Basic Economic Concepts

A is correct. New residential construction represents current production of goods and services, which is what GDP measures. Construction adds value to the economy and creates new capital goods.

B (Purchase of existing home) is incorrect because GDP only counts new production, not resales of existing assets. C (Stock market transactions) is incorrect because buying stocks is simply transferring ownership of existing assets, not producing new goods or services. D (Social Security payments) is incorrect because transfer payments redistribute money but don't represent production of goods or services.

B is correct. Open market operations (the buying and selling of government securities) is the Fed's most frequently used tool because it allows for precise, flexible adjustments to the money supply on a daily basis.

A (Reserve requirements) is incorrect because changing reserve requirements is a powerful but drastic tool that the Fed uses rarely due to its significant impact. C (Discount rate) is incorrect because while the Fed does adjust this rate, it's used less frequently than open market operations. D (Prime rate) is incorrect because the prime rate is set by commercial banks, not the Federal Reserve.

C is correct. Fiscal policy (government decisions about taxation and spending) is controlled by the President and Congress through the federal budget process. This is a constitutional separation of powers.

A (Federal Reserve), B (FOMC), and D (Board of Governors) are all incorrect because these entities control monetary policy, not fiscal policy. The Federal Reserve is an independent central bank that controls money supply and interest rates, while fiscal policy involves government spending and taxation decisions made by elected officials.

C is correct. The business cycle moves in this sequence: Trough (the bottom) → Expansion (growth phase) → Peak (the top) → Contraction (decline) → back to Trough. This represents the natural rhythm of economic activity.

The other choices present the same four phases but in incorrect sequences. Understanding the proper order is essential for recognizing where the economy stands in the cycle and anticipating what typically comes next. The cycle is continuous, with each contraction eventually reaching a trough and beginning a new expansion.

A is correct. The Federal Reserve's preferred inflation measure is the Personal Consumption Expenditures (PCE) Price Index, which the Fed believes provides a more comprehensive and accurate picture of inflation than other measures.

B (CPI) is incorrect. While widely followed by the public and used for Social Security adjustments, it's not the Fed's primary measure. C (PPI) is incorrect because it measures wholesale/producer prices rather than consumer inflation. D (GDP Deflator) is incorrect because while it's the broadest measure, the Fed specifically targets PCE for policy decisions.

B is correct. The real rate of return is calculated by subtracting inflation from the nominal return: 9% - 3% = 6%. This represents the actual increase in purchasing power after accounting for inflation's erosive effect.

C (9%) is incorrect because it's the nominal return before adjusting for inflation. A (3%) is incorrect because it only shows the inflation rate, not the real return. D (12%) is incorrect because it incorrectly adds inflation to the nominal return rather than subtracting it.

A is correct. Interest rates and bond prices have an inverse relationship. When the Fed raises rates, existing bonds with lower coupon rates become less attractive, causing their market prices to fall. Investors can now buy new bonds paying higher rates, so older bonds must decrease in price to offer competitive yields.

B (Increase) is incorrect because it describes a direct relationship, which is the opposite of how bonds actually work. C (No impact) is incorrect because existing bonds are immediately affected by rate changes. D (Only new bonds) is incorrect because existing bonds actually experience the most significant price impact since their coupon rates are fixed.

B is correct. Building permits for new housing is a leading indicator because it predicts future construction activity and economic expansion. When permits increase, it signals builders expect stronger demand and economic growth ahead.

A (Industrial production) is incorrect because it's a coincident indicator that moves with the current economy, not ahead of it. C (Average duration of unemployment) is incorrect because it's a lagging indicator that confirms trends after they've occurred. D (CPI) is incorrect because it's also a lagging indicator, reflecting price changes after they've happened.

B is correct. Stock prices are a leading indicator, not a lagging indicator. Stock markets tend to anticipate future economic conditions and typically move before the economy changes direction, making them predictive rather than confirmatory.

A (Average prime rate), C (Average duration of unemployment), and D (Consumer credit to income ratio) are all lagging indicators. They confirm trends after they've already occurred. Lagging indicators are useful for validating that economic changes have actually taken place rather than predicting what will happen next.

D is correct. An inverted yield curve occurs when short-term interest rates exceed long-term rates, which is unusual and historically has preceded every U.S. recession since 1970. It signals that investors expect economic weakness ahead, typically arriving within 7-18 months.

A (Strong growth) is incorrect because strong growth expectations would create a steep, upward-sloping yield curve. B (Low inflation) is incorrect because an inverted curve reflects recession expectations, not specifically inflation forecasts. C (Neutral outlook) is incorrect because an inverted curve is a strong signal, not a neutral one. It's one of the most reliable recession predictors.