Adverse selection is created by asymmetric infromation before a transaction occurs.  Adverse selection is usually found in insurance and credit markets, but can be found in other markets as well.  Adverse selection is a part of agency theory.

For instance in the credit market those who have bad credit and are therefore bigger risks are more likely to seek out a loan.  They are bigger risks because they are more likely to take chances with the money and use it poorly, this is why they have bad credit to begin with, and this is why they are in need of money.  Creditors will thus be less likely to lend anyone because they can assume that if someone wants a loan from that they most likely have bad credit, even though they may not.

Adverse selection is also obersvable in the used car market and is referred to as the “lemon problem.”  When you look to buy a used car from the newspaper you may not be able to tell right away that the transmission is on its last leg, even though the person who is selling the car, trying to dump it before it becomes cheaper to just buy a new one, knows that the transmission is on its last leg you do not, and there is an asymmetry of information.  Because everyone knows that there is this asymmetry of information a car automatically uses a large portion of its value as soon as it drives off the new car lot, as now the market can not be sure on whether or not it is a lemon.  Due to this lemon problem caused by adverse selection owners of non-lemons, referred to as peaches, may be unwilling to sell their car because they would receive less than its value in the market as its price would be lowered to compensate for the risk that it could be a lemon.

The market has found ways to combat adverse selection.  In the credit markets creditors are able to assign people credit scores that show their history of paying back loans and are an indictation of their likelihood to pay back future loans.  For people who do not yet have a credit score there usually need to be another signer with a favorable credit score on the loan, or the interest rate on the loan will be very high to compensate for the possibility of not being paid back.  In markets like the used car markets dealers have stepped up to combat the lemon problem.  They have expertise and methods to evaluate whether or not a car is a lemon before they buy it, eliminating the asymmetry of information, and then when they sell they can sell the car with their reputation and a warranty.  Because of the dealer the used car buyer should not have to worry on whether or not the used car they bought is a lemon because they are aware of the dealer’s reputation or they have a warranty on the car.

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.

Inflation is a sustained rise in the general level of prices, an increase in the price level.  As inflation goes up the amount of goods that money could once buy is diminished and thus less valuable.  It is ideal for a country to keep their inflation close to zero so that the country’s currency does not become devalued and the welfare of the people using that currency is not put in jeopardy.

Real Gross Domestic Product (GDP) is the most accurate number for comparing the GDP of an economy between different years as it holds the price level constant.  It is calculated as the sum of the quantities of final goods by constant, instead of current prices, held at a base year.  For instance if the base year is 2000 then the real GDP for 2002 is calculated by multiplying the quanitity of goods and services sold for 2002 against the prices in 2000, then the GDP growth can be compared for 2000 to 2002 and if calculated the same way for 2001 and 2003, etc.  Real GDP is also known as GDP in terms of goods, GDP in constant dollars, GDP adjusted for inflation, and GDP in chain year.

Nominal GDP is gross domestic product that is not adjusted for fluctuations in the price level, such as inflation or deflation.  It is the sum of quantities of final goods multiplied by their current price.  Nominal GDP is also known as Dollar GDP or GDP at current dollars.

Because nominal GDP does not take inflation into account it is not an accurate representation of the growth of an economy as it could be skewed by simply a rise in inflation, which gives a completely different representation of how well the economy is functioning.  A more informative number to look at is Real GDP