Macroeconomics: CPI, Inflation, Growth, and Financial Markets

What is the Consumer Price Index (CPI)?

A measure of the overall cost of goods and services purchased by a typical consumer; used to track inflation.

What is inflation?

An increase in the overall price level of goods and services over time.

What is the consumer price index used for?

To measure changes in the cost of living over time.

What is a market basket?

A collection of goods and services that a typical consumer purchases.

How is the CPI calculated?

(Cost of basket in current year ÷ Cost of basket in base year) × 100.

What is a base year?

The reference year against which prices and the CPI are compared; its CPI is set to 100.

How do you calculate the inflation rate using the CPI?

[(CPI in current year − CPI in previous year) ÷ CPI in previous year] × 100.

What does a CPI of 125 mean?

The market basket costs 25% more than it did in the base year.

What is the substitution bias in the CPI?

The CPI may overstate inflation because it does not fully account for consumers switching to relatively cheaper goods.

What is the introduction of new goods problem?

New goods give consumers more choices and can increase purchasing power, which the CPI may not fully capture.

What is the unmeasured quality change problem?

If products improve in quality, some price increases reflect better products rather than inflation, but the CPI may not fully account for this.

Why might the CPI overstate the cost of living?

Substitution bias, the introduction of new goods, and unmeasured quality changes can cause it to overstate increases in living costs.

What is the GDP deflator?

A measure of the price level for all final goods and services produced domestically.

How is the GDP deflator calculated?

(Nominal GDP ÷ Real GDP) × 100.

What is the main difference between the CPI and GDP deflator?

The CPI measures prices of a consumer market basket, including imported consumer goods; the GDP deflator measures prices of domestically produced final goods and services.

Which index includes imported consumer goods: CPI or GDP deflator?

CPI.

Which index covers domestically produced investment goods and government purchases?

The GDP deflator.

How do you compare dollar amounts from different years?

Amount in year B = Amount in year A × (Price index in year B ÷ Price index in year A).

What does indexation mean?

Automatically adjusting a dollar amount according to changes in a price index.

What is a cost-of-living adjustment (COLA)?

An adjustment to wages or benefits to account for changes in the cost of living.

What is a nominal interest rate?

The stated interest rate, not adjusted for inflation.

What is a real interest rate?

The interest rate adjusted for inflation; it measures the change in purchasing power from saving or borrowing.

What is the approximate formula for the real interest rate?

Real interest rate ≈ Nominal interest rate − Inflation rate.

If the nominal interest rate is 8% and inflation is 3%, what is the approximate real interest rate?

5%.

If the nominal interest rate is 4% and inflation is 6%, what is the approximate real interest rate?

−2%; purchasing power decreases by approximately 2%.

What is economic growth?

An increase in an economy's ability to produce goods and services over time, commonly measured by growth in real GDP.

Why is real GDP per person important?

It measures average real economic output per person and helps compare living standards across countries and over time.

What is productivity?

The quantity of goods and services produced per unit of labor input.

What is the main determinant of living standards in the long run?

Productivity.

What is the relationship between productivity and living standards?

Higher productivity generally allows a country to produce more output per person and sustain higher living standards.

What is physical capital?

Tools, equipment, buildings, and machinery used to produce goods and services.

What is human capital?

The knowledge and skills workers acquire through education, training, and experience.

What are natural resources?

Inputs into production provided by nature, such as land, minerals, forests, and water.

What is technological knowledge?

Society's understanding of the best ways to produce goods and services.

How does physical capital increase productivity?

It gives workers better tools and equipment, allowing them to produce more output.

How does human capital increase productivity?

Education, training, and skills help workers perform tasks more efficiently.

How do natural resources affect productivity?

They provide inputs that can support production, although productivity can still be high in countries with limited natural resources.

How does technology increase productivity?

It improves production methods, allowing more output from the same amount of resources.

What is investment in macroeconomics?

Spending on capital goods that will be used to produce future goods and services.

What is the opportunity cost of investment?

Consumption or other uses of resources given up today to increase future productive capacity.

What is diminishing returns to capital?

As more capital is added while other inputs remain fixed, the additional output from each extra unit of capital eventually decreases.

What is the catch-up effect?

The tendency for countries that start with lower levels of capital per worker to grow faster than wealthier countries, under certain conditions.

Why might poorer countries grow faster than richer countries?

They may experience larger productivity gains from additional capital and can adopt existing technologies rather than inventing them.

How can government policies promote economic growth?

By supporting education, saving and investment, research and development, infrastructure, stable institutions, and secure property rights.

Why are property rights important for economic growth?

They give people and businesses confidence that they can own assets and benefit from their investments.

Why is long-run economic growth important?

It can raise living standards, increase productive capacity, and improve society's ability to meet people's needs.

What is the financial system?

The group of institutions and markets that help move funds from savers to borrowers.

What is a financial market?

A market where people who want to save can directly supply funds to people or organizations that want to borrow.

What is a bond?

A debt instrument through which a borrower promises to make payments to the bondholder.

What is a stock?

A share of ownership in a company that can provide returns through dividends and changes in share price.

What is the difference between stocks and bonds?

Stocks represent ownership in a company; bonds represent debt owed by the issuer.

What is a financial intermediary?

An institution that helps transfer funds from savers to borrowers.

What is a bank's role in the financial system?

It accepts deposits from savers and makes loans to borrowers.

What is a mutual fund?

An institution that pools money from many investors to purchase a diversified portfolio of assets.

What is private saving?

Household income remaining after paying taxes and consumption expenses.

How is private saving calculated?

Private saving = Y − T − C.

What do the variables Y, T, and C represent in the saving equation?

Y = national income; T = taxes minus transfers; C = consumption.

What is public saving?

The government's tax revenue minus government spending on goods and services.

How is public saving calculated?

Public saving = T − G.

What is a government budget surplus?

A situation in which tax revenue exceeds government spending; public saving is positive.

What is a government budget deficit?

A situation in which government spending exceeds tax revenue; public saving is negative.

What is national saving?

The total income of a nation remaining after consumption and government purchases.

How is national saving calculated?

National saving = Y − C − G; equivalently, private saving + public saving.

What is the relationship between saving and investment in a closed economy?

National saving equals investment: S = I.

What is the difference between saving and investment in economics?

Saving is income not spent on consumption; investment is spending on newly produced capital goods.

What is the market for loanable funds?

A model showing how saving supplies funds and investment borrowing demands funds.

What is the supply of loanable funds?

Funds made available by savers for borrowing and investment.

What is the demand for loanable funds?

Funds households and firms want to borrow for investment.

What determines the equilibrium in the loanable funds market?

The real interest rate adjusts until the quantity of funds supplied equals the quantity demanded.

What happens to the quantity of loanable funds supplied when the real interest rate rises?

The quantity supplied generally increases because saving becomes more rewarding.

What happens to the quantity of loanable funds demanded when the real interest rate rises?

The quantity demanded generally decreases because borrowing becomes more expensive.

What happens when the government introduces saving incentives?

Saving may increase, shifting the supply of loanable funds to the right, lowering the equilibrium real interest rate and increasing investment.

What happens when the government introduces investment incentives?

Investment demand may increase, shifting the demand for loanable funds to the right, raising the equilibrium real interest rate and quantity of funds borrowed.

What is crowding out?

The reduction in private investment that can occur when government borrowing raises interest rates.

How can a government budget deficit affect the loanable funds market?

It reduces public saving and national saving, shifting the supply of loanable funds left, raising the real interest rate and reducing private investment, other things equal.

What happens to loanable funds when the government runs a budget surplus?

Public and national saving increase, shifting the supply of loanable funds right, lowering the real interest rate and encouraging investment, other things equal.

What is the relationship between the real interest rate and investment?

Higher real interest rates generally discourage investment; lower real interest rates generally encourage it.

What happens when the supply of loanable funds decreases?

The equilibrium real interest rate rises and the equilibrium quantity of loanable funds falls.

What happens when the demand for loanable funds increases?

The equilibrium real interest rate rises and the equilibrium quantity of loanable funds increases.

Who is considered employed?

A person who worked for pay or profit during the reference period, or who has a job but was temporarily absent.

Who is considered unemployed?

A person who is not employed, is available for work, and has actively searched for a job recently, or is on temporary layoff under the applicable survey rules.

Who is considered outside the labor force?

A person who is neither employed nor classified as unemployed, such as someone who is not currently seeking work.

What is the labor force?

The total number of employed people plus unemployed people.

How is the unemployment rate calculated?

(Unemployed people ÷ Labor force) × 100.

How is the labor force participation rate calculated?

(Labor force ÷ Adult population) × 100.

What is an example of someone outside the labor force?

A full-time student who is not working and is not actively seeking a job.

What is a discouraged worker?

A person who wants a job and is available to work but has stopped looking because they believe suitable jobs are unavailable.

How can discouraged workers affect the reported unemployment rate?

They are generally excluded from the official unemployed count and labor force, potentially lowering the reported unemployment rate.

What is frictional unemployment?

Short-term unemployment that occurs while people search for jobs or move between jobs.

What is structural unemployment?

Unemployment that occurs when workers' skills or locations do not match available jobs, or when labor-market institutions keep wages above equilibrium.

What is cyclical unemployment?

Unemployment associated with fluctuations in the business cycle, especially economic downturns.

What is the natural rate of unemployment?

The unemployment rate that exists when cyclical unemployment is zero; it includes frictional and structural unemployment.

What is job search?

The process workers use to find jobs that fit their skills, preferences, and circumstances.

Why does frictional unemployment exist?

Finding an appropriate job takes time, and workers and employers need time to find each other.

How can government policy reduce frictional unemployment?

By improving job information, employment services, and access to training or placement resources.

What are unemployment benefits?

Government payments that temporarily support eligible unemployed workers.

How can unemployment benefits affect job search?

They provide income support but may also lengthen job searches by reducing the immediate financial pressure to accept a job.

What is a minimum-wage law?

A law establishing the lowest hourly wage employers may legally pay covered workers.

How can a minimum wage cause unemployment in the standard competitive labor-market model?

If set above the equilibrium wage, it can increase the quantity of labor supplied and reduce the quantity demanded, creating a surplus of labor.

Which workers are most likely to be affected by a binding minimum wage?

Workers whose productivity and experience place them in lower-wage jobs, particularly some younger and less-experienced workers.