ECON201 Midterm 2

Macroeconomics

The study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

Microeconomics

The study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices.

Gross Domestic Product (GDP)

The market value of all final goods and services produced in a country during a period of time, typically one year.

Final Good

A good or service bought by the end consumer of that product. Included in GDP.

Intermediate Good

An input into another good or service (e.g., a tire on a car). Excluded from GDP to avoid double counting.

Double Counting

The mistake of counting output more than once as it travels through the production stages; avoided by only including final goods in GDP.

GDP Formula (Expenditure Approach)

Y = C + I + G + NX, where Y = GDP, C = Consumption, I = Investment, G = Government Purchases, NX = Net Exports.

Consumption (C)

Spending by households on goods and services, not including spending on new houses. The largest component of GDP.

Investment (I)

Spending by firms on new factories, office buildings, and inventories, plus spending by households and firms on new houses. Includes business fixed investment, residential investment, and changes in inventories.

Government Purchases (G)

Spending by federal, state, and local governments on goods and services. Does NOT include transfer payments.

Net Exports (NX)

Exports minus Imports. Represents domestic production sold abroad minus foreign goods purchased domestically.

Transfer Payments

Payments by the government to households for which no new good or service is received in return (e.g., Social Security). NOT included in GDP.

Trade Surplus

Occurs when a country's exports exceed its imports (NX > 0).

Trade Deficit

Occurs when a country's imports exceed its exports (NX < 0).

Nominal GDP

The value of final goods and services evaluated at current-year prices. Can rise due to price increases, not just more production.

Real GDP

The value of final goods and services evaluated at base-year prices. A better measure of actual changes in production over time.

Base Year

The reference year used to calculate real GDP and price indices; the GDP deflator equals 100 in the base year.

GDP Deflator

A measure of the price level calculated by: (Nominal GDP / Real GDP) × 100. Shows how much prices have risen relative to the base year.

How to calculate % change in price level using GDP Deflator

((GDP Deflator Year 2 − GDP Deflator Year 1) / GDP Deflator Year 1) × 100

Value Added Method

An alternative way to measure GDP; sums the market value each firm adds to a product at each stage of production.

GDP per Capita

GDP divided by population; used to compare standards of living across countries.

Household Production

Unpaid work done at home (childcare, cooking, cleaning) that is NOT counted in GDP.

Underground Economy

Buying and selling of goods and services concealed from the government to avoid taxes or because they are illegal. Not included in GDP.

Gross National Product (GNP)

The value of production performed by citizens of a nation, including overseas production by citizens; differs from GDP which is based on geographic location.

National Income

GDP minus depreciation (consumption of fixed capital).

Disposable Personal Income

Personal income minus personal taxes; the amount households can spend or save.

Circular Flow Model

A model showing the flow of goods, services, and money between households, firms, government, the financial system, and the rest of the world.

Real Flows (Circular Flow)

Goods/services flowing from firms to households; factors of production flowing from households to firms.

Monetary Flows (Circular Flow)

Money payments flowing between sectors: households pay firms for goods, firms pay wages, government taxes and spends, etc.

Business Cycle

Alternating periods of economic expansion and economic recession measured by movements in real GDP.

Expansion Phase

Period of the business cycle during which total production and employment increase, ending at a peak.

Recession Phase

Period of the business cycle during which total production and employment decrease, ending at a trough.

Peak

The point in the business cycle where expansion ends and recession begins.

Trough

The point in the business cycle where recession ends and expansion begins.

Recession (Definition)

A significant decline in economic activity lasting more than a few months; media definition is two consecutive quarters of declining real GDP.

NBER

National Bureau of Economic Research; the organization that officially tracks and dates U.S. business cycles.

Great Recession

The recession from late 2007 to mid-2009 — the longest and most severe since the Great Depression of the 1930s.

Great Moderation

The period since the mid-1980s characterized by unusually mild business cycles and reduced fluctuations in real GDP.

Inflation and Business Cycle

During expansions, high demand leads to higher inflation. During recessions, low demand leads to lower inflation or deflation.

Unemployment and Business Cycle

Unemployment rises during recessions and falls during expansions; unemployment often continues rising even after a recession officially ends.

Unemployment (Definition)

A person who does not have a job, has actively looked for work in the last four weeks, and is currently available for work.

Labor Force

The sum of employed and unemployed workers in the economy.

Working-Age Population

All people aged 16 and older not in the military, jail, hospital, or other institutional care.

Discouraged Workers

People available for work who have stopped looking because they believe no jobs are available; NOT counted in the labor force.

Unemployment Rate Formula

(Number Unemployed / Labor Force) × 100

Labor Force Participation Rate

(Labor Force / Working-Age Population) × 100

Frictional Unemployment

Short-term unemployment arising from the process of matching workers with jobs; includes job searching, seasonal work, and career transitions.

Seasonal Unemployment

A type of frictional unemployment where job availability fluctuates with seasonal demand (e.g., ski instructors, farm workers).

Structural Unemployment

Long-term unemployment caused by a persistent mismatch between workers' skills and the requirements of available jobs (e.g., CGI replacing hand-drawn animators).

Cyclical Unemployment

Unemployment caused by a business cycle recession; firms lay off workers as production falls.

Natural Rate of Unemployment (NRU)

Frictional + Structural unemployment; the unemployment rate when cyclical unemployment = 0. In the U.S., approximately 4%–6%.

Full Employment

When the actual unemployment rate equals the natural rate of unemployment; cyclical unemployment is zero.

Potential GDP

The level of real GDP when all firms operate at capacity and the economy is at full employment.

Efficiency Wage

An above-market wage a firm pays to increase worker productivity; leads to more labor supplied than demanded, causing some unemployment.

Minimum Wage

A legally mandated minimum hourly pay; can cause unemployment by keeping the wage above the market equilibrium, leading to more labor supplied than demanded.

Labor Union

An organization of workers that bargains collectively with employers for higher wages and better conditions; unionized wages above market rate can reduce hiring.

Problems with Unemployment Rate — Understatement

Excludes discouraged workers; only measures employment status, not intensity (ignores underemployment and part-time workers wanting full-time work).

Problems with Unemployment Rate — Overstatement

Some people may falsely claim to be looking for work; workers in the underground economy may report themselves as unemployed.

Price Level

A measure of the average prices of goods and services in the economy.

Inflation Rate

The percentage increase in the general price level from one year to the next.

Deflation

A decrease in the general price level (negative inflation rate).

Consumer Price Index (CPI)

Measures the average change over time in prices paid by a typical urban family for a basket of goods and services. CPI = (Cost of basket in current year / Cost of basket in base year) × 100.

CPI Inflation Rate Formula

((CPI Year 2 − CPI Year 1) / CPI Year 1) × 100

Cost-of-Living Index

Another name for the CPI; reflects changes in the cost of purchasing a standard basket of consumer goods.

Cost-of-Living Adjustments (COLAs)

Wage or benefit increases tied to the CPI to maintain purchasing power against inflation.

Substitution Bias (CPI)

CPI overstates inflation because consumers switch to cheaper goods when prices rise, but the fixed basket doesn't reflect this.

Quality Bias (CPI)

CPI may overstate inflation because product improvements (better cars, computers) are hard to separate from pure price increases.

New Product Bias (CPI)

The basket of goods is updated only every 10 years, so new products like smartphones are slow to be included.

Outlet Bias (CPI)

CPI uses full retail prices and doesn't fully account for purchases from discount stores or online retailers.

Producer Price Index (PPI)

Measures the average prices received by producers at all stages of production. Changes in PPI can signal future changes in the CPI.

Core CPI

CPI excluding food and energy prices; used by policymakers because food and energy prices are volatile and can be temporarily skewed.

Nominal Interest Rate

The stated interest rate on a loan, not adjusted for inflation.

Real Interest Rate

Nominal interest rate minus the inflation rate; reflects the true cost of borrowing. Formula: Real = Nominal − Inflation.

Demand-Pull Inflation

Inflation caused by spending increasing faster than production — "too much money chasing too few goods." Often due to excess demand or central bank money supply increases.

Cost-Push Inflation

Inflation caused by a rise in per-unit production costs (e.g., energy price spikes). Prices rise but output falls; supply shocks are the main source.

Financial System

The system of financial markets and financial intermediaries through which firms acquire funds from households.

Financial Markets

Markets where financial securities (stocks, bonds) are bought and sold.

Financial Security

A document stating the terms under which funds pass from the buyer to the seller (e.g., stock, bond).

Stock

A financial security representing partial ownership of a firm.

Bond

A financial security where a firm promises to repay a fixed amount of funds; essentially a loan from a household to a firm.

Financial Intermediaries

Firms (banks, mutual funds, pension funds, insurance companies) that borrow funds from savers and lend them to borrowers.

Three Key Services of the Financial System

Risk sharing (diversifying investments), Liquidity (ease of converting securities to cash), and Information (communicating facts about borrowers and expected returns).

Liquidity

The ease with which a financial security can be exchanged for money.

Private Savings Formula

S_Private = Y + TR − C − T (Household income + Transfer Payments − Consumption − Taxes)

Public Savings Formula

S_Public = T − G − TR (Tax Revenue − Government Purchases − Transfer Payments)

Budget Deficit

When government spending plus transfer payments exceed tax revenue (T < G + TR); public savings is negative (dissaving).

Budget Surplus

When tax revenue exceeds government spending plus transfer payments (T > G + TR); public savings is positive.

Balanced Budget

When tax revenue equals government spending plus transfer payments; public savings = 0.

S = I (Savings equals Investment)

In a closed economy, total savings (private + public) must equal total investment: S = I.

Market for Loanable Funds

A model of the financial system where the interaction of borrowers (firms) and lenders (households) determines the real interest rate and quantity of funds lent.

Crowding Out

The decline in private investment that occurs when government borrows to fund a budget deficit, raising real interest rates and reducing funds available to firms.

Economic Growth

The ability of an economy to produce increasing quantities of goods and services over time; sustained growth raises the standard of living.

Real GDP per Capita

GDP divided by population, adjusted for price changes; the most common measure of average standard of living.

Rule of 70

A shortcut to find how long it takes an economic variable to double: Years to double = 70 / annual growth rate (%).

Labor Productivity

The value an employed person creates per unit of input; the primary driver of long-run economic growth.

Human Capital

The accumulated knowledge, skills, education, and experience of the average worker; a key determinant of labor productivity.

Physical Capital (Capital per Worker)

Manufactured goods (machinery, computers, trucks) used to produce other goods; more capital per worker = higher productivity.

Technological Change

Combination of invention and innovation that enhances labor productivity; allows workers to produce more output in the same time.

Property Rights

Legal protections for private ownership; secure property rights are essential for a functioning market economy and economic growth.

Potential GDP

Real GDP when all firms operate at capacity; increases with labor force growth, capital accumulation, and new technology. U.S. potential GDP grows at approximately 3.3% per year.