Ch. 6-

What does it mean that trade-offs are everywhere?

Every decision involves giving up one option to choose another because resources (time, money, effort) are limited.

What is opportunity cost?

The value of the next best alternative you give up when you make a decision.

What does it mean to think at the margin?

Making decisions by comparing the additional (marginal) benefits and costs of a small change

How do people respond to incentives?

People change their behavior when costs or benefits change (higher rewards encourage action; higher costs discourage it).

Why can trade make everyone better off?

Trade allows people to specialize in what they do best and exchange goods, increasing total gains for all parties.

Why are markets usually a good way to organize economic activity?

Markets use prices to coordinate decisions, allocate resources efficiently, and reflect supply and demand.

When can governments help markets?

When markets fail—such as with externalities, public goods, monopolies, or unequal information.

Which big ideas explain individual decision-making?

trade-offs, opportunity cost, marginal thinking, and incentives.

Which big ideas explain interaction between people?

trade, markets, and government intervention.

What does it mean that economic booms and busts are inevitable but can be mitigated?

Economies naturally go through expansions and recessions, but government policies and programs can reduce how severe these cycles are.

How can governments mitigate economic fluctuations?

Through fiscal policy (government spending and taxes), monetary policy, and stabilizers like Employment Insurance

Why do prices rise when too much money is printed?

When the money supply grows faster than the economy, each dollar loses value, leading to inflation.

Who controls the money supply in Canada?

The Bank of Canada, which manages inflation and economic stability through monetary policy.

What happens if the money supply is poorly controlled?

It can cause high inflation or hyperinflation, harming economic stability and purchasing power.

What is the tradeoff between inflation and unemployment?

Policies that reduce unemployment may increase inflation, while policies that reduce inflation may raise unemployment.

Why must policymakers manage inflation and unemployment carefully?

Because pushing too hard on one can worsen the other, especially during recessions or economic shocks

What do the macroeconomic big ideas focus on?

The economy as a whole—growth, inflation, unemployment, and stabilization over time.

What are the two primary tools governments use to influence the economy?

• Monetary Policy

• Fiscal Policy

What is Monetary Policy?

Monetary policy involves adjusting key interest rates to influence overall spending, borrowing, and investment in the economy.

How does Monetary Policy affect the economy?

• Lower interest rates → more borrowing and spending

• Higher interest rates → less borrowing and spending

What is Fiscal Policy?

Fiscal policy involves changes in government spending and taxation to influence economic activity.

How does Fiscal Policy affect the economy?

• Increased government spending or lower taxes → boosts economic activity

• Decreased spending or higher taxes → slows economic activity

What is a business cycle?

The recurring pattern of economic expansion and recession over time

What is a recession?

A period when production and employment decline across most industries.

What is an expansion?

A period of economic improvement with rising production and employment

What is the peak of the business cycle?

The point where economic expansion ends and a recession begins.

What is the trough of the business cycle?

What is the trough of the business cycle?

What is inflation?

A rise in the prices of most goods and services over time

What is deflation?

A general drop in prices across the economy

How does inflation behave in the short run?

Inflation moves with the business cycle:

• Rises during economic expansions

• Falls during recessions

What determines inflation in the long run?

Inflation is mainly determined by changes in the money supply, not short-term economic fluctuations

Short run vs. long run inflation — what’s the key difference?

• Short run: Linked to the business cycle

• Long run: Driven by money supply growth

What is Gross Domestic Product (GDP)?

GDP measures the total value of final goods and services produced within an economy during a given period.

What two things does GDP measure at the same time?

• Total income earned by everyone in the economy

• Total expenditure on final goods and services produced

Why does total income = total expenditure in an economy?

Because every dollar spent on goods and services becomes income for someone else.

What are final goods?

Goods or services sold to the end user that represent the finished product and are counted directly in GDP

Give an example of a final good.

A customer buying a cookie from a bakery

What are intermediate goods?

Goods or services used as inputs to produce another good or service, purchased by businesses, not final consumers

Give examples of intermediate goods.

Flour, butter, and sugar bought by a bakery to make cookies.

Why does the distinction between final and intermediate goods matter for GDP?

• GDP includes only final goods and services

• Counting intermediate goods would overstate production

• Their value is already embedded in the final good’s price

What would happen if GDP included intermediate goods?

GDP would overstate total production.

Why does GDP use market values instead of quantities?

Market prices reflect what buyers are willing to pay, allowing different goods and services to be combined into one measure

What does it mean that GDP is a comprehensive measure?

GDP includes all legally produced final goods and services, including both goods and services

Give examples of items included in GDP.

Goods: laptops, shoes, coffee
Services: university tuition, chiropractic care, haircuts

What does GDP exclude and why?

GDP excludes illegal activities and unpaid household work because they are difficult to measure

Why does hiring a cleaner count in GDP but cleaning your own house does not?

Hiring a cleaner is a market transaction, while household work is unpaid and non-market

Why are intermediate goods excluded from GDP?

Their value is already included in the final product, so counting them separately would cause double counting

What does GDP count under new production?

Only newly produced goods and services within the given period.

Why are used goods excluded from GDP?

Because they do not reflect current economic production

What are the geographic boundaries of GDP?

GDP measures production within a country’s borders, regardless of who produces it

Does production by Canadians abroad count in Canadian GDP?

No. Only production inside Canada counts toward Canadian GDP

What is the GDP identity?

Y = C + I + G + NX

What does Y represent? in the GDP equation

Gross Domestic Product (GDP)

What is Consumption (C)?

Spending by households on goods and services.

Examples: cars, furniture, subscriptions.

What is Investment (I)?

Spending on goods that will produce future goods and services.
Examples: capital equipment, inventories, buildings.

Is buying a house consumption or investment?

Investment, not consumption.

What are Government Purchases (G)?

Spending on goods and services by local, provincial, and federal governments, including public infrastructure and government salaries.

What is excluded from government purchases?

Transfer payments (e.g., Employment Insurance) because they do not create new production.

How do exports affect GDP?

Exports increase GDP because they are domestically produced goods sold abroad.

How do imports affect GDP?

Imports are subtracted because they are produced outside the country.

What are Net Exports (NX)?

Net exports = exports − imports

What is Nominal GDP?

GDP calculated using current prices by multiplying quantities by current prices and summing total spending.

What is Real GDP?

GDP that measures production using constant (base-year) prices, allowing comparison of output across years.

Why is real GDP better than nominal GDP?

It removes the effect of price changes and reflects actual changes in production.

What does real GDP change reflect?

Changes in quantities produced, not prices.

What is the GDP deflator?

A measure of the overall price level that reflects price changes, not output changes.

Formula for the GDP deflator

(Nominal GDP ÷ Real GDP) × 100

What is the GDP deflator in the base year?

100, because nominal GDP equals real GDP.

If only quantities increase, what happens?

Nominal GDP ↑, Real GDP ↑, GDP deflator stays the same.

If only prices increase, what happens?

Nominal GDP ↑, Real GDP stays the same, GDP deflator increases.

When does the GDP deflator rise?

Only when prices rise, not when production increases.

What is inflation?

The percentage change in a price level from one period to the next.

What does GDP per capita measure?

Average income and spending power per person.

How does GDP treat leisure time?

GDP ignores leisure; working more hours raises GDP but may reduce quality of life.

What are non-market activities, and how does GDP treat them?

Unpaid activities (childcare at home, volunteering) are excluded from GDP despite contributing to well-being.

Why is environmental quality a limitation of GDP?

GDP counts production but ignores environmental damage and long-term costs.

How do social issues expose GDP’s limitations?

Crime or substance abuse reduce well-being but may increase GDP through higher spending.

Why doesn’t GDP capture inequality?

GDP and GDP per capita ignore income distribution, even if living standards differ greatly.

Why do economists still care about GDP?

Higher GDP allows countries to fund healthcare, education, infrastructure, and cultural programs.

The Consumer Price Index (CPI) is best described as:

A measure of the overall cost of goods and services purchased by a typical consumer.

The base year in CPI calculations is used to:

Provide a reference point for comparing price levels over time.

The inflation rate is calculated using which formula?

(CPIthisyear−CPIlastyear)÷CPIlastyear×100

Substitution bias occurs because CPI:

Assumes consumers keep buying the same basket even when relative prices change.

The introduction of new goods causes CPI to:

Overstate inflation by not fully accounting for increased variety and value.

If product quality improves but CPI does not fully adjust, measured inflation will be:

Overstated.

Unlike the GDP deflator, CPI includes:

Imported consumer goods.

Unlike CPI, the GDP deflator includes:

Prices of investment goods and government purchases.

CPI differs from the GDP deflator because CPI uses:

A fixed basket of goods and services.

The GDP deflator uses a variable basket, which means it:

Reflects changes in the mix of goods and services produced.

Labour productivity is defined as:

Output per worker.

Sustained increases in living standards depend primarily on:

Growth in productivity.

Natural resources contribute to economic growth mainly by:

Providing a one-time increase in income rather than sustained growth.

In the production function Y = A·F(K, L, H), A represents:

Technology or total factor productivity

Diminishing returns to capital means:

Each additional unit of capital adds less to output than the previous unit.

Long-run sustained growth in output per worker requires:

Technological progress.

In a closed economy, national saving always equals:

Investment.

Private saving is defined as:

Y − T − C.

Public saving is defined as:

T − G.

A government budget deficit occurs when:

Government spending exceeds tax revenue.

A budget surplus increases:

National saving.