ECON 2301 Exam 2 Review

What is Gross Domestic Product (GDP)?

The market value of all final goods and services produced within a country in a given period of time.

What is the difference between microeconomics and macroeconomics?

Microeconomics studies how households and firms make decisions and interact in markets. Macroeconomics studies economy-wide phenomena like inflation, unemployment, and economic growth.

What are the four components of GDP using the expenditure approach?

Y = C + I + G + NX, where C = consumption, I = investment, G = government purchases, NX = net exports (exports minus imports).

What is consumption expenditure?

Spending by households on goods and services, including durable goods (cars, appliances), non-durable goods (clothing, food), and services (education, haircuts).

What is investment in GDP terms?

Spending on final goods and services by firms, including business fixed investment (new capital goods), residential investment (new homes), and inventory investment (change in unsold goods).

How does economic investment differ from financial investment?

Economic investment is the increase in capital goods used for production (physical capital). Financial investment is purchases of stocks and bonds (ownership transfer) and does not directly increase production capacity.

What are government purchases in GDP?

Spending by federal, state, and local governments on final goods and services (fighter jets, teacher salaries). Excludes transfer payments (Social Security, food stamps) and interest on government debt.

What are net exports (NX)?

Exports minus imports. Exports are goods produced domestically and sold abroad; imports are purchases of foreign-produced goods.

What is the income approach to measuring GDP?

GDP = labor income + capital income. Labor income includes wages, salaries, benefits, and self-employment income. Capital income includes profits, rent, royalties, and interest (measured before taxes).

What is nominal GDP?

GDP valued at current-year prices. It reflects both changes in quantities and changes in prices.

What is real GDP?

GDP valued at base-year prices. It measures the physical volume of production by holding prices constant.

How do you calculate real GDP?

Use quantities from the current year and prices from the base year. Sum (current quantity × base year price) for all goods and services.

Why is real GDP a flawed measure of economic well-being?

It omits non-market transactions (household production, volunteer work), illegal activities, leisure time, environmental quality, resource depletion, and does not account for income inequality.

What is the underground economy?

All unreported transactions (legal and illegal, like cash-only work, drug dealing) that are not included in GDP.

What is inflation?

An increase in the overall level of prices in the economy, which reduces the purchasing power of money.

What is the Consumer Price Index (CPI)?

A measure of the cost of living. It tracks the cost of a fixed basket of goods and services purchased by a typical consumer relative to the cost of the same basket in a base year.

How is the CPI calculated?

(Price of basket in current year / Price of basket in base year) × 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 are the three main problems with the CPI?

Substitution bias (consumers switch away from expensive goods), introduction of new goods (basket becomes outdated), and unmeasured quality change (price increases due to quality improvements are not fully adjusted).

What is the difference between nominal and real interest rates?

Nominal interest rate is the annual percentage change in dollar value of an asset. Real interest rate = nominal interest rate - inflation rate.

What is the Fisher effect?

The tendency for nominal interest rates to be high when inflation is high and low when inflation is low; nominal interest rates follow the inflation rate in the long run.

What are the costs of inflation?

Shoeleather costs (cost of managing cash holdings), menu costs (cost of changing prices), tax distortions, arbitrary redistribution of wealth (between borrowers and lenders), and interference with long-term planning.

What is the difference between inflation, deflation, and disinflation?

Inflation = increase in price level. Deflation = decrease in price level (negative inflation). Disinflation = a reduction in the rate of inflation (prices still rise but more slowly).

What is hyperinflation?

Extraordinarily high and accelerating inflation (e.g., 50% per month or more), often caused by excessive money printing.

What is the quantity theory of money?

In the long run, the quantity of money determines the price level, and growth in the money supply is the primary cause of inflation.

What is the equation of exchange?

M × V = P × Y, where M = money supply, V = velocity of money, P = price level, Y = real output (GDP).

What is the velocity of money?

The rate at which money changes hands; calculated as nominal GDP divided by the money supply (V = (P × Y) / M).

What is the money multiplier?

The amount of money the banking system generates from each dollar of reserves. Money multiplier = 1 / reserve ratio.

How do banks create money?

When a bank receives a deposit, it holds a fraction as reserves and loans out the rest. That loan is deposited elsewhere, and the process repeats, multiplying the initial deposit.

What is the difference between M1 and M2?

M1 = currency in circulation + checkable deposits + other liquid deposits (most liquid). M2 = M1 + small-denomination time deposits + retail money market mutual funds (broader measure).

What is the federal funds rate?

The interest rate that banks charge each other for overnight loans of reserves. It is a key target of Federal Reserve monetary policy.

What are the main tools of the Federal Reserve?

1) Interest on reserve balances (IORB), 2) Open market operations (buying/selling bonds), 3) Reserve requirements, 4) Discount rate (interest on loans to banks).

What is an open market purchase?

When the Fed buys government bonds from the public, increasing bank reserves and the money supply.

What is an open market sale?

When the Fed sells government bonds to the public, decreasing bank reserves and the money supply.

What is the difference between commodity money and fiat money?

Commodity money has intrinsic value (e.g., gold, cigarettes). Fiat money has no intrinsic value; it is money because of government decree (e.g., U.S. dollar).

How is unemployment measured?

A person is unemployed if they are 16+, civilian, not institutionalized, and are willing and able to work but cannot find a job (actively looked in the past 4 weeks).

What is the labor force?

The total number of workers = employed + unemployed.

What is the unemployment rate formula?

(Number of unemployed / Labor force) × 100%.

What is the labor force participation rate?

(Labor force / Adult population (16+)) × 100%.

What are discouraged workers?

Workers who would like a job but have not looked for work in the past 4 weeks because they believe no jobs are available. They are counted as out of the labor force.

What is the difference between U-3 and U-6 unemployment measures?

U-3 is the official unemployment rate. U-6 includes U-3 plus discouraged workers, other marginally attached workers, and those employed part-time for economic reasons.

What are the three main types of unemployment?

Frictional (short-term, job search), structural (mismatch of skills or location due to changes in demand/technology), and cyclical (caused by business cycle recessions).

What is the natural rate of unemployment?

The normal rate of unemployment around which the actual unemployment rate fluctuates. It equals frictional unemployment + structural unemployment (excludes cyclical).

How does a minimum wage above equilibrium cause unemployment?

It creates a price floor. At the higher wage, quantity of labor supplied exceeds quantity demanded, leading to a surplus of workers (unemployment).

What are efficiency wages?

Wages kept above market equilibrium to reduce worker turnover, increase productivity, and attract better applicants, which can also cause unemployment.

How does unemployment insurance affect job search?

It reduces the cost of unemployment but may increase the duration of job search because workers have less incentive to accept the first job offer.

What is the demand for labor?

It depends on the productivity of workers and the price of the output. The value of marginal product (VMP) = extra revenue from hiring one more worker.

What is the reservation wage?

The lowest wage a worker would accept for a given job, based on the opportunity cost of lost leisure time.

What is skill-biased technological change?

Technological change that increases the marginal product (and thus demand) for higher-skilled workers more than for lower-skilled workers, leading to wage inequality.

What is the real wage?

The wage adjusted for inflation, measuring purchasing power. Real wage = nominal wage / CPI.

What is indexing?

Automatically increasing a nominal quantity each period by the percentage increase in a price index to preserve purchasing power (e.g., Social Security COLAs).

What is bracket creep?

When households are pushed into higher tax brackets due to nominal income increases from inflation, even though real income has not increased.

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

GDP deflator measures prices of all goods produced domestically; CPI measures prices of a fixed basket of goods bought by consumers (including imports).