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CFA Level I Study Session


When most businesses in the economy are operating at capacity, real GDP is ... If economy is in recession (below LRAS), expansionary fiscal policy shifts out ... – PowerPoint PPT presentation

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Title: CFA Level I Study Session

CFA Level I Study Session 4 Topic
Investment Tools - Macroeconomic Analysis and
PolicyInstructor Prof. John M. Veitch, CFA

CFA Level I Study Session 4
  • Modern Macroeconomics
  • A Brief Overview

The Economy in the Long Run
  • All markets all clear, prices and quantities
  • 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)
  • 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

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,
  • 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

The Market for Loanable Funds
Real Interest rate set by equilib. between
savings and investment.
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
  • 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.

Linking Economy in SR LR
Price Level
Income, Output, Y
CFA Level I Study Session 4.1A
  • Economic Fluctuations, Unemployment, and Inflation

Business Cycle
  • a) explain the phases of the business cycle
  • Business cycle fluctuations in the general
    level of economic activity in an economy as
    measured by changes variables such as real GDP,
    employment, and unemployment. Business cycles
    consist of distinct phases
  • Business Peak
  • When most businesses in the economy are
    operating at capacity, real GDP is growing
    rapidly and unemployment has fallen. It is not
    sustainable over a long period and thus leads to
  • Contraction
  • Aggregate business conditions slow, real GDP
    growth falls and may even turn negative, and
    unemployment begins to rise.
  • Recessionary trough
  • Is the point at which the economic slowdown
    reaches its lowest. From this point onward
    aggregate economic activity tends to rise
  • Expansion
  • When aggregate economic activity completely
    recovers from the previous slowdown. Real GDP
    growth rises, firms begin to increase their
    capacity utilization, and unemployment begins to

Measuring Unemployment
  • b) describe the key labor market indicators and
    discuss the problems in measuring unemployment
  • Key labor market indicators are
  • Civilian Labor Force Number of persons 16 years
    of age or greater who are either employed or are
    actively seeking work.
  • Unemployed Person who is not currently employed
    who is either (1) actively looking for a job or
    (2) waiting to begin or return to a job.
  • Labor Force Participation Rate Number of
    persons in the civilian labor force who are 16
    years or older who are either employed or
    actively seeking work as a percentage of the
    total civilian population 16 years of age or
  • Unemployment Rate Percentage of persons in the
    labor force who are currently unemployed.
  • Problems in measuring unemployment include
  • do not count discouraged workers as unemployed
    because they have given up looking for jobs
  • do not adjust for underemployed workers, those
    working part-time who would prefer to be working
    full-time, and
  • do not count non-market employment such as
    stay-at-home fathers/mothers as employed, even
    though they would be considered employed if
    working as maids, cooks, or nannies.

Types of Unemployment
  • c) describe the three types of unemployment
  • Frictional Unemployment Due to changes in the
    economy that prevent qualified workers from being
    immediately matched up with existing job
    openings. Frictional unemployment arises from
    incomplete information on the part of both
    employers and the unemployed.
  • Structural Unemployment Due to the structural
    characteristics of the economy that make it
    difficult for job seekers to find employment and
    employers to hire workers. Generally arises as
    result of mismatches between existing labor force
    skills and employer skill needs.
  • Cyclical Unemployment Due to business cycle
    fluctuations in overall economic activity.
    Unemployment rises during recessionary periods
    and falls during expansionary periods.
  • d) define and explain full employment and the
    natural rate of unemployment
  • Full Employment Level of employment that
    results from the efficient use of the labor force
    after making allowance for the normal rate of
    unemployment consistent with information costs,
    dynamic changes and structural characteristics of
    the economy.
  • Natural Rate of Unemployment Long-run average
    level of unemployment due to frictional and
    structural conditions in the economys labor
    markets. This level is not set in stone but
    rather is affected by dynamic economic change and
    public policy over time.

  • e) define inflation and calculate the inflation
  • Inflation The sustained rise in the general
    level of prices of goods and services in the
    economy. Annual inflation rate is calculated as
    the percent change in a chosen price index (PI).

  • f) discuss the harmful consequences of inflation.
  • Anticipated Inflation An increase in the
    general level of prices that was expected by most
    decision-makers on the economy.
  • Unanticipated Inflation An increase in the
    general level of prices that was not expected by
    most decision-makers on the economy.
  • Unanticipated inflation alters the outcome of
    long-term projects, increases the risks of
    long-term investment activities, and reduces the
    amount of long-term investment. Less investment
    today is likely to lead to lowers levels and
    growth of output in the future.
  • Inflation distorts the information contained in
    prices. Distorts signals of scarcity or plenty
    contained in prices, reducing the effectiveness
    of markets and harming economic activity.
  • High and variable rates of inflation lead people
    try to protect themselves from inflation risk.
    This is likely to harm current production as
    resources are devoted to inflation protection.

CFA Level I Study Session 4.1B
  • Fiscal Policy

Fiscal Policy
  • 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 (i.e. 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).

Fiscal Policy
  • 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.

Fiscal Policy
  • 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
  • If S and I fixed, then increase in Budget
    Deficit, (T-G) more negative, implies that NX
    more negative, ie. larger Current Account
  • 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

Fiscal Policy
  • 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.

CFA Level I Study Session 4.1C
  • Money and the Banking System

Money the Banking System
  • define and explain the three basic functions of
  • At a theoretical level, money supply consists of
    assets that acts as
  • Medium of Exchange - facilitates transactions
  • Unit of Account - used to quote prices.
  • Store of Value - transfer purchasing power to
  • 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

Money the Banking System
  • describe the fractional reserve banking system
  • Commercial Bank activities
  • Accept Deposits Hold Reserves Make Loans
  • Reserves are vault cash or deposits at central
  • 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

Fractional Reserve Banking
Money Multiplier
Banks and Money Creation
  • 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.

Money the Banking System
  • 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
  • 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.

Money the Banking System
  • 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
  • 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
  • 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
  • Lower discount rate, cheaper borrowed reserves,
    more reserves borrowed by banks, banks increase
    loans, which increases deposits in banking
    system, thus increasing money supply.

Money the Banking System
  • 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,
  • 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.

CFA Level I Study Session 4.1D
  • Monetary Policy

Monetary Policy
  • 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
  • Money Demand Md PL(r, Y)
  • Interest rate is opportunity cost of holding
  • 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.

Effects of Monetary Policy
Monetary Policy
  • discuss how anticipation of the effects of
    monetary policy can reduce the policys
  • 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.

Monetary Policy
  • identify the components of the equation of
    exchange, and discuss the implications of the
    equation for monetary policy.
  • 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.
  • Assume Velocity is constant
  • Then a change in the money supply, M, must result
    in the same proportionate change in Nominal GDP,
  • This is equivalent to saying that expansionary
    monetary policy shifts out the aggregate demand
  • How this increase is split between a price
    increase and an increase in output depends on the
    slope of the Short Run Aggregate Supply curve.

Inflation is everywhere and always a monetary
phenomenon Milton Friedman, Nobel Laureate
  • describe the quantity theory of money, and
    discuss its implications for the determination of
  • Quantity Equation states
  • m v p y
  • y growth of real GDP p inflation
  • m growth rate of money supply v growth rate
    of velocity
  • 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
  • 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

Monetary Policy
  • 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 economy when policies are
    initially unanticipated.
  • When policies are anticipated SR effects are less
    and LR effects occur more rapidly.
  • Unanticipated Expansionary Monetary Policy
  • 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

CFA Level I Study Session 4.1E
  • Stabilization Policy, Output,
  • and Employment

Leading Indicators Forecasts
  • 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.

Time Lags Policy Effects
  • discuss the time lags that may influence the
    performance of discretionary monetary and fiscal
  • 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
  • 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
  • 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).

Stabilization Policy
  • 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.
  • 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.
  • 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.

Stabilization Policy
  • 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
  • Fiscal Policy Rules
  • Balanced Budget Rule Fiscal Policy sets Budget
    Deficit 0. Problem is makes economy more
  • Stabilizing GDP Fiscal policy sets automatic
    stabilizers (income taxes, transfers). Cyclical
    Deficits and Surpluses.

CFA Level I Study Session 4.1F
  • The Phillips Curve Is There a Trade-off between
    Inflation and Unemployment

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
  • Temporary trade-off of higher inflation lower
  • Once the higher inflation is recognized,
    trade-off disappears.
  • Under Rational Expectations, individuals do not
    systematically under- or over-estimate future
  • Very temporary trade-off of higher inflation
    lower unemployment..
  • Higher inflation recognized very rapidly and
    trade-off disappears.

Shift in AD Curve SR vs LR
Price Level
Income, Output, Y
Phillips Curve Tradeoff
Unemployment, U
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
  • 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