Moral hazard is created by an asymmetry of information after a transaction has been completed.   In the financial markets this is usually in the form of a loan.  There is a risk, a hazard, that the borrower may engage in poor, immoral, decision making, from the lender’s perception, because these actions increase the likelihood that they will not get paid back.  Moral hazard is a part of agency theory.

Here is an example:  You decided to lend $500 to your cousin Jeb because he says he can double that $500 by buying an undervalued guitar for $500 and then selling it on eBay for $1,000, which is still below its value.  Your cousin Jeb knows guitars really well, you know enough about him from his renditions of “Stairway to Heaven” at the family reunions to not have an asymmetry of information there.  So you make the loan to cousin Jeb.  However, you did not know your cousin quite well enough, Jeb also loves to place bets at the dog track.  Once Jeb has the money he may be more tempted to place the $500 you loaned him on the dog Might-Win-This-Time for the 20 to 1 shot down at the track.  The bet has a greater risk and with it a greater reward.  If Jeb wins he gets $10,000 dollars and is able to pay you back your $500 and still get to go buy that dirt bike he has always wanted with the $9,500 he has left.  However, if Jeb loses the $500 on Might-Win-This-Time, which will probably happen (it usually isn’t Might-Win-This-Time’s time), then you will not get paid back and Jeb simply loses your faith in him.  Jeb was probably OK with that considering to him you’re just his turd litle cousin, Jeb isn’t very nice.  If you could’ve followed Jeb around you could’ve discouraged him from betting on Might-Win-This-Time and instead watched him buy the guitar and complete the transaction on eBay.  But, you don’t live near Jeb, and you can not always know what he is doing, you had an asymmetry of information of Jeb’s actions.  That asymmetry of information on Jeb’s whereabouts led to the moral hazard of Jeb betting your loaned money at the dog track.  Because of this moral hazard, even if you really, really believed Jeb would use that money to flip the guitar on eBay, you still may not make him the loan.

Moral hazard can be eliminated by the market and the law.  Financial intermediaries, institutions such as banks, have greater means and expertise to be able to monitor people that they lend to in the market.  You and a financial intermediary could write provisions, restrictive covenants, into your loan contract that restrict the borrower.  The covenants could say the loan can only be used for a certain thing, or that a minimum asset balance be maintained by the borrower, or that information be provided about activities periodically.  The covenant could also require collateral, also known as secured debt, so that if the loan is not paid back then you keep the collateral as payment.  This is like a morgatage on your home, if you don’t pay your morgatge to the bank that gave you the morgatge then they can seize the title to your home and auction it off to pay for what is owed to them.  However, legal fees may be too costly to purse a breaking of these covenants, which is why loans are usually done between financial intermediaries, because they can make use of economics of scale, and in larger denominations.  All of these tools help to make the moral in moral hazard not so hazardous and thus encourage people to make loans and fuel the economy.

The participation rate is the number of people who are in the labor force divided by the population that is of working age.  Working age is considered to be sixteen years of age to sixty-five years of age.  This is an interesting statistic in that it describes the number of people who could be working choose to do so.  For instance, in recent history the participation rate of women has increased dramatically as it has become more common place for women to leave the role of homemaker and enter the work force.  As the participation rate increases this is usually a sign of increased economic growth

The pariticpation rate is calculated as follows:

Participation Rate = Labor Force / Population of Working Age

The unemployment rate in an economy is the number of people who are unemployed as a ratio to the number of people in the labor force of the economy.  Unemployment has a direct effect on the welfare of the unemployed and invariably the economy in which they live.  The Current Population Survey (CPS), which is a monthly statistical survey of about 60,000 households, is used by the Bureau of Labor Statistics (BLS) uses the survey to provide a monthly report of the employment situation in the United States.  The survey is based on responses to a series of questions on work and job search activities, each person sixteen years and over in a sample household is classified as employed, unemployed, or not in the labor force.  A higher unemployment rate provides a signal that the economy may not be using some of its resources efficiently.

The unemployment rate is calculated as follows:

Unemployment Rate = Unemployed / Labor Force

The gross domestic product (GDP) growth rate tells much about whether an economy is getting larger, which creates more jobs and will bring up the standard of living, or if it is getting smaller, jobs are being lost and the standard of living is going down.  Periods of positive growth rates are called expansions and periods of negative growth rates are called recessions.

The equation to derive the GDP growth rate (in real GDP) is:

Where:

Y = real GDP

t = the time period being assesed

Real gross domestic product (GDP) per capita is the ratio of real GDP to the population of the country.

It is derived from the equation:

GDP/Population = Average Income per Person (GDP per capita)

This is an interesting number to investigate as it shows the standard of living that the average person can afford in that country, thus making it much easier to compare standards of living between countries.  It should be noted that GDP does account for all of the things that affect standard of living, but GDP and standard of living seem to be related, so the higher the GDP in a country, usually the higher the standard of living.