The Caroline Islands are a widely scattered archipelago in the western Pacific Ocean; they became part of a UN Trust Territory under US administration following World War II. The eastern four island groups adopted a constitution in 1979 and chose to become the Federated States of Micronesia. (The westernmost island group became Palau.) Independence came in 1986 under a Compact of Free Association (COFA) with the US, which was amended and renewed in 2004. Present concerns include large-scale unemployment, overfishing, overdependence on US foreign aid, and state perception of inequitable allocation of US aid.

As a signatory to the COFA with the US, Micronesians enjoy the right to migrate to and settle in any part of the US and its territories - this privilege reduces stresses on the island economy and the environment.

Economic activity consists largely of subsistence farming and fishing, and government, which employs two-thirds of the adult working population and receives funding largely - 58% in 2013 – from Compact of Free Association assistance provided by the US. The islands have few commercially valuable mineral deposits. The potential for tourism is limited by isolation, lack of adequate facilities, and limited internal air and water transportation.

Under the terms of the original Compact, the US provided $1.3 billion in grants and aid from 1986 to 2001. The US and the Federated States of Micronesia (FSM) negotiated a second (amended) Compact agreement in 2002-03 that took effect in 2004. The amended Compact runs for a 20-year period to 2023; during which the US will provide roughly $2.1 billion to the FSM. The amended Compact also develops a trust fund for the FSM that will provide a comparable income stream beyond 2024 when Compact grants end.

The country's medium-term economic outlook appears fragile because of dependence on US assistance and lackluster performance of its small and stagnant private sector.