Test 1 Material EC 205 NCSU

What is Gross Domestic Product (GDP)?

The market value of all final goods and services produced in an economy during a given period.

Why can GDP increase without an increase in actual production?

Because prices can rise (inflation), making output appear more valuable even if the quantity stays the same.

Why does the distinction between prices and quantities matter for GDP?

Only increases in quantity improve living standards; higher prices alone do not

What is nominal GDP?

GDP measured using CURRENT PRICES in the year the output is produced

Why is nominal GDP not useful for comparisons over time?

Because inflation can make GDP rise even when actual production does not change.

What is inflation?

A general rise in prices over time.

What is real GDP?

GDP measured using constant prices, removing the effects of price changes.

Why do economists prefer real GDP when discussing economic growth?

Because it reflects actual changes in production, not changes in prices

When the news says “the economy grew 2%,” what kind of GDP growth is being referenced?

Real GDP growth

How is nominal GDP calculated?

Quantity of output \times Current price for that year

How is real GDP calculated?

Quantity of output \times constant (average) prices.

What is chain-weighting?

A method that calculates real GDP growth using average prices between adjacent years and links those growth rates over time.

What is the approximate relationship between nominal GDP growth, real GDP growth, and price changes?

%\Delta Nominal GDP =~ %\Delta Real GDP + %\Delta Prices

How can you estimate real GDP growth from nominal GDP growth?

The GDP deflator

Why is the unemployment rate an important economic statistic?

It indicates the overall health of the economy and affects individuals’ job prospects

Who measures unemployment in the United States?

The U.S. Bureau of Labor Statistics (BLS)

Why does the BLS use a standardized definition of unemployment?

To allow comparisons over time and across countries.

Who is considered part of the working-age population?

Civilian, noninstitutionalized people age 16 and older.

Who is excluded from the working-age population?

People in the military and those in institutions like prisons or long-term care facilities.

Why does the BLS start counting working-age people at age 16?

Because that’s the age when individuals can choose between school and work.

Who is counted as employed?

Anyone in the working-age population who works at least one hour for pay during the week.

Are self-employed and gig workers considered employed?

Yes.

Are people temporarily absent from their jobs counted as employed?

Yes.

Who is considered unemployed?

Working-age people without jobs who are actively searching for work and available to work.

Why isn’t just wanting a job enough to be counted as unemployed?

You must be actively looking for work and able to accept a job

What is the labor force?

The sum of employed and unemployed people.

What are the three categories of the working-age population?

Employed, unemployed, and not in the labor force.

Who is “not in the labor force”?

Working-age people who are neither working nor actively seeking work

What is the labor force participation rate?

The percentage of the working-age population that is employed or unemployed.

What is the labor force participation rate formula?

\frac {Employed + Unemployed}{Working-age-population}\times 100

Who are considered prime-age workers?

Adults aged 25 to 54

Why is prime-age participation especially important?

Most people in this age range are not in school or retired.

What is the unemployment rate?

The percentage of the labor force that is unemployed.

What is the unemployment rate formula?

\frac {Unemployed}{Labor-Force} \times 100

Why is the unemployment rate measured as a share of the labor force?

To compare places with different labor force participation rates.

How does unemployment change over the business cycle?

It falls during economic growth and rises during downturns.

What is the equilibrium (or natural) unemployment rate?

The rate the economy tends to return to over time, typically around 4-5%

Why is unemployment never zero?

Because job transitions and labor market frictions always exist.

What is inflation?

A generalized rise in the cost of living

How does inflation affect the purchasing power of money?

It reduces purchasing power, meaning each dollar buys fewer goods and services.

Why must wages be compared to inflation?

To determine whether wage increases are keeping u with rising prices.

What is the Consumer Price Index (CPI)?

An index that tracks the average prices consumers pay for a representative basket of goods and services over time

Why is CPI important?

It is the most relevant measures of inflation for consumers.

What does the CPI basket include?

Goods and services such as food, housing, transportation, healthcare, education, and entertainment.

What is a “basket of goods”?

A list of goods and services that represent what a typical consumer buys.

What is the inflation rate?

The annual percentage change in the price of a fixed basked of goods and services

What is the inflation rate formula?

\frac{\left(Price\right)\left(level\right)\left(this\right)\left(year\right)-\left(Price\right)\left(level\right)\left(last\right)\left(year\right)}{\left(Price\right)\left(level\right)\left(last\right)\left(year\right)} \times 100

What is the difference between inflation and relative price changes?

Inflation is a general rise in prices; relative price changes affect individual goods compared to others.

What are the steps in calculating CPI?

• Step 1: Determine what people typically buy

• Step 2: Collect prices from stores and service providers

• Step 3: Tally the weighted cost of the fixed basked of goods

• Step 4: Calculate the inflation rate using percent change

What is the base year in the CPI?

An arbitrary year in which the basket is scaled to $100

What is deflation?

A generalized decrease in the overall price level.

Why can deflation be harmful?

It can cause people to delay spending, slowing economic activity.

Why is CPI an imperfect measure of the cost of living?

It assumes a fixed basket and doesn’t fully capture consumer adjustments.

How do quality improvements bias CPI?

CPI overstates inflation by not fully accounting for improved product quality.

How do new products bias CPI?

CPI ignores the benefits and cost reductions from new products.

What is substitution bias?

CPI overstates inflation because it ignores consumers substituting cheaper goods.

Three major things CPI misses?

Quality improvements, new products, and substitution.

What is the chained CPI?

An inflation measure that updates the basket frequently to reduce substitution bias.

How does chained CPI compare to CPI?

It is usually about 0.25 percentage points lower.

By how much does CPI likely overstate inflation?

By nearly 1% per year.

What is the GDP deflator equation?

\frac{(Nominal)(GDP)}{(Real)(GDP)} \times 100

Why does inflation make it misleading to compare dollar amounts from different years?

Because a dollar in the past had more purchasing power than a dollar today, so raw dollar comparisons ignore changes in prices

What is money illusion?

The tendency to focus on nominal dollar amounts rather than real purchasing power.

What tool do economists use to adjust past dollar values for inflation?

The Consumer Price Index (CPI)

What is the inflation adjustment formula?

Today’s dollars = Past dollars \times \frac {CPI-Today}{CPI-Past}

What is a nominal variable

A variable measured in current dollars that is affected by inflation.

What is a real variable?

A variable that has been adjusted for inflation to reflect true purchasing power.

Why do economists prefer real variables for comparisons over time?

Because real variables remove the effects of inflation and reflect actual changes in quantities.

What is a base year?

The year whose price level is used to express real values when adjusting for inflation.

How is a nominal value converted into a real value?

By multiplying the nominal value by the ratio of the base-year CPI to the CPI in the original year.

What shortcut can be used to calculate real growth?

Real growth = Nominal growth - Inflation

What is the nominal interest rate?

The stated interest rate measured in dollars, without adjusting for inflation.

What is the real interest rate?

The interest rate adjusted for inflation, measuring the change in purchasing power.

How can the real interest rate be approximated?

Real interest rate = Nominal interest rate - Inflation rate

Why might people accept a 0% nominal wage change during inflation?

Because money illusion makes them focus on unchanged dollar wages, even though real wages fall.

What is nominal wage rigidity?

Employer’s reluctance to cut nominal wages, even when real wages decline due to inflation.

Why is CPI-based inflation imperfect at measuring cost of living?

It fails to fully account for quality improvements, new products, and substitution behavior

What is substitution bias in the CPI?

The overstatement of inflation because the CPI assumes people buy the same goods even when they substitute cheaper alternatives

What is the chained CPI?

An alternative inflation measure that updates the basket of goods to reduce substitution bias.

What is the key lesson economists emphasize to avoid money illusion?

Always focus on real values and purchasing power, not nominal dollar amounts.

What are the three functions of money?

Medium of exchange, unit of account, and store of value.

What does it mean that money is a medium of exchange?

Money is used to buy and sell goods and services, replacing barter.

What problem does money solve compared to barter?

The double coincidence of wants.

What does it mean that money is a unit of account?

It provides a common measure for prices, debts, and contracts.

Why must money be a stable unit of account?

Stability makes prices meaningful and comparisons easy.

What does it mean that money is a store of value?

It preserves purchasing power over time.

Why is money better than storing goods like food or art

It is easy to store and doesn’t spoil or require physical space

How does inflation affect money’s usefulness?

Inflation weakens money’s roles as a medium of exchange, unit of account, and store of value.

Why does high inflation undermine money as a store of value?

Money rapidly loses purchasing power.

What is hyperinflation?

Extremely high inflation where prices rise very rapidly, often doubling within months.

How does hyperinflation affect daily life?

Cash becomes nearly worthless, barter increases, and transactions become very difficult.

What are menu costs?

The cost businesses incur from frequently changing prices (e.g., printing menus)

Why does inflation increase menu costs?

Higher inflation requires more frequent price adjustments.

What are shoe-leather costs?

Time and effort spent managing money to avoid losing value from inflation

Why does inflation increase shoe-leather costs?

People hold less cash and visit banks more often.

Why is unexpected inflation more harmful than expected inflation?

It causes confusion and redistributed wealth unfairly

How does inflation confuse price signals?

Producers can’t tell whether price increases reflect demand or inflation

What economic problem does this confusion cause?

Firms make inefficient production decisions.