CFA Level 1 - Economics Flashcards _ Quizlet

CFA Level 1 - Economics flashcards | Quizlet

http://quizlet.com/7758902/cfa-level-1-economics-flash-cards/

CFA Level 1 - Economics

Created by Jbotros

241 terms

Price Elasti sticity of Dem Demand and Formula

(% Ch Chan ang ge in in Quan Quanttity Demand anded) ed) / (%t Change in Price)

Cro Cross Elasti sticity of of Deman emand d Formula

(% Ch Chan ang ge in in Quan Quanttity De Demand anded) ed) / (% Change in Price of Substitute or Complement)

Incom come El Elast asticity city of Dem Demand and For Form mula ula

(% Ch Chang ange in in Quan Quanttity Dem Deman ande ded) d) / (% (% Change in Income)

Price Elasti sticity of Supply Formula

(% Change in Quantity Supplied) ed) / (% Change in Price)

Elasticity of Demand Factors

1) Availability of Substitute; 2) Relative amount of income spent on the good; 3) Time SINCE price change

Elasticity of Supply Factors

1) Available substitutes for resources (inputs) used to produce the goods; (2) the time that has elapsed since the price change

Income elasticity of an Inferior GoodPositive or Negative

Negative

Total Cost Formula

= Total Fixed Cost + Total Variable Cost

Average Fixed Cost Formula

Average Fixed Cost = TFC/Q

Average Variable Cost Formula

Average Variable Cost= TVC/Q

Average Total Cost Formula

= AFC + AVC

Unemployment Rate Formula

(Number of Unemployed) / (Labor Force) x 100

Labor abor Forc Forcee Par Parti tici cipa pati tion on Rate Rate Form Formul ulaa

(Lab (Labor or Forc Force) e) / (W (Worki orkin ng-Ag -Age Pop Popul ulati ation on(1 (16 6 or older) ) x 100

Emplo Employm ymen entt to to Popula Populati tion on Ratio Ratio Form Formul ulaa

(Num (Number ber of Emplo Employed yed)) / (Wor (Workin king g-Age -Age Population) x 100

CPI Formula

(Cost of Basket of Current Prices) / (Cost of Basket at Base Period Prices) x 100

Inflation Rate Formula

% change in CPI (Current CPI- Year Ago CPI)/ (Year Ago CPI) X 100



Potential Deposit Expansion Multiplier Formula

= 1 / (required reserve ratio)

Potential Potential In Increase In In Mon Money ey Supply Supply Formu Formula la

= (Poten (Potential tial Deposit Deposit Exp Expan ansion sion Multipl Multiplier) ier) x (Increase in Excess Reserves)

Money Multiplier for a change in monetary base Formula Formula

(1+c) / (d+c) c = currency as a % of deposits d = desired reserve ratio

Chan Ch ang ge in in Quan Quanti tity ty of Money oney Form Formul ulaa

(Ch (Chang ange in in Quan Quanti tity ty of Money oney)) = (Ch Chan ang ge in in Monetary Base) x (Money Multiplier)

Equation of Exchange Formula

= (Money supply) x (Velocity) = GDP = (Price) x (Real Output)

Quantity Theory of Money Formula

Price = M (V/Y)

What does it mean if Cross elasticity What elas ticity is positive

Two goods are reasonable substitutes for each other

What does it mean if Price Elasticity of Demand is less than one in absolute value?

Inelastic

What does it mean if Price Elasticity of Demand is greater than one in absolute value?

Elastic

Normal Goods Elasticity

Positive Income Elasticity (greater than 1)

Total Revenue Test

Estimate elasticity of demand: P Up-> R Up (Inelastic); P Up -> D Down (Elastic)

Cross Elasticity of Substitutes- Positive or Negative

Positive

Income Elasticity for normal goods- Positive or Negative

Positive

Income Elasticity for inferior goods- Positive or Negative

Negative

Command System

A central authority determines resource allocation, is used in centrally planned economies and is also used within firms and in the military

Majority Rule

Government policies such as taxation and transfer payments are an example of this type of resource allocation

Efficient allocation of resources

Marginal Benefit to society (Demand) = Marginal Cost for the "last" unit of each good and service to be produced (Supply). (MC = MB)



Marginal Cost Formula

(Change in Total Cost) / (Change in Output)

Two Concepts of Robert Nozick's Anarchy, State, and Utopia (Symmetry)

1) Governments must recognize and protect private property; 2) Private property must be given from one party to another only when it is voluntarily done

When demand is less elastic than supplyconsumers bear higher or lower burden

HIGHER

When supply is less elastic than demandconsumers bear higher or lower burden

LOWER, suppliers will bear a higher burden

Inelastic means more or less DWL

Less

Three Constraints to Profit Maximization

TMI 1) Technological, 2) Informational, 3) Market Constraints

Technological Efficiency

Output from least inputs

Economic Efficiency

Output from least cost

Two ways that firms can organize production

CI 1) Command System, 2) Incentive System

Command Systems

Organization according to a managerial chain of command, eg US Military [Told what to do]

Incentive System

Senior mangement creates a system of rewards intended to motivate workers to perform in such a way as to maximize profits [Motivated to do]

Principal- Agent Problem

Problems that arise when incentives and motivations or managers and workers (Agents) are not the same as the incentives and motivations of their firms.

Three Methods used to reduce Principal-Agent Problem

OIL 1) Ownership, 2) Incentive Pay, 3) Long-term contracts

Three Types of Business Organizations

PPC 1) Proprietorships, 2) Partnerships, 3) Corporations

Four Types of Economic Markets

PMOM 1) Perfect Competition, 2) Monopolitic Competition, 3) Oligopoly, 4) Monopoly

Four-Firm Concentration Ratio

The percentage of total industry sales made by the four largest firms in the industry. A highly competitive industry may have a four-firm concentration ratio near zero, while the ratio for monopoly is 100%, < 40% = Competitive Market, >60% is Oiligopy



Herfinhahl-Hirschman Index (HHI)

Calculated by summing the squared percentage market shares of the 50 largest firm in an industry (or all of the firms in the industry if there were less than 50). The HHI is very low in a highly competitive industry and increases to 10,000 (=100squared) for an industry with only one firm. An HHI between 1,000 and 1,800 is considered moderately competitive, while an HHI greater than 1,800 indicates that it is not competitive

HHI greater than 1,800

NOT Competitive

HHI between 1,000-1,800

Moderately Competitive

HHI less than 1,000

Competitive

Four-Firm Concentration Ratio 100%

Monopoly

Four-Firm Concentration Ratio less than 40%

Competitve

Four-Firm Concentration Ratio greater than 60%

Oligopoly

Three limitations to the HHI and Four-Firm Concentration Ratio

1) Problems with defining the geographical scope of the market; 2) Barriers to entry and firm turnover are NOT considered; 3) Weak link between market and an industry

Accounting Profits

Includes explicit costs

Economic Profit

Considers explicit and implicit costs

Economic Profit Formula

Economic Profit= Total Revenue Opportunity Costs = Total Revenue (Explicit + Implicit Costs)

Implicit Costs

Implied Rental Rate + Normal Profit

Implied Rental Rate

Term used to describe the opportunity cost to a firm for using its own capital. Sum of Economic Depreciation and Foregone Interest

Normal Profit

Opportunity cost of Owners' entrepreneurship expertise. It represents what owners could have earned if they used their organizational decision-making and other entreprenurial skills is another activity such as running another business.

Economic Efficiency

Producing a given output at the lowest possible cost

Technological Efficiency

Using the least amount of inputs to produce a given output



Income Elasticity of Demand > 0 "positive"

Normal Good

Income Elasticity of Demand > 1

Luxury Good

0 < Income Elasticity of Demand < 1

Necessity

Income Elasticity of Demand < 0 = "negative"

Inferior Good

On Straight-line Demand Curve - High Elasticity

Price Increase = Revenue Decrease E > 1 (absolute value) E > I -1 I

On Straight-line Demand Curve - Low Elasticity

Price Increase = Revenue Increase E < 1 (absolute value) E < I -1 I Price and Revenue move in the same direction

On Straight-line Demand Curve - Greatest Revenue

Unitary Elasticity (E = -1)

Large Price Increase = Smaller Demand Decrease

Relatively Inelastic, thus total expenditure on the good increases.

Small Price Increase = Large Demand Decrease

Elastic

Allocation of Resources - Methods

Market Price, Command, Majority Rule, Contest, First-come, First-served, Lottery, Personal Characteristics, Force.

Obstacles to efficient allocation of productive resources

1) Price Control (ceilings & floors); 2) Taxes and trade restricitions (subsidies & quotas); 3) Monopoly; 4) External Costs; 5) External Benefit; 6) Public goods and common resources

Consumer Surplus

Difference between total value to consumer and total amount paid by the customer A consumer surplus occurs when the consumer is willing to pay more for a given product than the current market price.

Producer Surplus

Difference between total cost of production and total amount received (market price).

Marginal Cost of production is

Minimum Supply Price

When the efficient quantity is produced the:

Sum of consumer surplus & producer surplus is maximized

Fairness Principles

Utilitarianism & Symmetry

Symmetry Principle

Equality of opportunity. economy is based on private property & voluntary exchange



Utilitarism

Greatest good occurs to the greatest number of people when wealth is transferred from the rich to the poor to the point where everyone has the same wealth 1) everyone wants and needs the same thing; 2) Marginal benefit of a dollar is greatest for the poor than the rich

Price Ceilings < Price Equilibrium

1. Excess demand results in Shortage 2. Black market prices > Ceiling Prices Long run impacts: Long waiting, Discrimination, Bribes, Lower Quality

Price Ceilings > Price Equilibrium

no impact

Price Floors < Price Equilibrium

no impact

Price Floors > Price Equilibrium

1. Excess supply results in Surplus Long run impacts: Excess supply, substitution in consumption

Tax Impact

Results in DWL Increase price equilibriums & Decrease quantity equilibrium

Deadweight Loss

decrease in total surplus due to an inefficient level of production

Statutory Incidence

Refers to who is legally responsible for paying the tax

Actual Incidence of Tax

Who actually bears the cost of the tax through an increase in the price paid (buyer) or decrease in the price received (sellers)

Statutory Incidence on the Buyer (Tax on Buyers) results in

Downward shift of the demand Increase in Price Equilibrium & Decrease in Demand Equilibrium

Statutory Incidence on the Seller (Tax on Seller) results in

Upward shift of the supply curve Increase in Price Equilibrium & Decrease in Demand Equilibrium

Minimum Wage > Price Equilibrium results in

Excess supply of labor; Decrease in non-monetary benefits; DWL from underproduction

Quotas < Quantity Equilibrium results in

DWL: Underproduction Marginal Social Benefit (MSB) > Marginal Social Cost (MSC)

Subsidies

DWL: Overproduction Marginal Social Benefit (MSB) < Marginal Social Cost (MSC) Increase Qe Decrease Pe to Consumers



Tax Incidence if Demand is less elastic

Buyer bears higher burden

Tax Incidence if Supply is less elastic

Supplier/Seller bears higher burdern

Market for Illegal Goods: Penalties on Sellers

Decrease Supply

Market for Illegal Goods: Penalties on Buyer

Decrease Demand

Market Coordination

occurs when a firm employs resources outside the firm more efficiently than if they relied only on internal resources. (Eg. outsourcing & contracting)

Firm Coordination

Management determines the flow of resources to determine what price to charge and how much to produce

Firm Coordination can be more efficient than Market due to:

Lower transaction costs, economies of scale, scope, and team production.

Fixed Costs aka Sunk Costs

remain unchanged in short-run, therefore should NOT be considered in current decision making. Related to passage of time NOT production.

Marginal Cost

Add'l cost of producing one more unit of output

Regarding Cost of Production

Marginal Product curve (MP) intersects Average Product curve (AP) @ its max. The Q at which AP = maximum = Q for which AVC is at its minimum.

Economies of Scale

LRAC cost is decreasing

Max Profits - Perfectly Competitive markets produce at quantities

MC = MR = Price

Marginal Cost curve (MC) intersects

AVC & ATC at their minimum. MC does NOT intersect AFC at min b/c AFC decreases as production increases due to allocation of fixed costs.

Features of Perfect Competition

1) Homogeneous product; 2) Many small sellers; 3) No barriers to entry/exit; 4) Existing firms doe not have have advantage over new entrants; 5) Consumers and sellers are knowledgeable about prices.

Perfect Competition - Price takers

1) small output relative to the market; 2) no influence on price; 3) Horizontal demand curve (perfectly elastic)

Perfect Competition - Output in the Long Run

Zero economic profits = normal return P = MC = ATC



Perfect Competition - Increase in Demand

Increase in Pe & Qe -> Economic profit -> Firms expand -> New entrants -> LR: zero economic profit

Perfect Competition - Long Run Price Equilibrium After Permanent Increase in Demand

Lower (external economies) Higher (external diseconomies)

Perfect Competition - Technological changes:

Higher quantitiy, lower price LR: price = min ATC for the new technology -> zero economic profit

Features of Monopoly

1) No good Substitues; 2) Distinguished by higher entry barriers - Legal barriers - gov't licensing & patents - Natural barriers- substantial economies of scale

Monopoly - Profit Maximization

Produce Q where MR = MC Produce in the elastic range of demand curve Higher prices & lower quantities

Monopoly - Price searcher

1) Downward sloping demand curve; 2) Reduce price to increase sales; 3) MR < price 4) MR curve lies below the demand curve

Monopoly vs. Perfect Competition

1) DWL; 2) Smaller consumer surplus 3) Rent seeking

Monopoly - Price-setting strategies

1) single-price; 2) price discrimination

Price Discrimination

1) Firm must have downward sloping demand; 2) Identifiable groups of consumers w/ diff price elasticities of demand 3)Prevent resale between groups 4) charge different prices Results in Higher Economic Profit

Is Perfect Price Discrimination Efficient?

Yes. 1) No DWL; 2) No consumer surplus; 3) Same quantity as perfect competition

Regulating Natural Monopolies - Average Cost Pricing:

Increase output & social welfare

Regulating Natural Monopolies - Marginal Cost Pricing:

May lead to loss, may need subsidy if MC < ATC Issues: Lack of information, quality deterioration, firm lacks incentive to reduce costs, political influence seeking.

Gains from Monopoly

1) Innovation incentive; 2) Economies of scale and scope



Features of Monopolistic Competition

1) Large # of independent sellers; 2) Differentiated products; 3) Compete on price, quality, and marketing; 4) Low barriers to entry; 5) Downward sloping, highly elastic demand (due to lots of close substitutes)

Monopolistic Competition vs. Perfect Competition

1) Excess capacity: Q< efficient quantities; 2) Mark up:P>ATC

Monopolistic Competition - Output in the SR & LR

1) Produce where MR = MC; 2) SR economic profits; 3) LR- new firms enter - zero economic profits (like PC) but price is greater than marginal cost.

Monopolistic Competition - Efficiency

Unclear b/c (cost vs. benefit) Social costs of not producing at P = MC Benefits due to: information, values from brand names, product innovation/differentiation and advertising. It is possible that the loss resulting form producing an inefficient quantity could be offset by the value gained form product variety.

Features of Oligopoly

1) significant barriers to entry; 2) Small # of interdependent sellers with incentive to cooperate (faced with prisoners' dilemma) 3) Downward sloping demand curve

Oligopoly - Prisoners' Dilemma

Model used to analyze oligopoly output restrictions. Best course of action is to enter into a collusive agreement and cheat.

Two Oligopoly Models

1) Kinked demand curve- follow price decrease only; 2) Dominant firm oligopoly-dominant firm sets price

Marginal Revenue (MR)

The addition to total revenue from selling one more unit of output

Marginal Revenue Product (MRP)

The addition to total revenue from selling the additional output from employing one more unit of a productive resource(input) To maximize profits: MRP labor = Price labor

Factors Increasing Demand for Labor

1) Increase in output price; 2) Increase in substitute price; 3) Decrease in complement price; 4) Advances in technology or new capital that increases labor's MP



Factors of Elasticity of Demand for Labor

1) Labor intensity (more the better/not automated process); 2) Elasticity of demand for output; 3) Input substitution [Demand for labor is more elastic in the LR vs. SR.]

Supply of Labor - Substitution Effect

Higher wage results in less leisure, more labor supplied

Supply of Labor - Income Effect

higher income results in more leisure, less labor supplied

Shifts in Labor Supply caused by:

1) Size of adult population; 2) Capital accumulation to allow more adults working outside.

Labor Market Power - Labor Union vs. Monopsony

Labor Union: (collective bargaining/ only group of employees) increase wage rate and reduce employment Monopsony: (single buyer/employer) reduce wage rate and employment b/c MC of an add'l worker > wage.

Labor Market Power - Increase Demand for Labor Union (to offset decrease in employment)

1) Increase MP of labor via training; 2) Advertise to increase demand for union-made products; 3) Advocate trade restrictions on foreign goods that compete with union-made domestic goods; 4) Reducing the supply or increasing the price of substitutes for union labor (higher min wage & immigration restrictions)

Physical Capital

1) PP&E; 2) Inventory (WIP & Finished goods)

Financial Capital

Pays for physical captial 1) Equity; 2) Debt Securities

Financial Capital - Demand

QD up when Interest Rate down QD down when Interest Rate up Reflect PV of MRP of physical capital in production

Financial Capital - Supply

Supplied by savings - [Increase/(Decrease)] 1) Interest Rates [up/(down)] ; 2) Current Incomes [up/(down)]; 3) Expected Future Income [down/(up)]

Natural Resources - Non-Renewable

1) Elastic supply (horizontal); 2) QSupply determined by Demand; 3) Current Pirce is the PV of the expected price next period. e.g. oil



Natural Resources - Renewable

1) Inelastic supply (vertical); 2) price is determined by demand e.g. water

Economic Rent

Difference between actual earnings and opportunity cost of a factor of production

Economic Rent - Supply Elasticities

1) Perfectly elastic supply (unskilled labor)no economic rent; 2) Perfectly inelastic supply (golf ability)- max economic rent; 3) Upward sloping supply curve -> some economic rent

Real wage rate

Money wages adjusted for changes in price level

Aggregate hours

Total hours worked in a year by all employed people

Unemployment

Actively looking for work, Laid off, waiting to be called back, Starting a job w/in 30 days

Three Types of Unemployment:

1) Frictional; 2) Structural; 3) Cyclical

Natural Rate of Unemployment:

1) Frictional; 2) Structural

Natural Rate of Unemployment - Frictional

imperfect information and job searches taking time

Natural Rate of Unemployment - Structural

skills being in shortage and the economy changing

Unemployment - Cyclical

associated with the business cycle Negative Cyclical may exist (SR) Real GDP > Potential GDP = levels of above full capacity Positive Cyclical Real GDP < Potential GDP = levels of undercapcity

Economy is at full employment when

unemployment rate = natural rate of umemployment NO cyclical umemployment Real GDP = Potential GDP

Labor Force

= # of employed + # of unemployed Includes all people who are either employed or actively seeking employment. DOES NOT include discouraged workers or those who are available for work but are neither employed nor actively seeking (i.e. housewives)

Consumer Price Index (CPI)

Average price for a "basket" of goods and services purchased by a typical urban household (excludes food & fuel/energy)



Biases in CPI Data

Tend to overstate inflation by ~ 1% Does not account for the following: 1) New Goods; 2) Quality change; 3) Commodity substitution; 4) Outlet substitution

Short-Run Aggregate Supply (SRAS)

1) Upward sloping supply curve (assumes fixed money wage); 2) Decreases (shifts) with rising wages or expected inflation; 3) Changes in price level are movements along SRAS curve (function of price level)

Long-Run Aggregate Supply (LRAS)

1) Vertical supply curve at potential GDP (independent of price level); 2) Full employment real output of economy; 3) Increases/(Decreases) with Increases/(Decreases) in quantity of labor, capital, and existing technology.

Increases (Decreases) in Long-Run Aggregate Supply (LRAS) due to:

Increases (Decreases) in 1) Quantity of labor; 2) Quantity of capital in the economy; 3)Technology the economy possess.

Aggregate Demand Formula (AD)

Aggregrate Demand = (Consumption) + (Investment) + (Government Spending) + Net Exports

Aggregate Demand Factors

1) Expectation about incomes, Inflation, and profits; 2) Fiscal & Monetary Policy; 3) The growth rate of the world economy

Aggregate Demand Curve is DownwardSloping Due To:

1) Wealth effect - price increases, individual wealth decreases, therefore save more (spend less); 2) Intertemporal substitution - price level rises, interest rate rises, consumption later is substituted with consumption now.

Increases (Decreases) in Aggregate Demand due to:

1) Increases (Decreases) in Expected inflation, Income, Profits, Foreign incomes and (Decreases) Increases in Domestic exhcange rate.

The Economy is in Long-Run Equilibrium

At price levels where AD intersects the LRAS. higher prices = excess supply & downward pressure on production and prices lower prices = excess demand & upward presssure on production and prices.



The Economy is in Short-Run Equilibrium

At output levels above/below Full-employment GDP (LRAS) If below LRAS = recession & downward pressure on wages & prices. If above LRAS = inflationary pressure on wages & prices. Changes in Money Wages (and other resource prices) cause SAS to shift, bringing the economy back to LR equilibrium

If aggregate demand and LRAS grow at the same rate, what should happen to Inflation & real GPD?

No inflation change and an increase in real GDP.

Stagflation

recession combined with inflation

A change in the amount of capital in the economy will lead to

a change in the SRAS curve, assuming workers' inflation expectations are unchanged. why? b/c result in more productive work force, increasing potential GDP. This will shift both the LRAS & SRAS curves. Assuming no change in the money wage rate, an increase in the price level will cause the quantity of real GDP that is supplied to increase, resulting in a movement along the same SRAS. Also, increase in Demand will result in a greater quantity supplied hence movement along the same SAS.

3 Schools of Macroeconomic Thoughts

1) Classical; 2) Monetarists; 3) Keynesian & New Keynesian

Classical

1) Shifts in AS & AD are driven by changes in technology; 2)Money wages change to restore LRe @ Full employment; 3)Taxes are primary impediment to LRe (DWL) Economy is self-regulating

Monetarist

1) Unpredictables changes in monetary policy are the cause of deviations from full-employment GDP; 2) Recession due to inappropriate decreases in money supply; 3) Recommend: Follow steady and predictable monetary policy (steady growth of money supply) and taxes should be kept low Economy is self-regulating



Keynesian

1) Shifts in AD are caused by changes in expectations (confidence & investments); 2)Business cycles caused by shift in AD; 3) Wages "downward sticky" not flexible so SAS adjusts slowly; 4) Recommend: Increases in AD to restore full employment via fiscal or monetary policy

New Keynesian

Prices of other factors also 'sticky' not flexible

Measures of Money M1 & M2

M1 = currency + Travellers' checks + checking accounts M2 = M1 + time & saving deposits + money market mutual funds

Function of Depository Institutions

1) Create liquidity; 2) Act as financial intermediaries; 3) Pool default risks

How Banks Create Money

1) fraction of deposit held in reserves; 2) Remainder can be loaned (excess reserves); 3) Quantity of money increases with a multiplier effect;

Monetary base:

Fed notes, coins, and banks' reserves deposits at the Fed. Size of monetary base restricts the total amount of money that can be created.

Change in Money Supply -

change in monetary base x money multiplier

The lower the desired reserve ratio and the lower the currency drain results in

greater money multiplier

Federal Reserve Policy Tools

1) Discount rate; 2) Reserve requirements (least used); 3) Open market operations (most used)

Federal Reserve Policy Tools - Discount rate

Rate at which banks can borrow reserves from the Fed. - Lower discount rates increase money supply & decrease interest rates; - Higher discount rates decrease money supply & increase interest rates

Federal Reserve Policy Tools - Reserve Requirements

Least used Higher % decreases money supply & increase interest rates; Lower % increases money supply & decreases interest rates



Federal Reserve Policy Tools - Open market operations

Most used Fed buying & selling Treasury Securities. Fed purchases increases cash for lending, decreases interest rates. Fed sales remove cash, increasing interest rates

Fed's Balance Sheet - Assets

Primarily Treasury securities, gold, deposits with other central banks, IMF special drawing rights, loans to banks at the discount rate

Fed's Balance Sheet - Liabilities

US currency in circulation; bank reserve deposits

Determinants of Money Demand

1) Interest rates (most critical); 2) Inflation (increases demand for nominal money); 3) Real GDP growth (increases the demand for nominal and real money).

Supply of Money

Determined by the central bank independent of interest rates. (vertical supply curve)

Influences of Financial Innovations & Effect on Demand of Money

1) changes in economic environment; 2) Technology; 3) Regulation Reduce demand for money include: 1) ATM; 2) Internet Banking; 3) credit card usages;

Goals & Targets of the Fed

1) keep inflation low (stable prices); 2) Maintain full employment; 3) Smooth business cycles; 4) Promote economic growth (Moderate long-term interest rates)

Effect of Money on Real GDP (LRAS) Increase in Money Supply will:

Decrease nominal and real interest rates Cheaper current consumption and investments Dollar depreciates -> more exports Short run: AD, real GDP, and price levels increase Long run: full-employment GDP

If the interest rate increases

opportunity cost of holding money will increase and therefore demand decreases

Quantity Theory of Money equation

Money Supply (M) x Velocity (V) = Price (P) x Real output (Y)

Velocity =

average # of times per year each dollar is used = GDP/ Money



Quantity Theory of Money (assuming velocity & real output does NOT change)

an increase in the money supply will cause a proportional increase in price. in other words: growth in money supply in excess of the growth rate of real GDP is inflationary

what is the LR & SR impact of an increase in monetary base while at full GDP?

SR: Increase in real GDP, Employment and Price level LR: Increase in Price level only

Demand-pull inflation

Results from an increase in aggregate demand -Increases in AD that increases equilibrium GDP above full-employment GDP in Short-run. Unemployment below natural rate, lead to increase in real wages. Increased wages shift (decrease) SRAS, resulting in new equilibrium of full-employment GDP @ higher prices. Demand-pull inflation will cont. if gov't continues fiscal or monetary policies that are increasing AD.

Cost-push inflation

Results from a decrease in aggregate supply -Unexpected increases in the real price of factor inputs such as wages or energy. SRAS decreases (***** up and to the left), results in SRe below full-employment GDP and higher prices. If gov't responds wiht monetary or fiscal policy to increase AD, equilibrium GDP can be increased to full-employment GDP but at higher prices. Sustained cost-push inflation happends when input costs cont. to increase and the gov't cont. to make policy changes that further increase AD.

Nominal Rate = Real Rate + Expected Inflation

Higher inflation -> higher nominal rates Faster Money Supply (MS) growth -> higher nominal rates

Inflation & Unemployment

Actual Inflation= expected -> remain @ full employment (LRPC is vertical at full-employment real GDP= natural rate of unemployment) Actual Inflation> expected -> employment increases Actual Inflation< expected -> employment decreases



Mainstream Business Cycle Theory

Potential GDP (LAS) grows at a steady rate while AD growth fluctuates AD grows faster than LAS = expansion AD grows slower than LAS = contraction Includes Classical, Keynesian, and Monetarist schools of thoughts

Phillips Curve

Short run Phillips curve, level of UNemployment is negatively related to inflation. (think N in unemployment = negatively related) HENCE employment is positively related to inflation.

Phillips Curve - change in expected inflation will

shift short-run phillips curve but NOT the long-run phillips curve.

Real Business Cycle Theory

Think: "real random" Random fluctuations in productivity are the main source of economic fluctuations

Fiscal Policy =

Government tax and spending Balanced budgets budget deficits -> dissavings budget surpluses -> savings

Fiscal Policy Supply Side Effects

1) Income taxes reduce incentive to work (hence reduce supply of labor only); 2) Expenditure taxes reduce purchasing power of wages (hence reduce the real wage rate); 3) Reduce potential GDP

Laffer Curve

Increases in tax rates increase tax revenue only up to some tax rate (difficult to determine) (Hence higher income tax rate may result in a decrease in tax revenue b/c it decreases the supply of labor)

Fiscal Policy - Sources of Investment

1) Investment financed by gov't savings; 2) national savings; 3) borrowing from foreigners -Captial income tax reduce returns on investments.

Crowding out effect

When gov't borrows to finance the federal budget deficit, tendency for businesses to reduce investment. In other words, increased deficits raise interest rates and reduce private investments.



Generational Effects of Fiscal Policy

Gov't expenditures that are NOT funded by current taxes. Studies show that over half of fiscal imbalance will be paid by future generations (medicare)

Discretionary fiscal policy (counter cyclical)

1) Increase gov't spending and reduce tax rates during recession 2) Cut gov't spending and raise tax rates during inflationary period

Fiscal Multiplier Effect

Expenditure multiplier (increased gov't spending increases AD) > tax multiplier (increase in tax decrease consumption) HENCE an equal increase in both taxes and expenditures will increase GDP. Therefore balanced budget multiplier is positive

Fiscal Policy Limitation

1) Recognition delay (recognizing bubbles); 2) Administrative delay (passing laws); 3) Impact delay (too late)

Discretionary fiscal policy multiplier effect

1) Gov't purchase multiplier: $1 in gov't spending causes >$1 increase in AD; 2) Tax multiplier: less impact than gov't multiplier; 3) Balanced Budget multiplier: Increase in spending coupled with an equal increase in taxes = positive effect on AD.

Automatic stabilizers (counter cyclical)

1) Induced taxes: graduated tax = Econ boom -> higher tax bracket; Econ downturn -> lower tax bracket 2) Needs- tested spending: more money is paid out as umemployment increases

Monetary Policy (Federal Reserve) Decision Making Strategies

1) Instrument rule: Sets FFR based on current economic state. Taylor Rule: FFR = 2% + inflation + 0.5(inflation - 2%) + 0.5(output gap) 2) Targeting rule (Inflation) sets FFR so that the forecast of inflation is equal to the target inflation rate, 2%

How does the Fed operationalize their goals?

by focusing on 1) core inflation (differences between actual and target inflation rates; and 2) output gap (differences between acutal and potential GDP)

Monetary Policy (Federal Reserve)

1) Increase in MS decreases Fed Funds Rate (FFR); 2) Decrease in MS increases FFR; 3) Implemented by open market operations



To maintain maximum employment when output is positive (negative):

positive output = inflationary gap, FED sell securities negative output = recessionary gap, Feds buy securities

To determine price stability, the Feds:

Monitor CPI which excludes food & fuel

To moderate long-term interest rates, the Feds

work to keep long-term real interest rates close to long-term nominal interest rates.

Open Market Operations (Transmission Mechanism) during recessionary gap (negative output gap)

1) Fed buys Treasuries, excess reserves, FFR falls 2) Other short-term rates fall 3) Longer-term rates fall 4) Business expand investment (AD up) 5) Domestic currency value falls imports down/exports up (AD up) 6) Consumer (financed) purchases increase (AD up) Opposite during inflationary gap (positive output gap)

Federal Reserve Open Market Operations determines the

supply of bank reserves

Limitations with Open Market Operations (trasmission mechanism)

1) No link between FFR and LT rates (FFR closely linked to ST int. rates); 2) MS increase can increase inflation and LT rates; 3) Lag between monetary policy and effects can lead to expansion and contraction at wrong times

Alternative Strategies/Drawbacks

1) Targeting growth of monetary base (McCallum rule): cycles can still result from fluctuation in AD; 2) Targeting growth of money supply (Friedman's k-percent rule): result in fluctuation in AD and velocity; 3) Target the foreign exchange rate: inflation would be that of foreign countries; 4) Inflation targeting: less flexible, may or may not be better.

Freidman's k-percent rule

A money targeting rule that works when demand for money is stable and predictable. If the demand for money is unpredictable, the money target rule becomes unreliable.

The main functions of a central bank are

1) issuing currency; 2) setting monetary policy; 3) controlling the MS; 4) regulating the banking system; 5) assessing and reacting to economic and financial conditions

When Marginal Product (MP) is at its Max

Marginal Cost (MC) is at its Min



Marginal Product (MP) intersects AP at

the point where AP is at it's maximum

AP is at its Max

AVC is at its Minimum

Describes the relationship between marginal cost (MC), average variable cost (AVC), marginal product (MP), and average product (AP)

When MP = AP, MC = AVC.

In the short run, if price is below average total cost (ATC) the firm will:

keep running as long as it is covering its variable costs

An increase in the supply of capital, assuming no change in the demand for capital, will:

cause the equilibrium interest rate to fall.

A firm operating under perfect competition will experience economic losses when:

Market price is less than average total cost. P < ATC

A monopolist will continue expanding output as long as:

The optimum behavior of all firms is to produce until the point where MR = MC. So, the monopolist can increase total profit by increasing production as long as marginal revenue is greater than marginal costs.

When MR = MC = P, economic profit equals

Total Revenue - Total Cost

What would be the impact of an unanticipated increase in aggregate demand (AD) on an economy's rate of unemployment, rate of inflation, and the short-run Phillips curve (SRPC)?

1) Decrease in rate of unemployment; 2) Increase in rate of inflation; 3) Upward movement along the Phillips curve (SRPC)

CFA Level 1 - Economics Flashcards _ Quizlet

Recommend Documents