CFA Level I Study Session

1
CFA Level I Study Session 4

• Investment Tools -
• Macroeconomic Analysis and Policy

2
CFA Level I Study Session 4

• Modern Macroeconomics
• A Brief Overview

3
The Economy in the Long Run

• All markets all clear, prices and quantities
  adjust.
• Real Output, Y
• Set by levels of capital, labor, and technology.
• Production function Y F(K, L) LRAS vertical.
• Real Interest Rate, r
• Determined by Loanable Funds Market equilibrium.
• Savings from private and public (govt budget)
  sectors.
• Investment demand from private firms.
• Price level, P and Inflation rate, p
• Quantity Theory MV PY
• Price level determined by level of Money Supply.
• Inflation rate money growth real output growth

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The Economy in the Long Run

• Nominal Interest rate, i
• Expected (or ex ante) Real interest rate
  determined by Loanable Funds market.
• Nominal Interest rate determined by Expected Real
  Interest Rate, re, and Expected Inflation, pe,
  as
• i re pe
• Actual versus Expected Real Interest Rate
• Actual Real Interest rate, r, differs from
  Expected Real Interest rate, re, when expected
  inflation does not equal actual inflation.
• re i - pe vs. r i - p

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The Market for Loanable Funds
Real Interest rate set by equilib. between
savings and investment.
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The Economy in the Short Run

• Markets may not clear, prices are sticky.
• Real Output, Y
• Determined by downward-sloping Aggregate Demand,
  AD, and upward-sloping SR Aggregate Supply, SRAS.
• May have real GDP above or below LRAS level in
  SR.
• Price level, P and Inflation rate, p
• Determined by AD and SRAS equilibrium with Y.
• Inflation rate also affected by expectations.
• Real Interest Rate, r
• Determined by Money Market equilibrium.
• Monetary Fiscal Policies
• Govt policies may change AD and/or SRAS in SR.

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Linking Economy in SR LR
Price Level
LRAS
P
SRAS1
P1LR
AD1
YLR
Income, Output, Y
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CFA Level I Study Session 4.1A

• Modern Macroeconomics
• Fiscal Policy

9
Fiscal Policy

• The candidate should be able to
• explain the process by which fiscal policy
  affects aggregate demand and aggregate supply
• Fiscal policy affects AD directly through govt
  spending indirectly through effects of taxes on
  consumption and investment. Taxes may affect AS
  by changing incentives for workers and firms.
  Fiscal policy can be restrictive (lowers AD) or
  expansionary (raises AD).
• explain the importance of the timing of changes
  in fiscal policy and the difficulties in
  achieving proper timing
• Recognition lag, implementation lag before policy
  passed, effectiveness lag before policy works. If
  timed correctly can stabilize economy, if not
  policy will bring more instability (usually in
  opposite direction).

10
Fiscal Policy

• The candidate should be able to
• discuss the impact of expansionary and
  restrictive fiscal policy based on the basic
  Keynesian model, the crowding-out model, the new
  classical model, and the supply-side model
• Keynesian model assumes SRAS upward-sloping. If
  economy is in recession (below LRAS),
  expansionary fiscal policy shifts out AD, moves
  economy back to LRAS.
• Crowding out model similar but notes expansionary
  fiscal policy raises govt deficit, which changes
  interest rates and exchange rates. These changes
  lower investment and net exports, partly
  offsetting expansionary fiscal policy.
• New Classical model believes fiscal policy has no
  effect because any change in deficit (from
  spending or tax changes) is offset by changes in
  private savings behavior.
• Supply-side model believes tax changes affect
  productivity and so can increase equilibrium
  output in long run.

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Fiscal Policy

• The candidate should be able to
• explain how and why budget deficits and trade
  deficits tend to be linked.
• Natl Income identity Y C I G NX
• Rearrange yields Y- C - G I NX or (Y-C-T)
  (T-G) I NX
• Where Y-C-T Private Saving S, T-G Budget
  Balance
• If S and I fixed, then increase in Budget
  Deficit, (T-G) more negative, implies that NX
  more negative, ie. larger Current Account
  Deficit.
• identify automatic stabilizers and explain how
  they work , etc.
• Automatic stabilizers are fiscal policies that
  automatically promote budget deficits during
  recessions and surpluses during booms. Examples
  are unemployment compensation, corporate profits
  tax, and progressive income tax. These policies
  affect AD in ways that offset economic
  fluctuations.

12
Fiscal Policy

• The candidate should be able to
• discuss the supply-side effects of fiscal policy.
• Changes in tax rates, particularly marginal tax
  rates, affect aggregate supply through their
  impact on the relative attractiveness of
  productive activity in comparison top leisure and
  tax avoidance. Supply-side tax cuts are a
  long-term growth-oriented strategy that will
  eventually increase both SRAS and LRAS.
• explain the relationships among budget deficits,
  inflation, and real interest rates
• In theory, higher govt budget deficits should
  lead to higher real interest rates by loanable
  funds market analysis. In practice effect is not
  as strong as expected.
• Higher govt budget deficits may lead to higher
  inflation rates if govt finances deficit by
  printing money.

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CFA Level I Study Session 4.1B

• Money and the Banking System

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Money the Banking System

• The candidate should be able to
• define and explain the three basic functions of
  money
• At a theoretical level, money supply consists of
  assets that acts as
• Medium of Exchange - facilitates transactions
  (liquidity).
• Unit of Account - used to quote prices.
• Store of Value - transfer purchasing power to
  future.
• define the money supply
• At a practical level, U.S. money supply defined
  by 3 widely-used measures M1, M2, M3
• M1 Currency Travelers Checks Demand
  Deposits Other Checkable Deposits
• M2 M1 Savings Deposits Small Time Deposits
  Money Mkt. Mutual Funds
• M3 M2 Large Time Deposits Term Repos

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Money the Banking System

• The candidate should be able to
• describe the fractional reserve banking system
• Commercial Bank activities
• Accept Deposits Hold Reserves Make Loans
• Reserves are vault cash or deposits at central
  bank,
• required by central bank to hold minimum level
  against deposits.
• Reserve requirement, rr. Required Reserves rr
  x Deposits
• Bank activities summarized by a Bank Balance Sheet

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Fractional Reserve Banking
BANK ONE
Assets
Liabilities
Reserves
Deposits
Loans
BANK TWO
Money Multiplier
Assets
Liabilities
Process
Reserves
Deposits
Loans
BANK THREE
Assets
Liabilities
Reserves
Deposits
Loans
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Banks and Money Creation

• MONEY CREATION PROCESS
• Original Deposit 1,000
• Bank One Lending (1-rr)x1000
• Bank Two Lending (1-rr)2 x1000
• Bank Three Lending (1-rr)3 x1000
• and so on _____________
• Total DMs 1 (1-rr) (1-rr)2
• (1-rr)3 x 1,000
• (1/rr) x 1,000 5,000
• In a fractional reserve banking system, banks
  create money.

• Banks accept deposits, hold fraction in reserve,
  lend out rest.
• Reserve-deposits ratio minimum is regulated
  reserve requirement, rr.
• New loans made create new deposits, increasing
  the money supply.
• Process is known as financial intermediation.

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Money the Banking System

• The candidate should be able to
• explain the relationship between reserve ratio,
  potential deposit expansion multiplier, and
  actual deposit expansion multiplier.
• Potential Deposit Expansion Multiplier
  1/(Reserve Requirement)
• Maximum potential increase in the money supply as
  a ratio of new reserves injected into the banking
  system
• Actual Deposit Expansion Multiplier
• Multiple by which a change in reserves changes
  the money supply
• Inversely related to the reserve requirement
• Smaller than the Potential Deposit Expansion
  Multiple to the extent that
• Persons hold currency rather than deposit it in
  the banking system
• Banks fail to lend out all excess reserves, i.e.
  banks choose to hold reserves in excess of the
  legal minimum required.

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Money the Banking System

• The candidate should be able to
• () describe the tools the central bank can use
  to control the money supply and explain how a
  central bank can use monetary tools to implement
  monetary policy and explain .
• Open Market Operations
• Purchase or sale of govt bonds by the central
  bank.
• Open Market purchase of bonds by central bank
  increases reserves at banks, banks lend excess
  reserves, and money supply increases.
• Reserve Requirements
• Govt regulates banks minimum reserve-deposit
  ratios.
• Increase in reserve requirements, lowers money
  multiplier, and so decrease money supply as banks
  call loans to build up reserves.
• Discount Rate
• Interest rate on reserves borrowed from central
  bank.
• Lower discount rate, cheaper borrowed reserves,
  more reserves borrowed by banks, banks increase
  loans, which increases deposits in banking
  system, thus increasing money supply.

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Money the Banking System

• The candidate should be able to
• discuss potential problems in measuring an
  economys money supply.
• Growth rate of money supply generally used to
  gauge monetary policy. Money supply measures
  subject to changes due to structural shifts
  financial innovations.
• Use of U.S. outside of U.S. US acts as
  international vehicle currency in international
  transactions, illegal activities, dollarisation,
  etc.
• Shifts from interest-bearing checking accounts to
  MMDAs checking accounts in M1 but MMDAs only
  in M2. Distorts M1 vs. M2 measures.
• Increased availability of low-fee stock and bond
  mutual funds Not counted in money measures but
  increasingly liquid, act as near-money.
• Debit cards and electronic money Reduce reasons
  to hold currency, may transfer transaction
  balances outside banking system.

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CFA Level I Study Session 4.1C

• Modern Macroeconomics
• Monetary Policy

22
Monetary Policy

• The candidate should be able to
• discuss the determinants of the demand for and
  supply of money
• Market for Money
• Money Supply Ms M0
• Set by the Central Bank using monetary policy
  instruments.
• Money Demand Md PL(r, Y)
• Interest rate is opportunity cost of holding
  money.
• Transaction demand depends on Real GDP, Y and on
  the level of prices, P, in the economy.
• Equilibrium M/P L(r, Y)
• Keynesian Theory of Liquidity Preference says
  real interest rate moves to equate demand and
  supply at any level of real GDP, Y.
• explain how monetary policy affects interest
  rates, output, and employment
• See Fig. 4.1C (next) for SR vs. LR effects of
  monetary policy on the economy.

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Fig. 4.1C - Effects of Monetary Policy
Real
Interest
Price
MS0
LRAS
Rate
Level
SRAS
r0
P0
AD0
MD(P0)
Y0
Money
Output
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Monetary Policy

• The candidate should be able to
• discuss how anticipating the effects of monetary
  policy can reduce the policys effectiveness
• To the extent that the effects of monetary policy
  are fully anticipated, they exert little impact
  on real activity, only nominal variables change.
• Expectations of inflation will affect nominal
  interest rates quickly, keeping real interest
  rate constant, reducing impact on AD.
• Escalator clauses in wages automatically raise
  costs, shifting SRAS economy more quickly back
  towards LRAS.
• compare and contrast the impact of monetary
  policy on major economic variables in the
  short-run and long-run, when the effects are
  anticipated or unanticipated
• See Fig. 4.1C (previous) for SR vs. LR effects of
  monetary policy on the economy when policies are
  initially unanticipated.
• When policies are anticipated SR effects are less
  and LR effects occur more rapidly.

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Monetary Policy

• The candidate should be able to
• (contd)
• Unanticipated Expansionary Monetary Policy
  Effects
• Real Output, Y
• SR Increase in Real GDP LR Returns to LRAS.
• Inflation Rate, p
• SR Prices (inflation) rise LR Prices
  (inflation) rise further.
• Real Interest rate, r
• SR Decrease in r. LR Returns to original
  level.
• describe the quantity theory of money and its
  implications for the determination of inflation.
• Quantity Equation states MV PY
• Y Real GDP, P Implicit GDP Price Deflator, M
  Money Supply, Velocity V times per year
  1 used to buy output.

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Inflation is everywhere and always a monetary
phenomenon Milton Friedman, Nobel Laureate
Economics

• Quantity Equation states
• MV PY m v p y
• Y Real GDP y growth of real GDP
• P Implicit GDP Price Deflator p inflation
• M Money Supply, m growth rate of money
  supply
• Velocity V times per year 1 used to buy
  output.
• Quantity Theory assumes
• Velocity is constant (or that growth rate of
  velocity v is constant).
• Implications for Long Run Inflation Rate
• Monetary policy affects only price level and
  inflation assuming velocity constant or varies
  predictably.
• Real Output, Y, determined by other factors.
• LR inflation rate equals growth rate of money in
  excess of the growth rate of real GDP i.e. p
  m y

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CFA Level I Study Session 4.1D

• Stabilization Policy, Output,
• and Employment

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Leading Indicators and Forecasting

• () describe the composition and use of the index
  of leading economic indicators
• The index of leading indicators is a composite
  index of 11 key variables that generally turn
  down prior to a recession and turn up prior to a
  recovery. Changes in the index are used to
  forecast future changes in the state of the
  economy but there is significant variability in
  the lead time of the index, and hence the index
  is not always an accurate indicator of the
  economys future.

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Time Lags Policy Effects

• () discuss the time lags that may influence the
  performance of discretionary monetary and fiscal
  policy
• Recognition lag
• Time between when policy needed to stabilize and
  when need recognized by policymakers.
• Length of this lag is the same for both monetary
  and fiscal policy and depends on ability of
  economic forecasters to accurately predict future
  state of the economy.
• Administrative or implementation lag
• Time between when the need for the policy is
  recognized and when the policy is actually
  implemented.
• Monetary policy tends to be implemented quickly,
  therefore it has a short implementation lag.
• Fiscal policy is implemented by Congress and the
  President, therefore it tends to have a long
  implementation lag.
• Impact or Effectiveness lag
• Time period after a policy is implemented but
  before the policy actually begins to affect the
  economy.
• Monetary policy tends to have a long and variable
  impact lag.
• Fiscal policy affects the economy immediately
  thus it has a short impact lag.
• If timed correctly can stabilize economy, if not
  policy will bring more instability (usually in
  opposite direction).

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Stabilization Policy

• The candidate should be able to
• explain the role expectations play in determining
  the effectiveness of fiscal and monetary policy
• Adaptive Expectations hypothesis
• Individuals base their future expectations on
  actual outcomes in the recent past.
  (Backward-looking)
• Rational Expectations hypothesis
• Individuals weigh all available evidence,
  including information about probable effects of
  current future economic policy, when forming
  expectations about future economic events.
  (Forward-looking)
• Expectations determine how quickly SRAS adjusts
  to changes in AD Curve, leading the economy back
  to LRAS.
• Fiscal monetary policies (expansionary
  restrictive) will be less effective when people
  anticipate their effect on prices more quickly.

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Stabilization Policy

• The candidate should be able to
• explain a non-activist strategy for monetary and
  fiscal policy.
• Monetary Policy Rules MVPY
• Money Growth Target Money growth should be
  determined by Quantity Theory (Monetarists).
• Nominal GDP Target Money growth adjusted to keep
  Nominal GDP growing at target rate.
• Price Level Target Money growth adjusted to
  keep Price level within some target range of
  growth.
• Fiscal Policy Rules
• Balanced Budget Rule Fiscal Policy sets Budget
  Deficit 0. Problem is makes economy more
  unstable.
• Stabilizing GDP Fiscal policy sets automatic
  stabilizers (income taxes, transfers). Cyclical
  Deficits and Surpluses.

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CFA Level I Study Session 4.1E

• The Phillips Curve Is There a Trade-off between
  Inflation and Unemployment

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Inflation Unemployment

• describe the Phillips Curve
• discuss the trade-off between unemployment and
  inflation in the context of expectations.
• See the slides that follow this one for
  discussion of Phillips Curve.
• Unanticipated higher inflation reduces real
  wages, expands production, reduces unemployment
  below natural rate, UN.
• Once the higher inflation is recognized, real
  wage adjusts back to normal, unemployment returns
  to UN and output returns to LRAS.
• Under Adaptive Expectations, individuals
  underestimate future inflation when rate is
  rising.
• Temporary trade-off of higher inflation lower
  unemployment..
• Once the higher inflation is recognized,
  trade-off disappears.
• Under Rational Expectations, individuals do not
  systematically under- or over-estimate future
  inflation.
• Very temporary trade-off of higher inflation
  lower unemployment..
• Higher inflation recognized very rapidly and
  trade-off disappears.

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Shift in AD Curve SR vs LR
Price Level
LRAS
P
SRAS1
P1LR
AD1
YLR
Income, Output, Y
35
Phillips Curve Tradeoff
Inflation
p
Unemployment, U
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Details of the Phillips Curve

• Sources of shifts in Phillips Curve trade-off
• p pe - b(u- uN) u b gt 0
• Changes in inflation expectations, pe.
• Adaptive expectations pe p-1 inertia in
  Phillips curve.
• Rational Expectations use all info. available to
  set pe including expected fiscal monetary
  policy.
• Demand-Pull inflation, (u- uN).
• Higher aggregate demand leads to lower cyclical
  unemployment and higher inflation.
• Cost-Push Inflation, u.
• Adverse supply shock (u gt 0) tends to raise
  inflation.