Difficulty: Introductory-Intermediate | Prerequisites: GDP and national income accounting (Part 1 of these notes)
Big picture: Once you can measure total output (GDP), the next questions are: how healthy is the labour market, how fast are prices rising, and what drives the economy to grow over time? This set of notes covers the key indicators economists use to answer those questions. The labour market formulas and CPI calculation are among the most commonly tested items on Exam 2, and the economic growth material sets up the policy discussions that follow.
The unemployment rate, labour force participation rate, and employment-to-population ratio each tell you something different about the labour market, and you need all three to see the full picture. CPI measures the cost of a fixed basket of goods over time and is used to calculate the inflation rate, but it tends to overstate true inflation because of several known biases. Economic growth in the long run comes from capital, human capital, technology, and good institutions, not just more spending.
Population (P)
The total civilian non-institutional population, typically aged 16 and over. This is the denominator for several labour market ratios.
Labour Force (LF)
Employed (E) plus Unemployed (U). Everyone who is either working or actively looking for work. Think of it as the pool of people participating in the job market.
Unemployment Rate
The number of unemployed people divided by the labour force, expressed as a percentage. U / LF x 100. In simple terms, the share of people who want a job and are looking but have not found one.
Labour Force Participation Rate (LFPR)
The labour force divided by the total population, expressed as a percentage. LF / P x 100. Think of it as the share of the population that is either working or trying to work.
Employment-to-Population Ratio (EPR)
The number of employed people divided by the total population, expressed as a percentage. E / P x 100. This is the most direct measure of how many people in the population are working.
Discouraged Workers
People who want a job but have stopped looking because they believe no jobs are available for them. They are not counted in the labour force and therefore do not appear in the unemployment rate.
Marginally Attached Workers
People who want a job, have looked in the past year, but have not looked in the past four weeks. Like discouraged workers, they are excluded from the official unemployment rate.
Underemployment
Part-time workers who want full-time hours but cannot find them. They are counted as employed in the official statistics, even though they are clearly underutilised.
Consumer Price Index (CPI)
A measure of the average change in prices paid by urban consumers for a fixed basket of goods and services over time. The basket is held constant so that price changes (not quantity changes) drive the index. Think of it as a price tag on a standard shopping trolley, tracked over the years.
Inflation Rate
The percentage change in the CPI from one period to the next. Inflation = (CPI_t - CPI_{t-1}) / CPI_{t-1} x 100.
New Goods Bias
The CPI basket takes time to include new products. Until it does, consumers are benefiting from new choices and potentially lower effective prices that the index misses.
Quality Improvement Bias
When a product improves in quality, its price may rise, but the CPI may record the entire increase as inflation rather than partly as a quality gain.
Commodity Substitution Bias
The CPI uses a fixed basket, but real consumers substitute towards cheaper alternatives when relative prices shift. The fixed basket overstates the cost increase.
Outlet Substitution Bias
Consumers shift to discount retailers and online shops over time. The CPI, based on an older outlet mix, misses these savings.
Real GDP Growth
The percentage change in real (inflation-adjusted) GDP between periods. Measures change in total output in the short to medium run.
Economic Growth
A long-run concept: the increase in an economy's capacity to produce, usually discussed as the trend rise in real GDP per capita. Driven by productivity, capital accumulation, technology, and labour force growth.
Human Capital
The skills, knowledge, and health that workers bring to production. Education and training are the main ways to build it. Think of it as the quality of the workforce, as distinct from the physical tools they use.
Solow Growth Model
A model of long-run economic growth that highlights capital accumulation and diminishing returns. In the Solow model, long-run growth in output per worker is driven by technological progress, which is treated as exogenous (coming from outside the model).
Three key definitions sit underneath every labour market calculation:
Population (P): civilian non-institutional population, age 16+
Labour force (LF) = Employed (E) + Unemployed (U)
Not in labour force (N) = P - LF
From these you get three ratios:
Unemployment rate = U / LF x 100
Labour force participation rate (LFPR) = LF / P x 100
Employment-to-population ratio (EPR) = E / P x 100
Worked example: P = 2,500, E = 1,500, U = 100. Then LF = 1,500 + 100 = 1,600. Unemployment rate = 100 / 1,600 = 6.25%. LFPR = 1,600 / 2,500 = 64%. EPR = 1,500 / 2,500 = 60%.
The official unemployment rate (U / LF) misses several categories of people who are, in practice, not fully employed:
Discouraged workers have given up looking entirely and drop out of the labour force. They want work, but the unemployment rate does not see them.
Marginally attached workers looked in the past year but not in the past four weeks. They are excluded from LF.
Underemployed workers are working part-time but want full-time hours. The official rate counts them as employed.
Involuntary exits and labour market slack are not captured by the headline number.
The U.S. Bureau of Labor Statistics publishes a broader measure called U-6 that includes discouraged workers, marginally attached workers, and those working part-time for economic reasons. U-6 is always higher than the headline (U-3) rate.
The CPI tracks the cost of a fixed basket of consumer goods over time. The steps:
Choose a base year and a comparison year
Fix the basket of goods (the quantities stay the same)
Find the prices of each item in both years
Calculate the cost of the basket in each year: Cost_t = sum of (P_i_t x Q_i_basket)
Compute the CPI: CPI_t = (Cost_t / Cost_base) x 100
Compute the inflation rate: Inflation = (CPI_t - CPI_{t-1}) / CPI_{t-1} x 100
Worked example: base-year basket costs $200, current-year basket costs $220. CPI_current = (220 / 200) x 100 = 110. Inflation = (110 - 100) / 100 x 100 = 10%.
The CPI tends to overstate the true rise in the cost of living. Four biases explain why:
New goods bias: new products expand consumer choice and may lower effective prices, but the CPI basket takes time to include them
Quality improvement bias: price increases that reflect better quality (a more powerful phone at the same price) are partly recorded as inflation rather than as value gains
Commodity substitution bias: the fixed basket assumes consumers keep buying the same goods in the same proportions, but people substitute towards relatively cheaper alternatives
Outlet substitution bias: consumers shift towards discount retailers and online shopping, which the CPI's older outlet sample misses
The net effect is that CPI overstates the true cost-of-living increase. Historical estimates of the combined bias vary, but it is consistently positive.
These two terms are related but distinct:
Real GDP growth is the percentage change in inflation-adjusted GDP between periods. It tells you whether total output rose or fell in the short to medium run.
Economic growth is a long-run concept: the sustained increase in an economy's capacity to produce, usually measured as the trend rise in real GDP per capita.
The per capita distinction matters. If GDP rises 3% but the population also grows 3%, output per person has not changed. Economic growth discussions typically focus on real GDP per capita.
Five main drivers:
Physical capital accumulation (K): more and better machinery, equipment, and infrastructure
Human capital: education, training, and health improve the quality of the labour force
Technological progress: new methods, innovations, and better ways of organising production
Natural resources: helpful but not strictly necessary (resource-poor countries like Japan and Singapore have grown rapidly)
Institutions and policies: property rights, rule of law, trade openness, stable macroeconomic environment, and incentives for investment and innovation
The Solow growth model formalises the role of capital accumulation and shows that it faces diminishing returns. In Solow, long-run growth in output per worker depends on technological progress, which the model treats as exogenous.
Governments can support long-run growth through:
Promoting human capital: funding education, training programmes, and public health
Encouraging investment: stable macro policy, low and predictable taxes on investment, access to credit
Supporting R&D and innovation: grants, tax credits, intellectual property protection
Opening markets and trade: trade liberalisation boosts productivity through competition and specialisation
Institutional improvements: strengthening property rights, contract enforcement, reducing corruption
Infrastructure investment: public goods that lower the cost of doing business
Sound monetary and fiscal policy: keeping inflation low and expectations stable
Labour market: Unemployment rate = U / LF x 100 LFPR = LF / P x 100 EPR = E / P x 100 LF = E + U N (not in labour force) = P - LF
CPI: CPI_t = (Cost_t / Cost_base) x 100 Inflation rate = (CPI_t - CPI_{t-1}) / CPI_{t-1} x 100
Growth: Real GDP growth rate = (Real GDP_t - Real GDP_{t-1}) / Real GDP_{t-1} x 100 Per capita real GDP = Real GDP / Population
The unemployment rate is one of the most closely watched economic indicators because it directly affects political decisions and central bank policy. When the headline rate looks low but the LFPR has also dropped, it may mean people have left the labour force rather than found jobs. This happened after the 2008 financial crisis, when a falling unemployment rate masked a significant rise in discouraged workers.
CPI biases have practical consequences: if the CPI overstates inflation by even one percentage point, then cost-of-living adjustments to wages, pensions, and tax brackets are systematically too generous, which compounds over time into large fiscal costs.
Students often confuse the unemployment rate denominator. It is the labour force (E + U), not the total population. Dividing by the population gives you a different ratio entirely.
Discouraged workers are not "unemployed" in the official statistics. They have left the labour force. This is one of the most common exam mistakes.
CPI does not measure the cost of living directly. It measures the cost of a fixed basket. The two are related but not the same, because real consumers adjust their behaviour.
Real GDP growth and economic growth are not synonyms. Real GDP growth is a short-run measure of total output change. Economic growth is a long-run concept about expanding productive capacity, usually per capita.
Labour market calculation questions are near-certain on Exam 2. Given P, E, and U, you should be able to compute the unemployment rate, LFPR, and EPR quickly. Watch the denominator.
Expect a question asking why the unemployment rate understates true joblessness. Name discouraged workers, marginally attached workers, and underemployment.
CPI calculation questions follow the six-step process. Be comfortable going from basket costs to CPI to inflation rate in one chain.
Know the four CPI biases by name and be able to explain each in one sentence. A common question format: "Which bias explains why CPI overstates inflation when consumers switch to cheaper brands?"
The distinction between real GDP growth and economic growth may appear as a conceptual short-answer question.
For growth drivers, be able to list the five main causes and connect at least two to specific government policies.
True or false: Discouraged workers are included in the unemployment rate. (False, they have left the labour force.)
Fill in the blank: LFPR = ________ / Population x 100. (Labour force, i.e. E + U.)
True or false: The CPI tends to understate the true rise in the cost of living. (False, it tends to overstate it due to substitution bias, new goods bias, quality bias, and outlet bias.)
Fill in the blank: In the Solow growth model, long-run growth in output per worker is driven by ________. (Technological progress.)
True or false: If real GDP grows by 2% and population grows by 3%, real GDP per capita has risen. (False, per capita GDP fell.)
Q: Population = 2,000; Employed = 1,300; Unemployed = 200. Calculate the unemployment rate, LFPR, and EPR.
A: LF = 1,300 + 200 = 1,500. Unemployment rate = 200 / 1,500 = 13.33%. LFPR = 1,500 / 2,000 = 75%. EPR = 1,300 / 2,000 = 65%.
Q: Basket cost in the base year is $160. Basket cost in the current year is $176. What is the CPI and the inflation rate?
A: CPI = (176 / 160) x 100 = 110. Inflation = (110 - 100) / 100 x 100 = 10%.
Q: Explain commodity substitution bias in one or two sentences.
A: The CPI uses a fixed basket of goods, but real consumers shift their purchases towards relatively cheaper goods when prices change. Because the basket does not adjust, the CPI overstates the price increase consumers experience.
Q: Name three causes of long-run economic growth.
A: Any three of: physical capital accumulation, human capital development, technological progress, natural resources, and strong institutions and policies.
Q: Why might a falling unemployment rate not indicate an improving labour market?
A: If the unemployment rate falls because discouraged workers have left the labour force (reducing both U and LF), the rate drops without anyone finding a job. The LFPR would also fall in this case, which is the signal that people are leaving rather than finding work.
The CPI and inflation rate connect directly to the distinction between nominal and real GDP from Part 1. If you know CPI, you can convert nominal values into real values and compare across years. The labour market indicators link to the AD-AS model in Part 3: when actual output is below potential (a recessionary gap), the unemployment rate rises above the natural rate, which is one of the signals that the economy is in a downturn. The growth material, especially the role of investment, connects back to the I component of GDP and forward to the multiplier effect.
Unemployment rate, labour force participation rate, LFPR, employment-to-population ratio, EPR, discouraged workers, marginally attached, underemployment, U-6, U-3, BLS, Consumer Price Index, CPI, inflation rate, base year, basket of goods, new goods bias, quality improvement bias, commodity substitution bias, outlet substitution bias, cost of living, real GDP growth, economic growth, GDP per capita, human capital, physical capital, technological progress, Solow growth model, diminishing returns, pro-growth policy, institutions, trade liberalisation, R&D, ECO2013, macroeconomics, University of Florida, Exam 2