value of money. If inflation is running at a 10% annual rate, for example, the book that cost $10 one year would cost $20 just seven years later. For comparison's sake, if inflation averaged 3% a year, the same book wouldn't cost $20 for 24 years.

Inflation may also prompt investors to buy things they can resell at huge profits -- like art or real estate -- rather than putting their money into companies that can create new products and jobs.

WHO GETS HURT?

The people hit the hardest by inflation are those living on fixed incomes. For example, if you're retired and have a pension that was determined by a salary you earned in less inflationary times, your income will buy less of what you need to live comfortably. Workers whose wages don't keep pace with infl ation can also find their lifestyle slipping.

But inflation isn't bad for everyone. Debtors love it because the money they repay each year is worth less than it was when they borrowed it. If their own income keeps pace with inflation, the money they repay is also an increasingly smaller percentage of their budget.

WHEN THERE'S NO INFLATION

When the rate of inflation slows, it's described as disinflation. Several years of 1% annual increases in the cost of living are disinflationary after a period of more rapid growth. Employment and output can continue to be strong, and the economy can continue to grow.

Deflation, though, is a widespread decline in the prices of goods and services. But instead of stimulating employment and production, deflation has the potential to undermine them. As the economy contracts and people are out of work, they can't afford to buy even at cheaper prices.

The World of Money

Currencies are floated against each other to measure their worth in the global marketplace.

A currency's value in the world marketplace reflects whether individuals and governments are interested in using it to make purchases or investments, or in holding it as a source of long-term security. If demand is high, its value increases in relation to the value of other currencies. If it's low, the reverse occurs.

Some currencies, like the U.S. dollar and the Swiss franc, are relatively stable in price, reflecting an underlying financial and political stability. Most experts expect the euro, introduced in 1999 as the currency of the European Union, to join that group of strong currencies.

Some other currencies experience wild or rapid changes in value, the sign of economies in turmoil as the result of runaway inflation, deflation, defaults on loan agreements, serious balance-of-trade deficits or economic policies that seem unlikely to resolve the problems.

NOTHING IS FIXED

Currency values of even the most stable economies change over time as traders are willing to pay more -- or less -- for dollars or pounds or euros or yen. For example, great demand for a nation's products means great demand for the currency needed to pay for those products.

If there's a big demand for the stocks or bonds of a particular country, its currency's value is likely to rise as overseas investors buy it to make investments. Similarly, a low inflation rate can boost a currency's value, since investors believe that the value of long-term purchases in that country won't erode over time.

HOW CURRENCY VALUES ARE SET

Between 1944 and 1971, major trading nations had a fixed, official rate of exchange fied to the U.S. dollar, which could be redeemed for gold at $35 on ounce. Since 1971, when the gold standard was abandoned, currencies have floated against each other, influenced by supply and demand and by various governments' efforts to manage their currency. Some countries, for example, have sought stability by pegging, or linking, their currency to the value of the U.S. dollar. In Europe, the European Union established the euro as a common currency for 11 participating member nations. At year's end, 1998, their currencies were permanently aligned with one another.

STABILITY IS A GOAL

Governments usually want their currency to be stable, maintaining a constant relative worth with the currencies of their major trading partners. Sometimes they interfere with market forces -- buying up large amounts of their own currency or agreeing with trading partners to lower interest rates -- to achieve that goal.

If interest rates are lowered, however, fewer foreign investors will want to put money in the country's banks. They'll look for better return elsewhere.

Other times, a currency is deliberately devalued if a government decides to lower the value of its currency against those of other countries, often to make its exports more competitive.

CURRENCY CROSS RATES

Currency cross rates, reported as the late New York trading price of the basic units of 11 major currencies, including the euro, in relation to each other, are published daily in The Wall Street Journal. Since these exchange rates apply to bank trades of $1 million or more, they usually reflect a higher unit of foreign currency per dollar than you would get in a retail transaction, such as changing money at a bank.

To find the current exchange rate between two currencies, you find the place on the chart where one country's name (listed alphabetically in the vertical column) intersects with the other's currency value (in the horizontal column). Here, for example, the Mexican peso is trading at 9.7920 to the dollar.

The values of the U.S. dollar and the euro appear first and second, in recognition of the primary roles they play in international transactions. The chart has a global perspective, however, providing exchange information for a number of trading partners whose transactions may not be handled in dollars or euros -- Japanese yen and U.K. pounds, for example, or yen and Canadian dollars.

The Value of Money

Exchanging dollars for euros, pounds for yen, or rupees for rubles is big business -- to the tune of $1.5 trillion a day.

Some currencies are more widely traded than others, dominating world markets and setting standards of value. The U.S. dollar has held that position in recent years, along with the Japanese yen and the German mark. The euro, the currency of the European Union, is widely expected to be a major force in the world economy.

CURRENCY TRADING

Money flows across national borders all the time, so foreign exchange -- changing one currency for another -- flourishes. But there is no actual physical marketplace where the world's currencies are traded. The global foreign exchange market, or forex, is a network of interconnected telephones and computers that operate virtually around the clock. Traders working for big banks and other financial institutions buy and sell currencies in what is by far the largest single financial market in the world. On a typical day, roughly $1.5 trillion in currencies is traded electronically around the world.

TRADING FOR BUSINESS

Corporations that do business in more than one country depend on foreign exchange. If a corporation knows it needs Japanese yen to pay for a shipment of electronic equipment, it asks its bank to buy Japanese currency at the best exchange rate possible.

On a smaller scale, when a New York retailer buys sweaters from a Norwegian company, the New Yorker tells his bank to pay his bill. The bank either dips into its own reserves of kroners or buys them in the currency market. Then the bank calculates the current exchange rate between dollars and kroners, deducts the dollars from its client's acc ount, and instructs the Norwegian company's bank in Oslo to credit the seller's account with the appropriate number of kroners.

Trading Money

Everybody wants to do business at the best possible exchange rates.

You're unlikely to be involved in having to negotiate what a dollar is worth, since currency exchange is a huge business, handled by traders working for large commercial banks or through electronic brokering systems. But you are directly affected by the fact that its value is constantly changing, whether you're traveling abroad or buying imported goods. Basically, a strong dollar means more buying power.

WHAT A DOLLAR'S WORTH

A survey of the approximate rates of exchange for the U.S. dollar against various world currencies is reported every week in The Wall Street Journal. The figures give the amount of foreign currency a dollar would buy. Here, for example, a dollar was worth 1.79 Aruban florins and 35.8896 Belgian francs. A few countries with close tourist or political ties to the U.S., like Bermuda, set the value of their currency permanently at $1.

MONEY AWAY FROM HOME

Travelers exchanging money are very minor players in the currency market. But if they're savvy, they can benefit from banks' and credit card companies large-volume trading. The key is to get the most local currency for their own currency by exchanging where the rate is the best and the commission, or charge for the transaction, is the lowest.

YOUR MONEY ABROAD

The near-universal popularity of credit cards and the growing use of globally linked electronic banking systems has made it easier to handle money matters when you travel.

In most places, you can pay for goods and services with a credit card. When the bills appear on your statement, the value of the transactions is converted to dollars, ususally at favorable rates because the credit card companies do such a huge volume of international business.

With an ATM, American Express or Diner's Club card, you can withdraw cash in local currency directly from your checking account. There's a fee, typically $1 to $2 for each transaction, but the exchange rate is usually the best that you can get anywhere.

BIG DEALS

Large-scale currency trading is done by telephone or electronically through a network controlled by banks or other financial institutions, in what's known as an over-the-counter market. The trades can be handled three different ways, as
* Spot transactions
* Forward transactions
* Swap contracts

TRADING ON THE SPOT

Spot transactions, in which the currency trade occurs immediately and is settled within two days, are big money deals, with minimum trades of $1 million. Trading goes on around the clock, through what is known as the global trading day, which begins when the New Zealand market opens and runs through the end of New York trading.

Exchange rates are updated constantly, and traders must pay careful attention, as a good deal typically depends on split-second timing and small price differences.

FORWARDS AND SWAPS

Companies doing business in more than one country need to protect themselves against sudden or dramatic changes in the relative value of currencies, so they hedge commitments to invest, sell or borrow with agreements that have predetermined forex, or foreign-exchange, rates. Conventional deals are described as pla in vanilla, while others are complex, customized transactions.

Basically, swaps involve converting a cash flow or interest rate in one currency to a cash flow or interest rate in another. Forward transactions mean agreeing on an exchange rate that will apply when currency is traded on a set date in the future.

Copyright © 1999 by Lightbulb Press, Inc. and Dow Jones & Co. Inc.