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Bản Tin Sớm www.bantinsom.com CFA Level I - Study Session 41. A. “Economic Fluctuations, Unemployment, and Inflation”The candidate should be able toa) explain the phases of the business cycle;Business cycle is a description of the 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 fall. Business Cycle & Economic SectorsEconomicSlowdownSlowdown/RecoveryEconomicExpansionExpansion/PeakEconomy Slowing Slow Growing DeceleratingMonetary Policy Neutral Easy Neutral TightInterest Rates Falling Falling Rising RisingProfits Slowing Falling Rising DeceleratingSector Groups Cons. Staples Consumer Basics Utilitiesexpected Finance Cyclicals Capital Goodsto do well Health Care Tech. &EnergyStock Non-Cyclical Econ. Sensitive Cyclical Non-cyclicalCharacteristics Blue Chip Visible Earnings Leveraged Visible Earnings High Yield Growth Oriented High Growth High YieldLevel I SS4 Macroeconomics 2005 Page 1 of 17 Bản Tin Sớm www.bantinsom.com 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 older.Unemployment Rate: Percentage of persons in the labor force who are currently unemployed.Problems in measuring unemployment include; (1) do not count discouraged workers as unemployed because they have given up looking for jobs; (2) do not adjust for underemployed workers, those working part-time who would prefer to be working full-time, and (3) 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.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 economy’s 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 rate;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).11Inflation rate 100t tttPI PIPI---= ´Level I SS4 Macroeconomics 2005 Page 2 of 17 Bản Tin Sớm www.bantinsom.com 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.1. Unanticipated inflation alters the outcome of long-term projects, increases the risks of long-term investment activities, and so reduces the amount of long-term investment undertaken. Less investment today is likely to lead to lowers levels and growth of output in the future.2. Inflation distorts the information contained in prices. This distorts the signals of scarcity or plenty contained in prices, reducing the effectiveness of markets and harming economic activity.3. 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.1. B. “Fiscal Policy” The candidate should be able to:a. explain the process by which fiscal policy affects aggregate demand and aggregate supply;Fiscal policy affects AD directly through gov’t 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).b. 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).c. 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, and moves economy back to LRAS.• Crowding out model similar but notes expansionary fiscal policy raises gov’t 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.Level I SS4 Macroeconomics 2005 Page 3 of 17 Bản Tin Sớm www.bantinsom.com d. explain how and why budget deficits and trade deficits tend to be linked.Nat’l Income identity Y = C + I + G + NXRearrange yields: Y- C - G = I + NX or (Y-C-T) + (T-G) = I + NXWhere 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, i.e. larger Current Account Deficit.e. 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.f. 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.g. explain the relationships among budget deficits, inflation, and real interest rates;In theory, higher gov’t budget deficits should lead to higher real interest rates by loanable funds market analysis. In practice effect is not as strong as expected.Higher gov’t budget deficits may lead to higher inflation rates and higher nominal interest rates if gov’t finances deficit by printing money.1. C. “Money and the Banking System” The candidate should be able to:a. identify and explain the three basic functions of money.At a theoretical level, money supply consists of assets that act as:• Medium of Exchange - facilitates transactions (liquidity).• Unit of Account - used to quote prices.• Store of Value - transfer purchasing power to future.b. define the money supply;At a practical level, U.S. money supply defined by 3 widely-used measures: M1 = Currency + Traveler’s Checks + Demand Deposits + Other Checkable Deposits M2 = M1 + Savings Deposits + Small Time Deposits + Money Mkt. Mutual Funds M3 = M2 + Large Time Deposits + Term Repo’sLevel I SS4 Macroeconomics 2005 Page 4 of 17 Bản Tin Sớm www.bantinsom.com c. 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 % of deposits, Reserve requirement, rr. Required Reserves = rr x Deposits• See PP slides for more details of Commercial bank activities and role of reserve requirement in money supply. d. 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 systemActual 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:i. Persons hold currency rather than deposit it in the banking systemii. Banks fail to lend out all excess reserves, i.e. banks choose to hold reserves in excess of the legal minimum required.e. describe the tools that a central bank can use to control the money supply and explain how a central bank can use monetary tools to implement monetary policy.Open Market Operations:• Purchase or sale of gov’t 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• Gov’t 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 increase deposits in banking system, thus increasing money supply.f. discuss potential problems in measuring an economy’s 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.i. Use of U.S. $ outside of U.S. – US$ acts as international vehicle currency in international transactions, illegal activities, dollarisation, etc.Level I SS4 Macroeconomics 2005 Page 5 of 17 Bản Tin Sớm www.bantinsom.com ii. Shifts from interest-bearing checking accounts to MMDA’s – checking accounts in M1 but MMDA’s only in M2. Distorts M1 vs. M2 measures.iii. Increased availability of low-fee stock and bond mutual funds – Not counted in money measures but increasingly liquid, act as near-money.iv. Debit cards and electronic money – Reduce reasons to hold currency, may transfer transaction balances outside banking system.1. D. “Modern Macroeconomics: Monetary Policy”The candidate should be able to:a. 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= P*L(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: M0/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.b. discuss how anticipation of the effects of monetary policy can reduce the policy’s 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. c. identify the components of the equation of exchange, and discuss the implications of the equation for monetary policy;Equation of Exchange states that MV = PY where Y = Real GDP, P = Implicit GDP Price Deflator, M = Money Supply, and V= Velocity of Money.If one assumes that Velocity is constant, or changes slowly, then a change in the money supply, M, must result in the same proportionate change in Nominal GDP, PY. This is equivalent to saying that expansionary monetary policy shifts out the aggregate demand curve. 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. Level I SS4 Macroeconomics 2005 Page 6 of 17 Bản Tin Sớm www.bantinsom.com d. describe the quantity theory of money and its implications for the determination of inflation; Quantity Equation states MV = PY or in growth rates m + v = p + yY = Real GDP, y = growth of real GDPP = Implicit GDP Price Deflator, p = inflationM = Money Supply, m = growth rate of money supplyVelocity = V = # times per year $1 used to buy output.In LR monetary policy affects only price level and inflation assuming velocity constant or varies predictably. Real Output, Y, determined by other factors. p = m – y or inflation equals growth rate of money in excess of the growth rate of real GDP.e. compare and contrast the impact of monetary policy on the inflation rate, real output, employment, and interest rates in the short run and long run, when the effects are anticipated or unanticipated; See Fig. 4.1D for SR vs. LR effects of monetary policy on the economy when policies are initially unanticipated.Unanticipated Expansionary Monetary Policy Effects: Real Output, YSR – Increase in Real GDP LR – Returns to LRAS.Inflation Rate, pSR – Prices (inflation) rise LR – Prices (inflation) rise further.Real Interest rate, rSR – Decrease in r. LR – Returns to original level.When monetary policies are anticipated, their SR effects on out put are less and LR effects occur more rapidly.Fig. 4.1D - Effects of Monetary PolicyMD(P0)AD0P0Y0MS0r0InterestRateMoneyOutputPriceLevelMS11.r12.AD1SRASLRASYSR3.PSR3.RealPLR4.4.Level I SS4 Macroeconomics 2005 Page 7 of 17 Bản Tin Sớm www.bantinsom.com 1. E. “Stabilization Policy, Output and Employment”The candidate should be able to:a. 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 economy’s future.1. Length of the average work week in hours.2. Initial weekly claims for unemployment compensation.3. New manufactures orders. 4. % of companies receiving slower deliveries from suppliers.5. Contracts & orders for new plant & equipment.6. Permits for new housing starts.7. Change in unfilled orders for durable goods.8. Change in sensitive materials prices.9. Change in S&P 500 index. 10. Change in money supply (M2).11. Index of consumer expectations b. discuss the time lags that may influence the performance of discretionary monetary and fiscal policy;Recognition lag: Time period between when the policy is needed to stabilize and when the need is recognized by policymakers. Note the length of this lag is the same for both monetary and fiscal policy and depends on the ability of economic forecasters to accurately predict the future state of the economy.Administrative or implementation lag: Time period 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). In addition, there may be a bias towards using fiscal policy to stimulate the economy before an election, regardless of whether it is warranted by the state of the economy, as a way to ensure incumbents are reelected.c. explain the role expectations play in determining the effectiveness of fiscal and monetary policy;Expectations determine how quickly SRAS adjusts to changes in AD Curve, leading the economy back to LRAS. Fiscal & monetary policies (both expansionary & restrictive) will be less effective when people anticipate their effect on prices more quickly.Level I SS4 Macroeconomics 2005 Page 8 of 17 Bản Tin Sớm www.bantinsom.com d. contrast the adaptive expectations hypothesis to the rational expectations hypothesis;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)e. distinguish between an activist and a non-activist strategy for stabilization policy.Monetary Policy Rules: MV=PY• Money Growth Target : Money growth determined by Quantity Theory.• Nominal GDP Target : Money adjusted to hit Nominal GDP target growth rate.• Price Level Target : Money growth used to keep Price level within target 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.1. F. “Stabilization Policy, Output and Employment”The candidate should be able toa. describe the Phillips curve;Phillips Curve was an empirical relationship that showed that higher rates of wage inflation were associated with lower rates of unemployment in developed countries. This relationship tended to change over time when used by policymakers. Higher wage inflation initially leads to lower unemployment on a fixed Phillips Curve, but then the Phillips Curve shifts out leading to higher unemployment rate at the higher rate of wage inflation. Thus the “trade-off” between higher inflation and lower unemployment was transitory, not permanent if used by policymakers. See slides in the PP presentation for extended discussion of Phillips Curve.b. discuss the trade-off between unemployment and inflation in the context of expectations.Unanticipated higher inflation reduces real wages, expands production, and reduces unemployment below natural rate, UN. Once higher inflation is recognized, real wage adjusts back, 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.Level I SS4 Macroeconomics 2005 Page 9 of 17 Bản Tin Sớm www.bantinsom.com 2004 Level I, Study Session 4 – Macroeconomics1. Which phase of the business cycle is associated with falling real GDP growth and capacity utilization?A. Recessionary troughB. Economic expansionC. Economic ContractionD. Business Peak2. A software developer loses his job as a result of outsourcing to a firm in India. This software developer is suffering from what type of unemployment?A. International unemploymentB. Frictional unemploymentC. Cyclical unemploymentD. Structural unemployment3. An expansionary fiscal policy is likely to have the largest effect on output in the short run under which type of macroeconomic model?A. New classical modelB. Keynesian modelC. Crowding out modelD. Pigovian model4. Which of the following statements is true regarding time lags affecting discretionary fiscal and monetary policy?A. Fiscal policy has a longer recognition lag but a shorter implementation lag.B. Fiscal policy has a shorter recognition lag but a longer implementation lag.C. Monetary policy has a longer implementation lag but a shorter effectiveness lag.D. Monetary policy has a shorter implementation lag but a longer effectiveness lag.5. When banks hold reserves in excess of those required:A. The potential deposit expansion multiplier is smaller than the actual deposit multiplier.B. An increase in government spending will be more effective.C. Monetary policy will be more effective in affecting real output.D. The potential deposit expansion multiplier is larger than the actual deposit multiplier.Level I SS4 Macroeconomics 2005 Page 10 of 17 [...]... permission from the 1995 Level I CFA Study Guide Copyright (1995), Association for Investment Management and Research, Charlottesville, VA All rights reserved Reprinted with permission from the 1996 Level I CFA Study Guide Copyright (1996), Association for Investment Management and Research, Charlottesville, VA All rights reserved Reprinted with permission from the 1997 Level I CFA Study Guide Copyright... permission from the 1998 Level I CFA Study Guide Copyright (1998), Association for Investment Management and Research, Charlottesville, VA All rights reserved Reprinted with permission from the 1999 Level I CFA Study Guide Copyright (1999), Association for Investment Management and Research, Charlottesville, VA All rights reserved Reprinted with permission from the 2000 Level I CFA Study Guide Copyright... permission from the 2001 Level I CFA Study Guide Copyright (2000), Association for Investment Management and Research, Charlottesville, VA All rights reserved Reprinted with permission from the 2002 Level I CFA Study Guide Copyright (2001), Association for Investment Management and Research, Charlottesville, VA All rights reserved Reprinted with permission from the 2003 Level I CFA Study Guide Copyright... Research, Charlottesville, VA All rights reserved Reprinted with permission from the 2004 Level I CFA Study Guide Copyright (2003), Association for Investment Management and Research, Charlottesville, VA All rights reserved Reprinted with permission from the 2005 Level I CFA Study Guide Copyright (2004), CFA Institute, Charlottesville, VA All rights reserved Level I SS4 Macroeconomics 2005 Page 17 of . change in Nominal GDP, PY. This is equivalent to saying that expansionary monetary policy shifts out the aggregate demand curve. How this increase is split. reserved.Reprinted with permission from the 2005 Level I CFA Study Guide. Copyright (2004), CFA Institute, Charlottesville, VA. All rights reserved.Level