Level I Review, Economics

Study session five in the Level I CFA Program curriculum covers macroeconomic analysis (reading 17-19). Again, the Institute is not expecting you to become a star economist with these readings so do not get bogged down in the details. There are a few basic equations that may be testable but you should focus on the concepts and definitions.
Aggregate Output, Prices and Economic Growth
This is largely a definitional reading to set up for further issues. Understand the components within GDP (household, business, government, and net exports) and the issues with measuring it. Additionally, understand the components of GDP by the expenditure method: consumer spending, business gross fixed investment, change in inventories, government spending, government gross fixed investment, and net exports.
Understand the difference between GDP and National Income and the components of NI: employee compensation, enterprise profits before taxes, interest income, proprietor’s income, rent, and indirect business taxes.
A matrix is helpful to learn the short- and long-run changes in the aggregate supply/demand curve given various changes. Understand the determinants of the curves and which way a shift will occur.
An increase in stock prices, housing prices, consumer or business confidence, capacity util, government spending, bank reserves, or global growth will cause a rightward (higher) shift in aggregate demand.
An increase in labor supply, natural resources supply, human or physical capital, productivity or technology, expectations for future prices, or subsidies will cause a rightward shift in the short-run aggregate supply though expectations and subsidies will not affect the long-run curve (the others will affect both curves). An increase in nominal wages, input prices, and taxes will cause a leftward shift in the short-run aggregate supply curve but will have no impact on the long-run.
Understand the sources of economic growth: labor, human and physical capital, technology, and natural resources (you will need to know how they affect growth according to different theories in a future reading).
Understanding Business Cycles
A matrix chart is again useful here with economic activity on the vertical axis and cycle points on the horizontal.
Employment

  • Layoffs slow and net employment turns positive in early expansion (recovery) with businesses first turning to overtime and temp workers
  • Full time hiring picks up and the unemployment rate falls in late expansion
  • The rate of hiring slows but the unemployment rate continues to fall at the peak
  • Hiring freezes and hours are cut followed by outright layoffs in contraction (recession)

Consumer and Business Spending

  • Cyclical sectors start to pick up in early expansion and consumer spending increases
  • Increase in spending is broad-based with construction and capital spending pickup in late expansion
  • Spending continues to expand but the growth rate of spending slows at peak
  • Industrial production, housing, consumer and durable goods fall first in recession

Inflation

  • Remains moderate and may continue to fall in early expansion
  • Starts to increase in late expansion
  • Accelerates at peak
  • Decelerates but with a lag in recession

This list is abbreviated and you may want to expand it with further detail but remember to stick to the broader concepts.
Understand how an increase/decrease in foreign GDP growth should affect forex rates and trade (i.e. when the domestic currency appreciates then imports should increase through cheaper foreign goods and decrease net exports).
The rest of the reading is devoted to a discussion on the various theories. Again, understand the definitions and how each theory says the economy works as well as basic criticism of each. The most you will see (in my opinion) is definitional and comparison questions on these rather than detailed procedural stuff.
Understand the definitions for unemployment and how it is calculated as well as issues with NARU AND NAIRU. Understand the basic definitions for the components of leading, coincident and lagging indicators.
Monetary and Fiscal Policy
The quantity theory of money is easily testable but a pretty basic calculation. MV = PY or the quantity times the velocity of money equals the average price level times real output. Understand the basic theory and what it means for inflation.
Lists like monetary policy tools are important on the exams because they cover broad conceptual ideas and are easily worked into questions. Central banks have three primary tools: open market operations buying or selling government bonds, changing the policy or discount rate, and changing the reserve requirement for banks. Understand the basic process behind using each of these and the affect on the economy.
Lists of limitations to a policy or measure are also important. Understand the basics of monetary policy tools like problems with the transmission mechanism, bond market vigilantes, deflationary traps and liquidity traps.
Fiscal policy and its affect on aggregate demand is important. Understand the difference between automatic stabilizers and discretionary policy.
The key to the reading is the relationship between monetary and fiscal policy. Build out a chart with easy versus restrictive policy on one axis and monetary/fiscal policy on the other.

  • Easy fiscal/tight monetary: higher output and rates with expansion in public sector
  • Tight fiscal/easy monetary: lower rates and expansion of private sector
  • Easy monetary/easy fiscal: higher aggregate demand and lower rates with both public and private sector growth
  • Tight monetary/tight fiscal: higher rates and lower aggregate demand

Study session six in the Level I CFA Program curriculum concludes economics with two readings on exchange rates and international trade.
‘til next time, happy studyin’
Joseph Hogue, CFA

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