Test 1 Review

Comprehensive review covering Chapters 9 (GDP), 11 (Unemployment), 12 (Inflation), and 17.1 (Business Cycle). This test includes 45 multiple choice questions based on class material.

Key Concepts Overview

• Chapter 9: GDP measures economic activity through three equivalent approaches (expenditure, value added, income). Real GDP adjusts for inflation and is better for comparisons over time.
• Chapter 11: Unemployment has three types (frictional, structural, cyclical). The equilibrium rate (NAIRU) is about 5% and never zero.
• Chapter 12: CPI measures inflation in a fixed basket. Real variables adjust for inflation. Money has three functions that inflation undermines.
• Chapter 17.1: The business cycle tracks deviations between actual output ($Y$) and potential output ($Y^{\ast }$). Output gaps predict unemployment via Okun’s Rule.

Critical Formulas to Memorize

Exam Alert - GDP Formulas

Expenditure Approach: $Y=C+I+G+NX$

Value Added: $\text{Value Added}=\text{Total Sales}-\text{Cost of Intermediate Inputs}$

Growth Approximation: $\%\Delta \text{Real GDP}\approx \%\Delta \text{Nominal GDP}-\%\Delta \text{Prices}$

Rule of 70: $\text{Years to double}\approx \frac{70}{\text{Annual Growth Rate (\%)}}$

Exam Alert - Unemployment Formulas

Labour Force: $\text{Labour Force}=\text{Employed}+\text{Unemployed}$

Labour Force Participation Rate: $\text{LFPR}=\left(\frac{\text{Employed}+\text{Unemployed}}{\text{Working Age Population}}\right)\times 100$

Unemployment Rate: $\text{Unemployment Rate}=\left(\frac{\text{Unemployed}}{\text{Labour Force}}\right)\times 100$

Exam Alert - Inflation Formulas

Inflation Rate: $\text{Inflation Rate}=\frac{\text{Price of basket this year}-\text{Price of basket last year}}{\text{Price of basket last year}}\times 100$

Converting to Today’s Dollars: $\text{Value in today’s dollars}=\text{Value in past dollars}\times \frac{\text{CPI today}}{\text{CPI in past year}}$

Real Interest Rate: $\text{Real interest rate}=\text{Nominal interest rate}-\text{Inflation rate}$

Exam Alert - Business Cycle Formulas

Output Gap: $\text{Output Gap}=\frac{Y-Y^{\ast }}{Y^{\ast }}\times 100$

Okun’s Rule of Thumb: For every 1% that output falls below potential, unemployment rises by 0.33-0.5%

Chapter 9: Sizing Up the Economy Using GDP

What is GDP?

GDP is the market value of all final goods and services produced within a country in a given year.

Key Components of the Definition:

1. Market Value: Sum of $P\times Q$ for all goods
2. Of All: Includes goods and services, but excludes non-market activity and illegal activity
3. Final Goods: Only final products counted (not intermediate goods) to avoid double counting
4. Produced: Only new production (not resales of used goods)
5. Within a Country: Produced within borders, regardless of ownership
6. In a Given Year: Flow measure over a time period

The Circular Flow Model

The circular flow shows that every dollar spent by a buyer becomes income for a seller.

Key Insight

$\text{Total Output}=\text{Total Spending}=\text{Total Income}$

This equality is why GDP can be measured three different ways.

Three Approaches to Measuring GDP

A. Expenditure Approach (Most Common) $Y=C+I+G+NX$

• $C$ (Consumption): Household spending on final goods/services
• $I$ (Investment): Business capital spending + new housing + inventory changes
• $G$ (Government): Government purchases (NOT including transfer payments like CPP/EI)
• $NX$ (Net Exports): Exports - Imports (subtract imports because they’re in C, I, G but not produced domestically)

B. Value Added Approach Sum the value added at each production stage to avoid double counting. $\text{Value Added}=\text{Total Sales}-\text{Cost of Intermediate Inputs}$

C. Income Approach Track who earns money from production: wages, salaries, interest, rental profits, dividends

Real vs. Nominal GDP

Critical Distinction

• Nominal GDP: Measured in current prices ($P_t\times Q_t$). Misleading for comparisons over time because it includes inflation.
• Real GDP: Measured in constant base-year prices ($P_{\text{base}}\times Q_t$). Isolates quantity changes. Best for comparing growth over time.

Limitations of GDP

GDP misses six key areas:

1. Prices ≠ Values: Market price doesn’t reflect consumer surplus (e.g., free services like Wikipedia)
2. Non-market Activities: Home production (childcare, cooking, cleaning) not counted
3. Shadow Economy: Illegal/off-the-books transactions missing
4. Environmental Degradation: Natural resources only count when extracted/processed
5. Leisure: No value placed on relaxation time
6. Distribution: GDP doesn’t show how income is divided (inequality)

Scaling Large Numbers

• Per Capita: Divide by population (Canada ≈ 38 million)
• % of GDP: Express as percentage of total economy
• Rule of 70: Years to double = $70/\text{growth rate}$

Chapter 11: Unemployment

Measuring Employment Status

The working-age population (15+, non-military, non-institutionalized) is divided into three categories:

1. Employed: Working ≥1 hour for pay, self-employed, or temporarily absent from job
2. Unemployed: Not working, actively searching, and able to accept a job
3. Not in Labour Force: Not employed or unemployed (retirees, students, gave up searching)

Remember

The unemployment rate is NEVER zero. People constantly flow in and out of jobs.

Key Metrics

Labour Force = Employed + Unemployed

LFPR = $\frac{\text{Employed + Unemployed}}{\text{Working Age Pop}}\times 100$

Unemployment Rate = $\frac{\text{Unemployed}}{\text{Labour Force}}\times 100$

Labour Market Dynamics

• In Canada, ~300,000 people start new jobs and ~300,000 leave jobs every month
• Most unemployment spells are short (<10 weeks)
• Long-term unemployment (>6 months) is dangerous: skill loss, employer discrimination, loss of hope

Hidden Unemployment

The official rate understates unemployment by excluding:

• Marginally Attached: Want work but stopped looking
• Discouraged Searchers: Not searching because believe no jobs available
• Underemployed: Working part-time but want full-time, or job doesn’t use skills

The broadest unemployment measure is ~50% higher than the official rate

Three Types of Unemployment

A. Frictional Unemployment Time needed for job matching (search time). This is why unemployment can never be zero.

Factors:

• Information availability (LinkedIn vs. newspaper ads)
• Skills mismatch (“sorting socks” - specific skills need specific jobs)
• Employment Insurance (EI) reduces opportunity cost of searching longer

B. Structural Unemployment Wage stuck above equilibrium → Supply > Demand → unemployment

Causes:

• Efficiency Wages: Firms pay above market rate to boost productivity/reduce turnover
• Unions: Collective bargaining raises wages ~15% → may reduce labour demand
• Job Protection Regulations: Hard to fire → firms hesitant to hire
• Minimum Wage: Price floor above equilibrium creates surplus

C. Cyclical Unemployment Caused by recessions. Economy slows → demand for goods falls → demand for labour falls

NAIRU (Natural Rate of Unemployment)

NAIRU = $U^{\ast }$ = Equilibrium unemployment rate ≈ 5%

GDP Gaps and Unemployment

• Inflationary Gap: $Y>Y^{\ast }$ → $U<U^{\ast }$
• Recessionary Gap: $Y<Y^{\ast }$ → $U>U^{\ast }$

Costs of Unemployment

Economic Costs:

• Individual: Lower wages upon return (~1.4 years earnings lost), scarring effect
• Macro: Hysteresis (temporary high unemployment → permanently higher $U^{\ast }$)
• Fiscal: Lost tax revenue + increased social spending

Social Costs:

• Depression, anxiety, divorce, suicide
• Intergenerational: Children of laid-off workers have worse outcomes

Chapter 12: Measuring Inflation

What is Inflation?

Inflation is a generalized rise in the overall level of prices (not just individual price changes).

The Consumer Price Index (CPI)

Tracks the average price consumers pay over time for a fixed basket of goods and services.

Constructing the CPI:

1. Find what people buy: Surveys to build representative basket
2. Collect prices: Visit retailers, online stores, service providers
3. Tally basket cost: Weight by purchase frequency, scale to base year = 100
4. Calculate inflation rate: % change in basket cost year-over-year

Inflation Calculation

If basket cost \796.70$in2021and$$820.00$ in 2022: $\text{Inflation}=\frac{820-796.7}{796.7}\times 100=2.9\%$

CPI Limitations

CPI likely overstates cost of living because it misses:

1. Quality improvements: Higher prices may reflect better features
2. New products: Doesn’t capture cost savings from innovations (smartphones replacing multiple devices)
3. Substitution bias: Fixed basket doesn’t capture consumers switching to cheaper alternatives

Different Price Measures

Consumer Measures:

• CPI: Used for cost-of-living adjustments, government payments
• Core Inflation: Excludes volatile food/energy, shows underlying trends
• CPI-Median: Bank of Canada’s preferred measure (50th percentile of price changes)

Bank of Canada's inflation target: 2% year-over-year CPI change

Business Measures:

• PPI (Producer Price Index): Tracks input prices
• GDP Deflator: Tracks prices of all domestically produced goods/services (used to convert nominal GDP to real GDP)

Adjusting for Inflation

Converting Past Dollars to Today: $\text{Value today}=\text{Value past}\times \frac{\text{CPI today}}{\text{CPI past}}$

Nominal vs. Real Variables:

• Nominal: Measured in dollars (value fluctuates with inflation)
• Real: Adjusted for inflation (true purchasing power)

To convert: $\text{Real}=\text{Nominal}\times \frac{\text{CPI base}}{\text{CPI current}}$

Real Interest Rate: $\text{Real rate}=\text{Nominal rate}-\text{Inflation rate}$

Example

5% nominal interest, 3% inflation → 2% real interest rate Your purchasing power increased by 2%

Money Illusion

The mistaken tendency to focus on nominal amounts instead of real (inflation-adjusted) amounts.

Effects:

• Distorts decisions (if all prices AND incomes rise 25%, nothing real changed)
• Leads to mis-pricing of assets
• Creates nominal wage rigidity (workers accept unchanged nominal wages as real wages fall)

Three Functions of Money

1. Medium of Exchange

• Used to buy goods/services
• Must be widely accepted
• Without it, barter requires “double coincidence of wants”
• Enables specialization

2. Unit of Account

• Common unit to measure economic value
• Simplifies comparisons
• Must be stable to be useful

3. Store of Value

• Shifts wealth to the future
• Should reliably hold value over time

Inflation undermines all three functions of money

Costs of Inflation

Expected Inflation:

• Menu Costs: Marginal cost of adjusting prices (reprinting menus, reprogramming systems)
• Shoe-Leather Costs: Time/effort spent avoiding holding cash (moving money to preserve value)

Unexpected Inflation:

• Confuses Price Signals: Hard to distinguish real demand changes from general inflation
• Redistribution: Transfers wealth from savers/lenders to borrowers (loans repaid in less valuable dollars)

Inflation Fallacy

The mistaken belief that inflation destroys purchasing power. Since wages also rise with inflation, purchasing power remains roughly unchanged. People blame inflation for high prices but credit themselves for wage increases.

Hyperinflation

Extremely high inflation rates (no precise threshold). Examples: Germany 1922-1923 (prices doubled every few days), Venezuela’s recent crisis.

Hyperinflation destroys all three functions of money, making economic life nearly impossible.

Chapter 17: Tracking the Business Cycle

Long-Run vs. Short-Run

• Long-run: Focuses on trend growth in potential output ($Y^{\ast }$)
• Short-run: Focuses on business cycle fluctuations where actual output deviates from potential

Key Variables to Track

1. GDP: Primary measure of total output
2. Unemployment: Key lagging indicator
3. Inflation: Tracks price stability
4. Interest Rates: Influences borrowing/investment
5. Exchange Rates: Impacts exporters

Potential vs. Actual Output

Key Terms

• Potential Output ($Y^{\ast }$): Level of output when all resources are fully employed (sustainable production capacity)
• Actual Output ($Y$): Real GDP actually occurring at a given time

The Output Gap

Measures how far the economy is from its potential:

$\text{Output Gap}=\frac{Y-Y^{\ast }}{Y^{\ast }}\times 100$

Three Situations:

1. Recessionary Gap ($Y<Y^{\ast }$): Negative output gap

   • Economy producing less than potential
   • Resources idle (high unemployment, empty storefronts)

2. Inflationary Gap / Boom ($Y>Y^{\ast }$): Positive output gap

   • Economy producing more than sustainable potential
   • Unsustainable (like “pulling an all-nighter”)
   • Often leads to inflation

3. Full Employment ($Y=Y^{\ast }$): Output gap = 0

   • Economy at potential

The Business Cycle

Business Cycle: Short-term fluctuations in economic activity where actual output deviates from potential output.

Stages:

1. Expansion: Growth phase from Trough → Peak
2. Recession: Decline phase from Peak → Trough

Key Characteristics:

• Asymmetry: Recessions are typically short and sharp; expansions are long and gradual
• Mortality: Expansions don’t die of old age; they end due to adverse shocks (pandemic, financial crisis, oil price shock)
• Persistence: Economic conditions today predict conditions tomorrow (booming now → likely booming next year)
• Not Really a “Cycle”: Term is misleading because fluctuations aren’t rhythmic or predictable. No two cycles are identical.

Co-movement and Indicators

By the Interdependence Principle, different parts of the economy move together. When one sector struggles, others often follow.

Leading Indicators: Predict future economic changes (change BEFORE the economy changes)

• Business confidence
• Consumer confidence
• Stock market
• New building permits

Lagging Indicators: Confirm trends after they’ve occurred (change AFTER the economy changes)

• Unemployment rate (firms wait to hire/fire until trend is clear)

Okun’s Rule of Thumb

Negative relationship between output gap and unemployment:

The Rule: For every 1% that actual output falls below potential (negative gap), unemployment rises by 0.33% to 0.5%

Example

If output gap moves from 0% to -3%, unemployment rate rises by ~1% (e.g., from 8% to 9%)

Analyzing Macroeconomic Data

To properly track the economy, data must be adjusted:

1. Seasonally Adjusted: Removes predictable patterns (winter weather, holiday shopping) to show real trends
2. Annualized Rates: Converts monthly/quarterly growth to annual figure (“If this pace continued for 12 months…“)
3. Real vs. Nominal: Always focus on Real variables (adjusted for inflation) to track quantities
4. Revisions: Initial releases are estimates. Watch for revisions as more complete data arrives

Top Ten Economic Indicators

A “dashboard” for the economy:

1. Real GDP: Broadest measure of economic activity
2. Exports: Critical for trading nations like Canada
3. Unemployment Rate: Indicates labour market slack
4. Payrolls: Tracks monthly job creation
5. Building Permits: Leading indicator for construction
6. Capacity Utilization: % of industrial capacity being used
7. Retail Sales: Indicates consumer confidence/spending
8. Inflation Rate: Tracks price stability (CPI)
9. Labour Cost Index: Tracks wage/benefit growth (leading indicator of inflation)
10. Stock Market: Indicates expected future profits (volatile)

Rules for Tracking the Economy

1. Track Many Indicators: Don’t rely on just one; look for consensus
2. Broad > Narrow: Economy-wide indicators better than niche ones
3. Just-in-Time Data: Distinguish timely (leading) from delayed (lagging) data
4. Find the Signal: Look past short-term noise and volatile components
5. Expectations Matter: Good/bad news is relative to expectations (3% growth is “bad” if 4% was expected)

Key Definitions for Test

Macroeconomics The study of the economy as a whole, focusing on totals like total income, output, and spending.

Gross Domestic Product (GDP) The market value of all final goods and services produced within a country in a given year.

Final Goods Products purchased by the final user (counted in GDP).

Intermediate Goods Goods used as inputs in production (NOT counted in GDP to avoid double counting).

Nominal GDP GDP measured in current prices. Useful for analyzing the present but not for comparisons over time.

Real GDP GDP measured in constant base-year prices. Isolates quantity changes. Best for comparing growth.

Recession A period of declining economic activity or two consecutive quarters of negative GDP growth.

Rule of 70 Years to double = 70 / annual growth rate (%).

Working-age Population People 15+ who are not in military or institutionalized.

Employed Working ≥1 hour for pay, self-employed, or temporarily absent from job.

Unemployed Not working, actively searching for work, and able to accept a job.

Labour Force Employed + Unemployed.

Not in Labour Force Working-age people who are neither employed nor unemployed.

Unemployment Rate (Unemployed / Labour Force) × 100.

Labour Force Participation Rate (Labour Force / Working-age Population) × 100.

Frictional Unemployment Unemployment due to time needed for job matching/search.

Structural Unemployment Unemployment because wages don’t fall to equilibrium (wage stuck above market-clearing level).

Cyclical Unemployment Unemployment due to recession/business cycle downturn.

NAIRU (Natural Rate of Unemployment) The equilibrium unemployment rate ($U^{\ast }$) ≈ 5%. The long-run rate the economy tends toward.

Efficiency Wage Wage paid above market rate to boost productivity/reduce turnover.

Hysteresis When temporary high unemployment leads to permanently higher equilibrium unemployment. []() Long-term Unemployed Unemployed for 6+ consecutive months.

Marginally Attached Want a job and looked within past year but not currently searching.

Discouraged Searcher Marginally attached worker not searching because believes no jobs available.

Underemployed Has some work but wants more hours, or job doesn’t adequately use skills.

Inflation A generalized rise in the overall level of prices.

Deflation A generalized decrease in the overall level of prices.

Consumer Price Index (CPI) An index tracking average price consumers pay over time for a representative basket of goods/services.

Inflation Rate The annual percentage increase in the average price level.

Substitution Bias The overestimate of cost of living because CPI’s fixed basket doesn’t capture consumers substituting toward cheaper alternatives.

Nominal Variable A variable measured in dollars (value fluctuates over time with inflation).

Real Variable A variable adjusted to account for inflation (true purchasing power).

Nominal Interest Rate The stated interest rate without correction for inflation.

Real Interest Rate The interest rate in terms of purchasing power changes. Real = Nominal - Inflation.

Money Any asset regularly used in transactions.

Money Illusion The mistaken tendency to focus on nominal amounts instead of inflation-adjusted amounts.

Menu Costs The marginal cost of adjusting prices (reprinting menus, reprogramming systems).

Shoe-Leather Costs The costs incurred trying to avoid holding cash (to preserve value during inflation).

Inflation Fallacy The mistaken belief that inflation destroys purchasing power (ignores that wages also rise).

Hyperinflation Extremely high rates of inflation.

Producer Price Index (PPI) Tracks prices of inputs into the production process.

GDP Deflator Tracks prices of all goods/services produced domestically. Used to convert nominal GDP to real GDP.

Potential Output ($Y^{\ast }$) Level of output when all resources are fully employed (sustainable production capacity).

Actual Output ($Y$) The actual amount of production (Real GDP) occurring at a given time.

Business Cycle Short-term fluctuations in economic activity where actual output deviates from potential output.

Output Gap $\frac{Y-Y^{\ast }}{Y^{\ast }}\times 100$ - measures how far economy is from potential.

Recession (Cycle Definition) Period of declining economic activity, running from peak to trough.

Expansion Period of increasing economic activity, running from trough to peak.

Peak A high point in economic activity.

Trough A low point in economic activity.

Co-movement The tendency of many economic variables to rise and fall together over the business cycle.

Leading Indicators Variables that predict future economic changes (change BEFORE economy changes).

Lagging Indicators Variables that follow business cycle movements with a delay (change AFTER economy changes).

Seasonally Adjusted Data Data stripped of predictable seasonal patterns to reveal underlying trends.

Annualized Rate Data converted to the rate that would occur if the same trend continued for a full year.

Okun’s Rule of Thumb For every 1% output falls below potential, unemployment rises by 0.33-0.5%.

Study Tips for Multiple Choice Test

Focus Areas

1. Formulas: Memorize all formulas in the “Critical Formulas” section above
2. Definitions: Know precise definitions, especially what’s INCLUDED vs. EXCLUDED
3. Calculations: Practice calculating inflation rates, unemployment rates, output gaps, and GDP components
4. Relationships: Understand inverse relationships (output gap ↔ unemployment), three functions of money, three types of unemployment
5. Common Mistakes: Review all [!warning] callouts - these are likely test questions
6. Examples: Work through calculation examples multiple times

High-Probability Test Topics

• GDP components ($Y=C+I+G+NX$) - what’s included in each?
• Difference between nominal and real GDP
• How CPI is calculated and its limitations
• Three types of unemployment and their causes
• Labour force calculations (who’s in, who’s out?)
• Real vs. nominal interest rates
• Output gap and its relationship to unemployment (Okun’s Rule)
• Leading vs. lagging indicators
• Three functions of money
• Costs of inflation (expected vs. unexpected)

Common Traps to Avoid

• Don’t confuse “not in labour force” with “unemployed”
• Remember: unemployed must be ACTIVELY SEARCHING
• Transfer payments (CPP, EI) are NOT in G (government purchases)
• Imports are SUBTRACTED in GDP formula
• Intermediate goods are NOT counted in GDP
• Resale of used goods is NOT counted in GDP
• CPI uses a FIXED basket (leads to substitution bias)
• Inflation doesn’t destroy purchasing power if wages also rise (inflation fallacy)
• NAIRU is about 5%, NOT zero
• Real GDP uses base year prices, not current prices