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Title: CFA Level 1 - Economics
Description: I create this summary of knowledge related to CFA level 1 for my 2017 December exam. I got into the top 10% with this. Hope this can help you. Please note that this does not guarantee for your pass, which requires dedication, hardwork and consistency. In case having trouble with any part, please refer to CFA notebook/Schwesser.
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Concepts

Description

Elasticity

Demand and Supply Analysis
Measure the ratio of the % change in one variable to a % of change in another
Own-price elasticity: % change in demand - to - % change in its own price
βˆ†π‘„
% π‘β„Žπ‘Žπ‘›π‘”π‘’ 𝑖𝑛 π‘žπ‘’π‘Žπ‘›π‘‘π‘–π‘‘π‘¦ π‘‘π‘’π‘šπ‘Žπ‘›π‘‘π‘’π‘‘
𝑃
βˆ†π‘„
𝑄
𝑂𝑀𝑛 βˆ’ π‘π‘Ÿπ‘–π‘π‘’ π‘’π‘™π‘Žπ‘ π‘‘π‘–π‘π‘–π‘‘π‘¦ =
=
=
Γ—
βˆ†π‘ƒ
% π‘β„Žπ‘Žπ‘›π‘”π‘’ 𝑖𝑛 π‘œπ‘€π‘› βˆ’ π‘π‘Ÿπ‘–π‘π‘’
𝑄
βˆ†π‘ƒ
𝑃
Cross-price elasticity: % change in demand - to - % change in related good price

πΆπ‘Ÿπ‘œπ‘ π‘  βˆ’ π‘π‘Ÿπ‘–π‘π‘’ π‘’π‘™π‘Žπ‘ π‘‘π‘–π‘π‘–π‘‘π‘¦ =

βˆ†π‘„
% π‘β„Žπ‘Žπ‘›π‘”π‘’ 𝑖𝑛 π‘žπ‘’π‘Žπ‘›π‘‘π‘–π‘‘π‘¦ π‘‘π‘’π‘šπ‘Žπ‘›π‘‘π‘’π‘‘
𝑃 β€² βˆ†π‘„
𝑄
=
=
Γ—
% π‘β„Žπ‘Žπ‘›π‘”π‘’ 𝑖𝑛 π‘π‘Ÿπ‘–π‘π‘’ π‘œπ‘“ π‘Ÿπ‘’π‘™π‘Žπ‘‘π‘’π‘‘ π‘”π‘œπ‘œπ‘‘π‘  βˆ†π‘ƒβ€²
𝑄
βˆ†π‘ƒβ€²
𝑃′

Income elasticity: % change in demand - to - % change in income

βˆ†π‘„
% π‘β„Žπ‘Žπ‘›π‘”π‘’ 𝑖𝑛 π‘žπ‘’π‘Žπ‘›π‘‘π‘–π‘‘π‘¦ π‘‘π‘’π‘šπ‘Žπ‘›π‘‘π‘’π‘‘
𝐼
βˆ†π‘„
𝑄
=
=
Γ—
βˆ†πΌ
% π‘β„Žπ‘Žπ‘›π‘”π‘’ 𝑖𝑛 π‘–π‘›π‘π‘œπ‘šπ‘’
𝑄
βˆ†πΌ
𝐼
|Own-price elasticity| > 1 β†’ demand is elas c
|Own-price elasticity| < 1 β†’ demand is inelas c
Cross-price elasticity > 0 β†’ related good is a subs tute (could replace each other)
Cross-price elasticity < 0 β†’ related good is a complement (go with each other, e
...
: car and petrol)
Income elasticity < 0 β†’ Inferior good
Income elasticity > 0 β†’ normal good
πΌπ‘›π‘π‘œπ‘šπ‘’ π‘’π‘™π‘Žπ‘ π‘‘π‘–π‘π‘–π‘‘π‘¦ =

Substitution effect, and
income effect

Substitution effect: When price of a good X decreases, there is a shift in consumption toward good X, and vice versa
Income effect: When price of a good X decreases, there is a shift in consumption toward more or less good X
3 possible outcome:
Substitution effect: Positive + Income effect: Positive β†’ Consump on of Good X increase
Substitution effect: Positive + Income effect: Negative, but smaller than substitution effect β†’ Consump on of Good X increase
Substitution effect: Positive + Income effect: Negative, but larger than substitution effect β†’ Consump on of Good X decrease

Normal good vs
...
g
...
Larger scale + Long run Average total cost decrease β†’ Economies of scale
2
...
Beyond the minimum efficient scale β†’ Larger scale + Long run Average total cost increase

Concepts

Description
Firm Structure - Market Structure
Perfect
competition

Characteristics of market structure

Monopolistic
competition

Oligopoly

Monopoly

Number of sellers

Many firms

Many firms

Few firms

Single firms

Barriers to entry

Very low

Low

High

Very high

Very good substitutes

Good substitutes, but
differentiated

Very good substitutes, or
differentiated

No good substitutes

Price only

Price, marketing, and features

Price, marketing, and
features

Advertising

Some to significant

Significant

Nature of substitute products
Nature of competition

Pricing power

Some
None

Perfect competition

Short-run equilibrium

Long-run equilibrium

In equilibrium:
Marginal revenue = Marginal cost = Price
Perfectly elastic demand curve
Could not earn economic profit in the long-run, since very low barrier to entry β†’ attract new firms if there is an economic profit
Monopolistic competition

Short-run equilibrium

Long-run equilibrium

In equilibrium:
Marginal revenue = Marginal cost < Price
Highy elastic demand curve (elasticity > 1)
Could not earn economic profit in the long-run, since very low barrier to entry β†’ attract new firms if there is any economic profit
Oligopoly

4 models:
1
...
Cournot duopoly model: Consider oligopoly with 2 firms, both have identical and constant marginal cost of production
...
These quantities will change each period until they are equal β†’ stable equilibrium
...
Nash equilibrium: applying prisoner's dilemma
Nash equilibrium = both firms cheat on the collusion,
even though the best outcome is to both honor the agreement

4
...

↓ price →↓demand of compe tor firms
Dominant firm sets the price as MR of dominant firm = MC of dominant firm (< price)
Competitors takes that as market price

Monopoly

In equilibrium:
Marginal revenue = marginal cost (< price)
Price discrimination: Monopolist might charge different customers different prices, for the same product / service
Regulations:
1
...
Marginal cost pricing: reduce Price and increase Quantity to the point where Marginal Cost curve intersects Market Demand
(Monopolist incurs loss because Price = ATC β†’ require Goverment's subsidy to prevent firm from leaving the market)
3
...
Firm wirh high market share, but would not have much pricing power of barrier to entry is low

Concepts

Description

Gross Domestic Product (GDP)

Aggregate output, prices and economic growth
Definition: Total market value of goods and services produced in a country within a certain time period
...
)
Expenditure approach: GDP = sum of the amounts spent on goods and services produced during the period
GDP = C + I + G + (X-M)
Income approach: GDP = sum of the amount earned by households and companies during the period (wage, interest income and business profits)

Nominal GDP /
Real GDP /
GDP Deflator /
Per-capita real GDP

Nominal GDP: Total output value of an economy, valued at current market prices
Real GDP: Total output value of an economy using prices from a base year
GDP deflator: price index to convert nominal GDP to real GDP

𝐺𝐷𝑃 π‘‘π‘’π‘“π‘™π‘Žπ‘‘π‘œπ‘Ÿ =

π‘π‘œπ‘šπ‘–π‘›π‘Žπ‘™ 𝐺𝐷𝑃
Γ— 100
π‘…π‘’π‘Žπ‘™ 𝐺𝐷𝑃

Per-capita real GDP = real GDP / population
National income

= Employees wages and benefits
+ Enterprises PBT
+ Interest income
+ Unincorporate net income
+ rent
+ indirect business taxes - susidies (taxes and subsidies are included in final prices)

Personal income

Pretax income received by household
Determine cunsumer purchasing power and consumption
= National income
+ transfer payment to household (unemployment, retirement)
- indirect business taxes
- Coporate income taxes
- Undistributed corporate profts

Personal disposable income

Personal income after tax
Personal disposable income = personal income - personal taxes

Relationship among saving,
GDP = C + I + G + (X - M)
investment, fiscal balance an trade Total income = C + S + T
balance
Since: GDP = Total income
C + I + G + (X - M) = C + S + T
or
(G - T) = (S - I) - (X-M)
In that:
C: consumption spending
I: Business Investment
G: Government spending
X: Export
M: Import
S: Household and business savings
T: net taxes (taxes paid - transfer payments received)
(G - T): fiscal balance
...
(X - M) < 0: trade deficit
Factors that determine
components of GDP

Consumption: taxes (↓ taxes β†’ ↑ consump on and saving)
Investment: Profitability (depend on overall level of economic output) and cost of financing (reflected in real interest rates)
Government purchaes: fiscal balance
Net export: domestic disposable income (affect import), foreign disposable income (affect export) an relative price of goods in foreign and domestic markets

Income-Saving curve
Liquidity-Money curve

Income-Saving curve (IS curve): negative relationship between real interest rates and real income
↓ interest rate β†’ ↓ saving + ↑ investment β†’ (S - I) < (G - T) + (X - M)
↑ real income β†’ ↑ saving + ↑ taxes receipt + ↑ import β†’ restore equilibrium
Liquidity-Money curve (LM curve): positive relationship between real interest rates and income, consistent with eqilibrium in the money market

Aggregate Demand curve /
Aggregate Supply curve

Aggregate Demand: Relationship between the quantity of real output demanded
(= real income) and the price level
↑ Price level β†’ ↓ real wealth, ↑ real interest rate
β†’ domes c goods more expensive compared to imported goods
β†’ ↓ domes c demand β†’Aggreegate demand curve slopes downward

Aggregate Supply: relationship between price level and quantity of real GDP supplied
- Very short run aggregate supply (VSRAS): perfectly elastic, since firms will adjust
output without changing price by adjusting labor hours and intensity of PPE used (overtime)
...
Output price increase in
proportion of price level β†’ Firms increase output for higher profit
- Long run aggregate supply (LRAS): wages and other input price change proportionally
to the price level β†’ Price level has no effect on AS β†’ perfectly inelas c

Causes of shift in aggregate
demand curve

1
...
Business expectations: more optimistic about future sales β†’ ↑investment in PPE and inventory (increase I)
3
...
High capacity utilization: Companies produce at high percentage of capacity β†’ ↑ investment in PPE (increase I)
5
...
Expansion of fiscal policy: ↓ taxes β†’ ↑ disposable income and consump on; or ↑ government spending (increase C an G)
7
...
Global economic growth: GDP growth in other countries β†’ ↑ export (increase net X)

Causes of shift in aggregate supply Short run aggregate supply
curve
1
...
Input prices:↓ nominal wages or prices of important produc ve input β†’ ↓ produc on costs β†’ firms ↑ output β†’ increase SRAS
3
...
Taxes and government subsidies: ↓ in business taxes or ↑ government subsidies β†’ ↓ produc on costs β†’ firms ↑ output β†’ increase SRAS
5
...
When produc ve inputs are imported β†’ ↓ produc on costs β†’ firms ↑ output β†’ increase SRAS
Long run aggregate supply
1
...
Increase in supply of natural resource: ↑ available amount of important produc ve inputs β†’ ↑ poten al real GDP β†’ ↑ LRAS
3
...
Technology: ↑ technology β†’ ↑ labor produc vity β†’ ↑ real output β†’ ↑ LRAS

Full employment equilibrium

LRAS crosses AD

Impact of fluctuations in AD and AS ↓ AD β†’ ↓ GDP + ↓ Price level β†’ GDP equilibrium < full employment GDP and Price level equilibrium < full employment price level (recessionary gap)
on the economy
- Classical economist: ↑ unemployment β†’ ↓ wages β†’ ↑ SRAS β†’ return GDP to full employment level
- Keynesian economist: expansionary fiscal policy (↑ government spending or ↓ taxes) and expansion monetary policy (↑ growth rate of money supply)
↑ AD β†’ return GDP to full employment level
↑ AD β†’ ↑ GDP + ↑ Price level β†’ GDP equilibrium > full employment GDP and Price level equilibrium > full employment price level (inflationary gap)
β†’ ↑ compe on for worker and produc ve input β†’ ↓ SRAS β†’ return GDP to full employment level
↑ wages and produc ve input β†’ ↓ SRAS β†’ ↓ GDP + ↑ Price level β†’ GDP equilibrium < full employment GDP and Price level equilibrium > full employment price level (stagflation)
↓ wages and produc ve input β†’ ↑ SRAS β†’ ↑ GDP + ↑ Price level β†’ GDP equilibrium > full employment GDP and Price level equilibrium < full employment price level

Effect of combined chanes in AS
and AD

↑ AD + ↑ AS β†’
↓ AD + ↓ AS β†’
↑ AD + ↓ AS β†’
↓ AD + ↑ AS β†’

↑ real GDP; change in price level depends on the magnitude of change of AD and AS
↓ real GDP; change in price level depends on the magnitude of change of AD and AS
↑ Price level; change in real GDP depends on the magnitude of change of AD and AS
↓ Price level; change in real GDP depends on the magnitude of change of AD and AS

Source of economic growth

1
...
of people > 16 yrs old, either working or available for work but currently unemployed
...
Human capital: ↑ educa on and skills of work force β†’ ↑ produc vity + ↑ ability to take advantage of technology β†’ ↑ economic growth
3
...
Technology: ↑ technology β†’ ↑ produc vity β†’ ↑ poten al GDP β†’ ↑ economic growth
5
...
Productivity and growth of labor force are also
neccessary

Input growth vs
...
Mortgage rate: ↓ interest rates β†’ ↑ home buying and construc on ; ↑ interest rates β†’ ↓ home buying and construc on
2
...
Speculative activity: ↑ home price β†’ specula ve purchase β†’ More construc on β†’ excess building β†’ falling prices that decrease/eliminate specula ve demand β†’ ↓ housing ac vity
overall
4
...

Recession β†’ downward pressure on money wage rate ; over-full employment β†’ upward pressure on money wage rate
Business cycle results from temporary deviations from LR equilibrium
Keynesian school: shift in AD due to changes in expectations
...
g
...
) in the
real economic environment
...
Frictional unemployment: due to time lag necessary to match employees seeking for work and employers needing their skills
2
...
Cyclical unemployment: due to changes in general level of economic activities
...

Measures of unemployment:
- Labor force: Include all people who are either employed or unemployed, except voluntarily unemployed (people choose not to be in labor force)
- Unemployment rate: % of unemployed workers / labor force
- Underemployed: people who work part-time but perfer to work full-time; people who are employed at low-paying job despite qualified for a signigicant higher-paying job
...

Inflation rate: % increase in price level, typically compared to last year
Hyperinflation: Inflation that accelerates out of control
Disinflation: Inflation, with inflation rate compared to last year decreases overtime, but remains > 0
Deflation: Persistent decrease in price level overtime

Construction of Indices used to
measure inflation

Price index: measures average price for a defined basket of goods and services
π‘π‘œπ‘ π‘‘ π‘œπ‘“ π‘π‘Žπ‘ π‘˜π‘’π‘‘ π‘Žπ‘‘ π‘π‘’π‘Ÿπ‘Ÿπ‘’π‘›π‘‘ π‘π‘Ÿπ‘–π‘π‘’π‘ 
𝑓𝑖π‘₯𝑒𝑑 π‘π‘Žπ‘ π‘˜π‘’π‘‘ π‘€π‘’π‘–π‘”β„Žπ‘‘ Γ— π‘π‘’π‘Ÿπ‘Ÿπ‘’π‘›π‘‘ π‘π‘Ÿπ‘–π‘π‘’
πΆπ‘œπ‘›π‘ π‘’π‘šπ‘’π‘Ÿ π‘π‘Ÿπ‘–π‘π‘’ 𝑖𝑛𝑑𝑒π‘₯ =
Γ— 100 =
Γ— 100
π‘π‘œπ‘ π‘‘ π‘œπ‘“ π‘π‘Žπ‘ π‘˜π‘’π‘‘ π‘Žπ‘‘ π‘π‘Žπ‘ π‘’ π‘π‘’π‘Ÿπ‘–π‘œπ‘‘ π‘π‘Ÿπ‘–π‘π‘’π‘ 
𝑓𝑖π‘₯𝑒𝑑 π‘π‘Žπ‘ π‘˜π‘’π‘‘ π‘€π‘’π‘–π‘”β„Žπ‘‘ Γ— π‘π‘Žπ‘ π‘’ π‘π‘Ÿπ‘–π‘π‘’
Note: Different countries/regions β†’ Different purchasing pa erns β†’ different in weight assigned to each good and service
Producer price index (PPI) or wholesale price index (WPI): to identify changes in relatives prices of producers' input β†’ shi s in demand of the industry
Headline inflation: price indexes for all goods
Core inflation: price indexes excluding volatile goods (e
...
: food and energy)

Uses and Limitation of inflation
measures

Laspeyres CPI: uses constant basket of goods and services
Limitation of Laspeyres CPI:
1
...
Quality changes: Price increase due to increase in quality β†’ not due to infla on, but s ll increase the index
3
...

Reasons of wages increases:
1
...
Expected inflation
Note: Wages increase are not inflationary as long as they remain in line with productiity gain
...

High rates of capacity utilization β†’ economy is producing at or above potentiial GDP β†’ may experience infla onary pressure

Economic Indicators

Leading indicators

Coincident indicators

Lagging indicators

- Avg
...
duration of unemployment
- Inventory-sales ratio
- Change in unit labor costs
- Avg
...
number of times per year each unit of money is used to buy goods / services
Assuming: Velocity (V) and Real output (Y) remain constant β†’ Change in Money supply (M) lead to change in Price level (P)
Money neutrality: Real GDP (Y) and Velocity (V) are not affected by Money supply (M) and Price (P)

Theory of money demand and
supply

Demand for money: Amount of wealth households and firms choose to hold in form of money
Supply of money: determined by central bank, and is independent of interest rate β†’ perfectly inelas c
Reasons for holding money:
- Transactional demand: ↑ GDP β†’ ↑ number of transac ons β†’ ↑ demand for money to carry out transac ons
- Speculative demand: Money available to take advantage of investment opportunities arising in the future
...
Supplier of money
2
...
Regulator and supervisor of payment system: Impose standards of risk-taking allowed and reserve requirements of banks; Oversee the payment system
4
...
Holder of gold and foreign exchange reserves
6
...
Control inflation (High inflation β†’ ↑ cost to minimise cash holding)
2
...
g
...
Sustainable positive economic growth
4
...
Stability in exchange rates with foreign currencies (e
...
: Vietnam, stabilise USD / VND rate - ↑ value of USD β†’ buy USD using VND)
...
unexpected
inflation

Expected inflation: Increase in Price of goods and wages, and Decrease in demand could be anticipated
Unexpected inflation:
- higher interest rate to compensate for additional risk the lender face from unexpected change in inflation
- Information about demand and supply is less reliable (Increase in price of a product does not result from an increase in demand, but increase in inflation)

Monetary policy tools

3 main monetary policy tools:
1
...
g
...
The price gap is the interest rate that central
banks is lending to member banks
Federal funds rate: rate that banks charge each other on overnight loans of reserves (Central banks use open market operations to adjust this rate)
2
...
Open market operations: Buying / Selling securities
E
...
: Central banks buy securities β†’ ↑ investors' cash β†’ ↑ banks have excess reserves β†’ ↑ funds available for lending ; ↑ money supply β†’ ↓ interest rate

Monetary transmission mechanism Definition: how a change in monetary policy affects price level and inflation
- ↑ in policy rate β†’ ↑ ST lending rate β†’ ↓ AD (↓ credit purchase of consumers and ↓ investment of firms)
- ↑ in policy rate β†’ ↑ discount rate applied to future CF β†’ ↓ Bond prices, equity prices and assets prices β†’ ↓ value of households' assets β†’ ↓ consump on ; ↑ savings
- ↑ in policy rate β†’ ↑ ST lending rate β†’ ↓ AD β†’ ↓ expecta on for future economic growth β†’ ↓ expenditures of consumers and businesses
- ↑ in policy rate β†’ ↑ ST lending rate β†’ ↑ value of domes c currency β†’ ↓ export ; ↑ importβ†’ ↓ AD

Quality of effective central banks

Determine expansionary /
contractionary

1
...

- Operational independence: allow to independently determine the policy rate
- Target independence: also defined how inflation is computed, set the target inflation rate, and determines how long the target is to be achieved
2
...
Transparency: Periodically disclose the state of economic environment by issuing inflation reports
Neutral interest rate = real trend rate of economic growth + inflation target
Where:
Real trend rate : An economy's LT sustainable real growth rate
Policy rate < Neutral interest rate β†’ expansionary
Policy rate > Neutral interest rate β†’ contrac onary

Limitations of monetary policy

1
...
Liquidity trap: demand for money becomes very elastic ; individuals willingly hold more money, even without a decrease in ST interest rate β†’ ↑ growth in money supply will not ↓ ST
interest rate, since individuals hold in cash rather than interest-bearing securities
3
...
Transfer payments - e
...
: Social Security & unemployment benefits
2
...
Capital spending: Gov's spending on infrastructure β†’ expect to boost future
productivity of economy
Justifications of spending tools:
- Provide services that benefits all residents
- Invest in infrastructure β†’ enhance economic growth
- Directly affect AD β†’ support the economic growth and unemployment targets
- Provide minimum standard of living
- Subsidise investment in R&D for certain high-risk ventures consistent with future
economic growth and other goals

Advantages / Disadvantages of
fiscal policy

Desirable attributes:
- Simplicity to use and enforce
- Efficiency: least interference wth market forces
- Fairness: People at similar situations β†’ pay similar taxes (horizontal equality) ;
Richer people pay more taxes (vertical equality)
- Sufficiency: taxes revenue = Gov's spending

Advantages
Disadvantages
- Quickly implement social policies via indirect taxes (discourage tobacco use)
- Direct taxes and transfer paymens take time to implement β†’ Delay the impact of fiscal
- Quickly implementation of indirect taxes β†’ ↑ Gov's revenue without significant addi onal policy
costs
- Capital spending takes long time to implement

Fiscal multiplier

πΉπ‘–π‘ π‘π‘Žπ‘™ π‘šπ‘’π‘™π‘‘π‘–π‘π‘™π‘–π‘’π‘Ÿ 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 =

1
1 βˆ’ 𝑀𝑃𝐢 Γ— (1 βˆ’ 𝑑)

πΉπ‘–π‘ π‘π‘Žπ‘™ π‘šπ‘’π‘™π‘‘π‘–π‘π‘™π‘–π‘’π‘Ÿ π‘‘π‘Žπ‘₯π‘Žπ‘‘π‘–π‘œπ‘› = 𝑀𝑃𝐢 Γ— πΉπ‘–π‘ π‘π‘Žπ‘™ π‘šπ‘’π‘™π‘‘π‘–π‘π‘™π‘–π‘’π‘Ÿ 𝑠𝑝𝑒𝑛𝑑𝑖𝑛𝑔 =

Ricardian equivalence

Revenue tools
Direct taxes: levied on income or wealth (Income tax, Corporate tax, capital gains tax,
etc
...
)

𝑀𝑃𝐢
1 βˆ’ 𝑀𝑃𝐢 Γ— (1 βˆ’ 𝑑)

↑ current budget deficit β†’ ↑ taxes in the future
Ricardian equivalence: Taxpayers ↓ consump on and ↑ savings to offset the expected cost of higher future taxes β†’ no effect on AD

Arguments for / against concerned Agurments for concerned with the size of fiscal deficit
with the size of fiscal deficit
- ↑ deficits β†’ ↑ future taxes
β†’ disincen ves to work and entrepreneurship β†’ ↓ LT economic growth
- Market lose confidence in Gov β†’ Investor not willing to refinancce debt
β†’Gov defaul ng / Print more money β†’ ↑ infla on

Arguments against concerned with the size of fiscal deficit
- If debt is primarily held by domestic citizens β†’ overstated scale of the problem
- Debt used to refinance productive capital investment
β†’ future economic gains is sufficient to repay the debt
- Fiscal deficit may prompt needed tax reform

- ↑ Gov's borrowing β†’ ↑ interest rates β†’ ↓ Corporate investment
β†’ ↓ impact on AD

- Deficits is not matter if Ricardian equivalent is existed
- If economy is operating at less than full capacity β†’ deficits help increase GDP and
employment

Discretionary fiscal policy vs
automatic stabilisers

Automatic stabilisers: A budget policy that automatically changes to stabilize fluctuations in GDP
...
discretionary is not exact science β†’ might be wrong
2
...
Other problems:
- Misreading the economic statistics: Full employment level is not precisely measured β†’ might drive infla on higher
- Crowding-out effect: ↑ Gov's borrowing β†’ ↑ interest rates β†’ ↓ Corporate investment β†’ ↓ impact on AD
- Supply shortage: If economic activity is slow due to resource constraints β†’ expansionary policy only increase infla on
- Limits to deficites: (Deficit/GDP) is to high β†’ higher interest rate β†’ ↓ AD
- Multiple targets: if the economy has hight unempoyment rate and high inflation, fiscal policy could not solve both problems simultaneously

Interaction of monetary and fiscal
policy

Monetary policy
Tight
Easy
Tight
Easy

Fiscal policy
Tight
Easy
Easy
Tight

Interest rates
Higher
Lower
Higher (M)
Lower (M)

Output
Lower
Lower
Higher (F)
Lower (F)

Private sector spending
Lower
Higher
Lower
Higher

Public sector spending
Lower
Higher
Higher
Lower

Concepts

Description

Gross national product

International Trade and Capital Flows
Measures the total value of goods / services produced by the labor / capital of a country's citizens
Note:
GNP = GDP + income of citizens work in other countries + income of capital invested in other countries - income of non citizens work within a country - income of foreign capital invested
within a country

Benefits / Costs of international
trade

Benefits:
- Importing country: lower-costs goods
- Exported country: ↑ employment, ↑ workers' wage, ↑ profit from export products
Costs:
- Importing country: ↑ umemployment for jobs related to the import products β†’ workers have to retrain for new jobs

Absolute advantage /
Comparative advantage

Absolute advantage: produce the goods / services at lower cost in term of resources than that of another country
Comparative advantage: opportunity costs in terms of other goods could be produced insteade is lower than that of another country
Country should produce goods with comparative advantage

Ricardian model of trade /
Heckscher - Ohlin model of trade

Ricardian model of trade (only 1 factor of production - labor): Differences in labor productivity due to differences in technology β†’ differences in produc on costs
...

Country with more capital β†’ specialise in capital intensive goods (machine), and trade for less capital intensive goods (food)
Country with more labor β†’ specialise in less capital intensive goods (food) , and trade for capital intensive goods (machine)
1
...
Reasons with little support:
- Protecting domestic jobs: Since free trade also create other new jobs
- Protecting domestic industries: Industry firms use political influence to get protection from forign competition

Types of trade resitrictions

Tariffs: taxes on imported goods, collected by the Gov
Quotas: Limits on the amount on imports allowed over some period
Export subidies: Gov payment to firms that export goods
Minimum domestic content: Requirement of % of domestic products within the product content
Voluntary export restraint: A country voluntrily restricts the amount of goods that can be exported to avoif tariffs / quotas imposed by trading partners

Effect of tariffs or quotas

In which:
A: Gain in producer surplus
D: Tariffs revenue / Quota rents
B+C: Deadweight loss

Export subsidies

Payments by Gov to exporters β†’ ↑ export and ↓ foreign price β†’ nega vely affect foreign producers; but also ↑ domes c price, and ↓ consumer surplus

Capital restriction

Definition: restrict the flow of capital across borders
Including:
- Prohibtion of investment in domestic country by foreigners
- Prohibition of / Taxes on income earned on foreign investments by domestic citizens
- Prohibition of foreign investment in certain domestic industries
- Restrictions on repatriation of earnings of foreign entities operating in a country
ST effect: help developing countries avoid impact of large inflows of capital during expansion, and large outflows of capital during contraction
LT effect: decrease economic welfare

Capital restriction - Objectives

1
...
Maintain fixed exchange rate
3
...
Protect strategic industries

Advantages / disadvantages of
trading agreements

Advantages:
- Increase trade according to comparative advantage
- Increase competition among firms in member countries
Disadvantages:
- Decrease in wealth of some firms / industries / groups of workers
- Workers might need to learn new skills

Types of trade agreements (a
...
a:
trading blocs, regional trade
agreements)

1
...
All countries adopt same set of restricitions with non-members
3
...
Members stablish common institutions and economic policy for the union
5
...
Current accounts: measures the flow of goods / services
- Merchandise and services
- Income receipts: foreign income from stock dividends and debt interest
- Unilateral transfers: one-way transfers of asstes (e
...
: money received from those working abroad, direct foreign aid)
2
...
Financial accounts: Investment flows
- Gov-owned assets abroad : gold, foreign currencies, foreign securities, reserve position in IMF ; credits, other LT assets, direct foreign investment and claims against foreign banks
- Foreign-owned assets in the country: domestic Gov and corporate securities, direct investment in the domestic country, domestic country currency, domestic liabilities to foreigners
reported by domestic banks

Decisions by consumers, firms and (G - T) = (S - I) - (X - M) β†’ (X - M) = S - I + (T - G) β†’ (X - M) = private savings + Gov savings - investment
Gov affect Balance of payments
↓ private savings + ↓ Gov savings (↑ Gov deficit) + ↑ investment β†’ ↓X and ↑M β†’ Current account deficit
Functions and objectives of IMF,
WB and WTO

IMF
Main goals:
- Promote international monetary cooporation
- Faciliate the expansion and balanced growth of
international trade; promote exchange stability
- Assist in establishment of multilateral system of
payments
- make resources available to members experiencing
balance of payments difficulties

World Bank
Missions:
- Fight porverty for lasting results
- Support people to help themselves and their
environment by providing resources, knowledge, bulding
capacity and creating partnership in the public and
private sectors
Fuctions:
Provide low-interest loans, interest-free credits and
grants to developing countries to invest in education,
health, public administration, infrastructure, finance and
private sector development, agriculture and
environmental and natural resource management

WTO
Functions: Ensure that trade flows as smoothly,
predictably and freely as possible
Objectives:
- Interprete agreements and commitments
- Ensure countries's trade policies conform with
agreements and commitments

Concepts

Description

Exchange rate

Price of cost of units of one currency in terms of another

Currency Exchange rates

E
...
: 1
...
416 USD
In which:
EUR: Base currency
USD: Price currency
Real exchange rate

Cost of purchasing that same unit of goods / services based on new exchange rate and the relative changes in price level of both countries

π‘…π‘’π‘Žπ‘™ 𝑒π‘₯π‘β„Žπ‘Žπ‘›π‘”π‘’ π‘Ÿπ‘Žπ‘‘π‘’ 𝑑 ⁄𝑓 = π‘π‘œπ‘šπ‘–π‘›π‘Žπ‘™ 𝑒π‘₯π‘β„Žπ‘Žπ‘›π‘”π‘’ π‘Ÿπ‘Žπ‘‘π‘’ 𝑑 ⁄𝑓 Γ—

𝐢𝑃𝐼
𝐢𝑃𝐼

Spot exchange rate /
Forward exchange rate

Spot exchange rate: Currency exchange rate for immediate delivery
Forward exchange rate: Exchange rate for an exchange to be done in the future, which is quoted for various future dates (30 days, 60 days, 90 days, 1 year)

Functions of FX market

Enable firms and consumers to purchase / sell foreign goods and services denominated in foreign currencies, or purchase / sell foreign physical assets as well as foreign financial securities

Participants in FX market

Sell side: large multinational banks
Buy side: buyers of foreign currencies and forward FX contracts, including:
- Corporations: to engage in cross-border transactions, or to hedge risk
- Investment accounts: Real money accounts (mutual funds, pension funds, insurance companies and other institutions that do not use derivatives) and Leverage accounts (hedge funds,
and other trading firms that do use derivatives)
- Government and government entities: for transaction needs, investment or speculation
...
g
...
60 ; MXN/USD = 10
...
60 Γ— 10
...
42

Forward quotations expressed on a Point basis:
point basis or in percentage terms 1 point = 1/10,000
AUD/EUR = 0
...
5 points
β†’ 1-year forward quota on = 0
...
5/10,000 = 0
...
7313
120-day forward exchange rate: -0
...
7313 + 0
...
062%) = 0
...
Formal dollarisation: a country could use currency of another country
...
Member of monetary union: Several countries use a common currency
...
However, they all participate in
determining the monetary policy of the union
Areas that have their own Currency
1
...
Conventional fixed peg arrangement: a country that pegs its currency within margin of Β± 1% vs
...
Exchange rate is maintained using:
- Direct intervention: purchase / sell foreign currencies in FX markets
- Indirect intervention: changes in interest rate policy, regulation of FX transactions, and convince people to constrain FX activities
3
...
g
...
Crawling peg: exchange rate is adjusted periodically
5
...
Managed floating exchange rates: Monetary authority attempts to influence the exchange rate in response to specific indicators (balance of payments, inflation rates, employment)
without any specific target exchange rate or predetermined exchange rate path
7
...
FX intervention is used only to slow the rate of change, and reduce ST fluctuations

Effect of exchange rates on
countries international trade
- ELASTICITIES APPROACH

Import and export demand is elastic β†’ currency deprecia on results in a greater improvement in trade deficit
Demand is more elastic for goods with close subsitutes, goods that represent a high proportion of consumer spending, and luxury goods
Demand is less elastic for goods that are neccessities, have few or no subsitutes, represent a small proportion of overall spending
Marshall-Lerner condition: condition under which depreciation in domestic currency will decrease trade deficit

π‘Š Γ— πœ€ + π‘Š Γ— (πœ€ βˆ’ 1) > 0
In which:
π‘Š = proportion of total trade that is exports
π‘Š = proportion of total trade that is imports
πœ€ = price elasticity of demand for exports
πœ€ = price elasticity of demand for imports
J-curve effect

Import / Export contracts for delivery of goods often require delivery and payment in the future β†’ ST Import / Export quan

es may be rela vely insensi ve

Effect of exchange rates on capital BT = Y - E
flows
- ABSORBTION APPROACH
In which:
BT = Balance of trade
Y = domestic production of goods and services (national income)
E = domestic absorption of goods and services (total expenditure)
β†’ Income rela ve to expenditure must increase fot balance of trade to imporve, in response to a currency deprecia on
* When economy is at less than full capacity: Currency depreciation β†’ domes c goods rela vely more a rac ve than foreign goods
β†’ Shi demand toward domes c goods β†’ Increase both expenditure and income
Since Income > Expenditure (due to saving), Nationa income increase more than total expenditure β†’ ↑ Balance of trade
* When economy is at full capacity: Currency depreciation β†’ decline in value of domes c assets
β†’ reduce savers' real wealth β†’ ↓ total expenditure (due to ↑ saving to rebuild wealth)
As real wealth increases, positive impact on saving decrease, and returning economy to its previous state and balance of trade

Title: CFA Level 1 - Economics
Description: I create this summary of knowledge related to CFA level 1 for my 2017 December exam. I got into the top 10% with this. Hope this can help you. Please note that this does not guarantee for your pass, which requires dedication, hardwork and consistency. In case having trouble with any part, please refer to CFA notebook/Schwesser.
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