CFA 2_Economics

Question 1

Demand function

Answer 1

Quantity demanded of x = f(Price of X, Income per year, Price of related goods, …)

The demand curve shows price as the independent variable on the y-axis, and quantity demanded as the dependent variable on the x-axis.

When given demand function in problem, plug in all the numbers, and then INVERT THE DEMAND FUNCTION by solving for P in terms of Q (rearrange and divide all by the coefficient of p). The new coefficient of Q is the slope of the demand curve.

In order to draw demand and supply curves, own price and own quantity must be allowed to vary. However, all other variables are held constant to focus on the relation of own price with quantity.

Question 2

Shift in, versus movement along, the demand curve

Answer 2

A change in price that only changes quantity demanded is movement along the demand curve.

A shift in the demand curve results from a change in an independent variable other than price.

Question 3

Aggregating demand and supply curves

Answer 3

Multiply all the variables of the function by the number of curves you are aggregating. The result is the market supply or market demand curve.

The point at which the market supply and demand curves equal is the equilibrium price and equilibrium quantity. Equilibrium is “stable” as long as market forces exist to move price and quantity back towards equilibrium.

Question 4

Determining equilibrium price from a supply and demand function

Answer 4

Set the functions equal to each other and solve for P.

Question 5

Common value v. private value auction

Answer 5

Common value auction: value of item to bid on is unknown, but will be of the same value to each bidder

Private value auction: Item will be of different values to each bidder, and they will bid no more than that

Question 6

Ascending price auction (English auction)

Answer 6

Bidders increase bids. Bidder who offers highest bid wins and pays that bid.

Question 7

Sealed bid auction

Answer 7

Each bidder submits one private bid. Highest bid wins and pays the price bid.

Reservation price: highest price a bidder is willing to pay.

Second sealed bid auction (Vickrey auction): bidder submitting highest bid wins, but pays the amount bid by the second highest bidder.

Question 8

Descending price auction (Dutch auction)

Answer 8

Offer price is reduced until a bidder agrees to pay it. Winning bidder must specify how many units of the item they want. If there are units left over they go on to be bid at lower prices.

Modified Dutch auction: winning bidders all pay the same price as the price that the bidder whose bid wins the last units offered.

Question 9

Bidding process for US Treasuries

Answer 9

Single price auction and must specify quantity, however bidders may submit a noncompetitive bid that doesn’t specify quantity.

Question 10

Consumer surplus

Answer 10

Excess of total value to consumer for a good above the amount they must pay for that good.

Calculated as area of triangle in demand curve. (1/2bh).

Where base = quantity demanded, and height = price.

1) Solve demand equation for P when Quantity demanded = 0. This is the point when demand curve crosses y-axis.
2) Solve demand equation when P = price we are determining the surplus for. This quantity demanded is the height of our triangle.
3) Subtract price we are determining surplus for from price when Q = 0. This is the base of our triangle.
4) Multiply base by height by 1/2 to get consumer surplus.

Question 11

Producer surplus

Answer 11

Excess of the market price above the opportunity cost of production.

The difference between the total revenue that sellers receive from selling a given amount of a good and the total variable cost of producing that amount.

ie Total revenue - Total vairable costs of production.

Calculated as area of triangle in demand curve. (1/2bh). Where base = quantity demanded, and height = price.

Question 12

Deadweight loss

Answer 12

The reduction in consumer and producer surplus due to under/overproduction. The allocation of resources is inefficient if the quantity supplied does not maximize the sum of consumer and producer surplus.

Question 13

Price ceiling

Answer 13

If the ceiling is below the equilibrium price, there will be a shortage due to excess demand, because consumers will purchase more than supplied at the artificial price.

Question 14

Price floor

Answer 14

If floor is above the equilibrium price, there will be a surplus (excess supply).

Question 15

Incidence of a tax

Answer 15

The allocation of a tax between buyers and sellers.

Statutory incidence: who is legally responsible for paying the tax.

Actual incidence: who actually bears the cost of the tax, ie an increase in price paid for buyers, or a reduction in price received for sellers. Actual incidence is independent of statutory incidence.

If demand is less elastic than supply, then consumers will bear a higher burden of the actual tax.If demand is more elastic than supply, then suppliers will bear a higher burden of the actual tax.

The price should be the same regardless of who incurs the tax.

Question 16

Price elasticity of demand

Answer 16

Responsiveness of quantity demanded to a change in price. Demand is elastic (> 1) if it is very responsive to a change in price.

% change in quantity demanded / % change in price

(Price / Q demanded from all variables plugged in) * Slope coefficient of what we are solving for

Question 17

Income elasticity of demand

Answer 17

Responsiveness of quantity demanded to a change in income.% change in quantity demanded / % change in income

Normal goods: an increase in income results in an increase in quantity demanded (income elasticity is > 0)

Inferior goods: an increase in income results in a decrease in quantity demanded (income elasticity is < 0)

(Income / Q demanded from all variables plugged in) * Slope coefficient of what we are solving for

Question 18

Cross price elasticity of demand

Answer 18

% change in quantity demanded of Good A / % change in price of related Good B

If goods are substitutes the relationship is positive (increase in price of B increases demand of A). (cross price elasticity > 0)

If goods are complements the relationship is negative (increase in price of B decreases demand of A). (cross price elasticity < 0)

With complements, consumption goes up or down together. With a negative cross-price elasticity, as the price of one good goes up, the demand for both falls.

Question 19

Solving for price elasticity (income)

Answer 19

1) Enter values in quantity of demand equation for all variables except income (or demand for demand elasticity, or price of comparable good for cross price elasticity).
2) Simplify and get formula with Qd = (aggregate you solved for in #1) +/- X(income)
3) Solve for Quantity demanded when income equals the amount presented in problem
4) Elasticity = (income [given] / Quantity demanded at that income) * Coefficient [slope] of income variable

Question 20

Condition of non-satiation

Answer 20

Utility theory. Holding all other quantities constant in a utility function while increasing one will always result in greater utility.

Question 21

Indifference curves

Answer 21

The plot of combinations of two goods that provide equal utility.

1) Slope downward

The slope of an indifference curve is the Marginal Rate of Substitution (MRS).

MRS = change in good A / change in good B

2) Are convex towards origin (consumer is more willing to exchange Good X for Good Y when he has more units of either). The slope of an indifference curve is called the “marginal rate of substitution” (MRS).
3) Cannot cross.

Question 22

Equilibrium bundle of goods

Answer 22

Optimal consumption bundle of goods for consumer. This is represented by the point when the indifference curve is tangent to the budget line.

Question 23

Substitution effect and income effect (Utility theory)

Answer 23

Substitution effect: always positive effect. when price of good X decreases, consumption of Good X ALWAYS increases.

Income effect: increase income resulting from decrease of Good X above can result in more OR less consumption of Good X.

Income effect is positive for normal goods. It is negative for inferior goods (and Giffen goods).

Question 24

Giffen good

Answer 24

Inferior good for which NEGATIVE income effect (utility theory) outweighs positive substitution effect when price falls. As price decreases demand falls as result of income effect dominating over the substitution effect. Likewise as price increases, demand increases as result of income effect being stronger.

A consumer good for which demand rises when the price increases, and demand falls when the price decreases. (violates Law of Demand).

Question 25

Veblen good

Answer 25

Higher price makes good more desirable (ie to be seen purchasing and using luxury goods). Likewise, lower prices decrease desirability.

Question 26

Is utility an ordinal or cardinal measure?

Answer 26

Ordinal, the number itself cannot tell you how much more something is worth compared to another. Only that it is greater.Ordinal numbers: tell the order of things in a set

Cardinal numbers: tell “how many”, show quantity

Nominal numbers: do not show quantity or rank. They are used only to identify something.

Question 27

Budget line

Answer 27

Divide total budget by price of Good X and Good Y independently. The result are the points at each axis at which we will create the budget line.Changes in income or the price of the goods will shift or change the slope of the budget line.

Question 28

Accounting profit

Answer 28

AKA net income.

Accounting profit = Revenue - Total accounting costs (aka explicit costs)

Question 29

Economic profit

Answer 29

AKA abnormal profit. We expect an economic profit of zero in equilibrium. Abnormal profits attract competition.

Economic profit = accounting profit [total revenues] - implicit costs

Implicit costs are the opportunity costs of resources supplied to the firm by its owners, and include the cost of a normal return to all factors of production.

Total economic profit = accounting profit - implicit costs - accounting (explicit) costs

Economic losses occur when price is below Average Total Costs

Question 30

Normal profit

Answer 30

The accounting profit that makes economic profit equal zero. This is the accounting profit the firm must earn to cover implicit opportunity costs.

Question 31

Economic rent

Answer 31

Income paid to a factor of production in excess of that which is needed to keep it employed in its current use.

Can be created due to natural scarcity (eg ownership of a limited factor of production), or enforced scarcity (eg a labor union).

Question 32

Total, average, and marginal revenue

Answer 32

Total revenue = price * quantity sold

Average revenue = total revenue / quantity sold

Marginal revenue = increase in total revenue from selling one more unit. for a firm in perfectly competitive market, all units sold at same price regardless of quantity, so AR = MR. Under imperfect competition, AR and MR will decline as quantity sold increases. Firms that face downward sloping demand curves are called “price searchers”.

Question 33

Production function

Answer 33

Q = f(Capital (PP&E), Labor)

Question 34

Total cost

Answer 34

TC = Total Fixed Cost + Total Variable Cost

Question 35

Marginal cost

Answer 35

Change in Total Cost / Change in output

Question 36

Short run / Long run

Answer 36

Short run: Time period over which some factors of production are fixed. Long run: all factors are variable in the long run.

Question 37

Shutdown and breakeven points

Answer 37

Breakeven: Total Revenue = Total Cost

If Total Revenue < Total Variable Costs, shut down in both short run and loss run.

If Total Revenue is > Total Variable Costs but < Total Costs, continue in short run but shut down in long run.

If Total Revenue is > Total Variable Costs and Total Costs, continue in short and long run.

Question 38

Economies and diseconomies of scale (graphed)

Answer 38

The long-run average total cost curve (LRATC) is U-shaped. The left side of the U is economies of scale, and the right side is diseconomies of scale. The middle point is the “minimum efficient scale”, which is the point at which ATC of production is minimized. Firms at perfect competition must be here in the LR.

Question 39

When does a firm maximize economic profit under imperfect competition?

Answer 39

When Marginal Revenue = Marginal Cost.As long as MC < MR, a firm should increase output.Or, when TR - TC is at its maximum.

Question 40

Decreasing cost, constant cost, and increasing cost industries

Answer 40

Increasing cost: resource prices increase as industry output increases. Long-run supply curve is upward-sloping.

Decreasing cost: resources prices fall as industry expands. Long-run supply curve is downward-sloping. (likewise, demand increases)

Constant cost: input prices do not increase or decrease as output increases. Flat.

Question 41

Marginal revenue product

Answer 41

The addition to revenue from selling the output produced by using one more unit of input. Calculated as (MP of production factor) * (MR of additional output).

Question 42

What is optimal combination to minimize cost and maximize profit of an input?

Answer 42

Ratio of marginal product of capital to its cost should = marginal product of labor to its cost. The ratio will be equal to 1.

Question 43

Perfect competition

Answer 43

Many firms, identical products. Compete only on basis of price (no pricing power). Low barriers to entry.

Demand curve is perfectly elastic (horizontal) (price takers). Because demand curve is flat, MR will always equal price.

Firm will continue to expand production until marginal revenue (MR) = marginal cost (MC). Price takers should produce where P = MC. At long run equilibrium P = MR = MC = ATC.

Question 44

Monopolistic competition

Answer 44

Many independent firms, products are substitutes but are differentiated. Compete on basis of price, marketing, and features. Low barriers to entry. Some pricing power.Demand curve is downward sloping (price searchers). Product innovation is important.

Question 45

Oligopoly

Answer 45

Few interdependent firms, products are substitutes but may be quite differentiated. Compete on basis of price, marketing, and features. High barriers to entry. Some to significant pricing power.Demand curve can be more or less elastic depending.

Question 46

Monopoly

Answer 46

Single seller, product with no substitutes. Compete on basis of advertising. High barriers to entry. Significant pricing power.

Downward sloping curve. Price searchers. Monopoly creates deadweight loss relative to perfect competition because monopolies produce a quantity that does not maximize the sum of consumer surplus and producer surplus. Rent seeking (process of entrepreneurs spending time and resources to try and acquire monopoly) also

Question 47

Kinked demand curve model (Oligopoly pricing model [4])

Answer 47

An increase in a firm’s product price will not be followed by competitors, but a decrease in price will. Assumes that firms believe that at some price, demand is more elastic for a price increase than a price decrease.

Question 48

Cournot duopoly model (Oligopoly pricing model [4])

Answer 48

assumes 2 firms, both identical, and both knowing quantity supplied by other firm in previous period. Firms assume quantity supplied is same as what will be supplied, and subtract this from the market demand curve to determine their profit maximizing quantity.

Question 49

Nash equilibrium model (prisoner’s dilemma) (Oligopoly pricing model [4])

Answer 49

When choices of all firms are such that there is no other choice that makes any firm better off.

Prisoner’s dilemma = Collusion agreement dilemma. Both firms are better off if they hold to the collusion agreement and don’t cheat.However, ultimately both firms choose to cheat (and both prisoners choose to confess) because for both choices of the opposing party A it is better to B if party B defaults.

Question 50

Stackelberg dominant firm model (Oligopoly pricing model [4])

Answer 50

A single firm with a significantly large market share because of its greater scale and lower cost structure is the dominant firm. DF determines the market price, and other competitive firms take this price.

Question 51

Monopoly pricing strategies [2]

Answer 51

Single price: one price to all customers

Price discrimination: different prices to different customers. Must be able to prevent customers from reselling to each other.Profit is still maximized when MR = MC.

Question 52

Forms of regulating monopoly pricing [2]

Answer 52

Average cost pricing: force monopolists to reduce price to where firm’s ATC intersects with market demand curve. This increases output and decreases price.

Marginal cost pricing: force monopolists to reduce price to where firm’s MC curve intersects market demand curve. This increases output and decreases price, but results in loss because price is below ATC; therefore, govt must provide subsidy.

Question 53

Supply function under different market structures

Answer 53

Monopolistic competition, Oligopoly, and Monopoly: all have no well-defined supply function because demand curve is downward sloping.

Perfect competition: Short run supply function is marginal cost [MC] curve above average variable cost [AVC] curve.

Question 54

Pricing strategy under different market structures

Answer 54

Perfect competition, monopolistic competition, and Monopoly: profits are maximized by producing Quantity for which MC = MR.

A purely competitive firm will tend to expand its output so long as market price is greater than MC. In short and long run, profit is maximized when P = MC.

Oligopoly: Depends on (1) Kinked demand curve; (2) Collusion; (3) Dominant firm model; (4) Game theory

Question 55

Concentration measures

Answer 55

N-firm concentration ratio: the sum or % market shares of the largest N firms in a market.

Herfindahl-Hirschman Index (HHI): sum of the squares of the market shares of the largest firms in the market. Better reflects effect of mergers on industry concentration.

Neither consider barriers to entry.

Question 56

Gross domestic product (GDP)

Answer 56

Total market value of final goods/services produced in a country within a given period. Includes only purchases of newly produced goods and services (eg resale of an older good is not included). Includes goods/services provided by govt, but not govt transfer payments (eg unemployment). Includes estimated value of owner-occupied housing along with rentals.

Question 57

Expenditure vs. Income approach for GDP

Answer 57

Expenditure approach: Calculated by summing amounts spend on goods and services produced during period.Income approach: Calculated by summing amounts earned by households and companies during period, eg wages and profits.

Question 58

Nominal GDP

Answer 58

GDP computed under the expenditure approach (total value of all final goods and services produced, valued at current market prices). Because nominal GDP is based on current prices, inflation will increase nominal GDP even if the physical output of goods and services remains constant year-to-year.

Nominal GDP = Sum(price of good x in year t) * (quantity of good x in year t)

Question 59

Real GDP

Answer 59

Removes effects of changes in prices so that inflation is not counted as economic growth. Because nominal GDP is based on current prices, inflation will increase nominal GDP even if the physical output of goods and services remains constant year-to-year.

Calculated by using prior year (base year) prices with current year quantities.

Real GDP = Sum(price of good x in year t - 1) * (quantity of good x in year t)

Question 60

GDP Deflator

Answer 60

Price index used to convert nominal GDP into real GDP

Ratio of nominal GDP to real GDP, or, current year prices to base year prices.

GDP deflator = (nominal GDP in current year / value of current output at benchmark [prior] year prices) * 100

NB it is NOT nominal GDP of current year / nominal GDP of prior year! You are only using the price of prior year.

Divide real GDP by the GDP deflator to get nominal GDP.

Question 61

Computing GDP under expenditure approach

Answer 61

GDP = C + I + G + (X - M)

GDP = Consumption spending + business Investment + Govt purchases + (eXports - iMports)

Question 62

Computing GDP under income approach

Answer 62

GDP = national income + capital consumption allowance + statistical discrepancy

National income: sum of income received by all factors of production that go into creation of final output

Capital Consumption Allowance: measures depreciation of physical capital from production over period

Stat Dis: adjustment for difference between GDP measured under income and expenditure approach, because they use different data.

Question 63

National income

Answer 63

NI = compensation of employees (wages and benefits) + corporate and govt enterprise profits before tax + interest income + unincorporated business net income + rent + (indirect business taxes - subsidies)

NI is the income received by all factors of production used in the creation of final output.

Question 64

Personal income

Answer 64

Measure of pretax income received by households. Includes all income households received, including transfer payments (excluded from GDP).

national income + transfer payments to households - indirect business taxes - corporate income taxes - undistributed corporate profits

Personal disposable income = personal income - personal taxes

Question 65

Relationship of private savings to everything else

Answer 65

Total income equals total expenditures.

Therefore:C + I + G + (X - M) = C + S + T

Consumption spending + business Investment + Govt purchases + (eXports - iMports) = Consumption spending + household and business Savings + net Taxes (taxes paid less transfer payments received)

Rearranged: S = I + (G - T) + (X - M)

(G - T): Fiscal balance, or difference between govt spending and tax receipts

(X - M): Trade balance, or net exports

Also, fiscal deficit must be financed by decrease in trade deficit increase in excess private savings over private investments:(G - T) = (S - I) - (X - M)

Question 66

IS Curve

Answer 66

Inverse relationship between the real interest rate and income. (I)nvestment and (S)avings are the primary variables in this relationship. The curve plots the combinations of income and real IRs for which aggregate output and income equal planned expenditures.

If interest rates fall, finance costs decrease, and investment by business increases, thus increasing real aggregate income in the relationship. An increase in investment must be accompanied by an equal increase in savings, which (holding Marginal Propensity to Save constant) can only result from an increase in income.

Question 67

LM Curve

Answer 67

The combinations of GDP or real income (Y) and real interest rate (r) that keep the quantity of real money demanded = quantity of real money supplied.

Demand for money is inversely related to the real interest rate. Higher the rate, the less people are willing to hold cash balances. However, demand for money increases when real income increases. If we hold the real money supply (nominal Money supply / price level) constant, the increase in demand due to an increase in real income must be offset by decrease due to increase in the real interest rate. So, in equilibrium, there is a positive relationship between income and the real interest rate. This is shown by the LM curve.

Question 68

Quantity theory of money

Answer 68

MV = PV(nominal Money supply)(Velocity of money in transactions) = (Price level)(real GDP)

Real money supply = M / P

Velocity = GDP / money supply

Demand for money is inversely related to the real interest rate. Higher the rate, the less people are willing to hold cash balances.

Question 69

Aggregate demand curve (combination of IS and LM curves)

Answer 69

Shows relationship between quantity of real output demanded (equals real income) and the price level.

When IS and LM curve are combined, the point at which they intersect is the level of real interest rate and income that is consistent with equilibrium between income and expenditure (IS curve) and the real money supply and real interest rate (LM curve). An increase in price level will decrease the real money supply. A decrease in price level will increase the money supply. Intersection point determines the equilibrium level of price and real income (real GDP) for a given level of real money supply.

Slopes downward because higher price levels reduce real wealth, increase IRs, and make domestic goods more expensive.

Question 70

Aggregate supply curve

Answer 70

Relationship between price level and quantity of real GDP supplies. ie, amount of output firms will produce at different price levels.Very short run: everything is fixed, so output can change without affecting prices.

Short run: input prices are sticky, but output prices will change according to changes in price level. (horizontal)

Long run: All price can vary, therefore no effect on aggregate supply. This level is referred to as “potential GDP” or “full-employment GDP”. (vertical)

Question 71

Shifts in aggregate demand curve

Answer 71

1) Increase in consumer’s wealth (Consumption increases)
2) Business expectations (Investment increases)
3) Consumer expectations of future income (Consumption increases)
4) High capacity utilization: when companies produce at high % of their capacity (Investment increases)
5) Expansionary monetary policy (Consumption and Investment increase)

Movements are due to changes in price level

Question 72

Shifts in short-run aggregate supply curve

Answer 72

1) Labor productivity: increase in productivity decreases unit costs to producers, therefore increasing output
2) Input prices: decrease in input prices increases output
3) Expectations of future output prices: expand production if expect higher prices in future
4) Taxes and govt subsidies: if decrease cost of production, expand output
5) Exchange rates: Appreciation of currency will decrease cost of imports. If purchasing inputs from another country, production increases

Movements are due to changes in price level

Question 73

Shifts in long-run aggregate supply curve

Answer 73

1) Increase in supply and quality of labor: increase in labor force/skills increases potential output
2) Increase in supply of natural resources
3) Increase in stock of physical capital
4) Technology

Movements are due to changes in price level

Question 74

Macroeconomic equilibrium

Answer 74

Price is the variable that leads to equilibrium in micro and macroeconomics.

If price level is above equilibrium there will be excess supply and downward pressure on prices and a “recessionary gap”. When real GDP is less than potential real GDP.

If price level is below equilibrium there will be excess demand and upward pressure on prices and a “inflationary gap”. When real GDP is greater than potential real GDP.

Question 75

Analysis implications if investor expects decrease in aggregate demand (recessionary gap, excess supply)

Answer 75

1. Increase investment in defensive industries
2. Increase investment in investment-grade bonds
3. Increase investment in long-maturity fixed income, because their prices rise more to falling interest rates than ST
4. Decrease investment in commodities, because there will be lower commodity demand

Question 76

Analysis implications if investor expects increase in aggregate demand (inflationary gap, excess demand)

Answer 76

1. Increase investment in cyclical companies
2. Increase investment in commodities, which will benefit from higher output
3. Decrease exposure to fixed income in anticipation of higher interest rates

Question 77

Analysis implications if investor expects stagflation

Answer 77

1. Decrease investment in fixed income securities in anticipation of higher inflation and nominal interest rates
2. Decrease investment in equities as profit margins will decrease
3. Increase investment in commodities because they will increase

Question 78

Stagflation

Answer 78

High unemployment and increasing inflation. Associated with decrease in aggregate supply, eg due to sudden increase in price of an input.

Question 79

Sources of sustainable economic growth

Answer 79

1. Labor supply
2. Human capital
3. Physical capital stock
4. Technology
5. Natural resources

Question 80

Sustainability of economic growth (equation)

Answer 80

potential GDP = aggregated hours worked * labor productivity

growth in potential GDP = growth in labor force + growth in labor productivity

Question 81

Production function

Answer 81

Economic output = Factor productivity * f(Size of labor force, Capital available)Y = A * f(L, K)

Production function exhibits diminishing marginal utility

Question 82

Solow model (neoclassical model)

Answer 82

growth in potential GDP = growth in technology + Wl(growth in labor) + Wc(growth in capital)

where Wl and Wc are labor’s/capital’s % share of national income.

growth in per-capital potential GDP = growth in technology + Wc*(growth in the capital-to-labor ratio)

NI = compensation of employees + corporate and govt enterprise profits before tax + interest income + unincorporated business net income + rent + (indirect business taxes - subsidies)

Question 83

Two methods for expenditure approach to measuring GDP

Answer 83

Value-of-final-output: Calculated by summing additions to value created at each stage of production and distribution

Sum-of-value-added: Calculated by summing the additions to value created at each stage of production and distribution.

Question 84

Four phases of business cycle

Answer 84

1. Expansion: real GDP increasing
2. Peak: real GDP stops increasing and reverses
3. Contraction or recession: real GDP decreases
4. Trough: real GDP stops decreasing and begins increasing

Question 85

Theories of business cycle

Answer 85

Neoclassical: caused by shifts in aggregate demand and supply due to changes in technology over time. They are however temporary deviations from LR equilibrium.

Keynesian: caused by shifts in aggregate demand due to changes in business owners expectations.

Monetarist: due to changes in rate of growth of money supply.

Austrian: govt intervention in economy.

New classical: “real business cycle” theory. Effect of real economic variables like changes in technology and external shocks. Argues policymakers should NOT try to counteract cycles because they are efficient market responses to real external shocks.

Question 86

Consumer Price Index

Answer 86

CPI = cost of basket at current prices / cost of basket at base period prices * 100CPI for services is a lagging indicator.

Question 87

Headline vs. Core inflation

Answer 87

Headline inflation: % change in price indexes for all goods

Core inflation: % change in price indexes that exclude food and energy

Question 88

Laspeyres index

Answer 88

Price index that uses constant basket of goods and services. Biased upward because:

1) New goods
2) Quality changes
3) Substitution”Hedonic pricing” can adjust price index for quality. A “Fisher index” (a chained index) can adjust for substitution. A chained or chain-weighted price index uses updated weights for each good and service in its market basket. A price index that is not chain-weighted, such as a Laspeyres index, is calculated using weights for each good and service in the market basket as of the index’s base period. A Fisher index is the geometric mean of a Laspeyres index and a Paasche index. A Passche index uses the current consumption weights, prices from base period in denominator, and prices in current period in numerator.

Passche index = (P1aW1a + …) / (P0aW1a …) * 100

Question 89

Two types of inflation

Answer 89

Cost-push: results from decrease in aggregate supply. eg, labor is most important cost of production, so wage pressure can do this.

Demand-pull: results from increase in aggregate demand. eg increase in money supply, or increased govt spending.Impact on output is key difference. Demand-pull increases GDP above full-employment GDP, while cost-push decreases GDP because its a decrease in aggregate supply.

Question 90

Unemployment

Answer 90

% of people not employed in “labor force”excludes those who are “voluntarily unemployed” (don’t participate in labor force)

Question 91

Disinflation

Answer 91

An inflation rate that is decreasing over time but still above 0

Question 92

Amount of money that can be created

Answer 92

Money created = new deposit / reserve requirement

Question 93

Money multiplier

Answer 93

1 / reserve requirement

Question 94

Quantity equation of exchange (quantity theory of money)

Answer 94

money supply * velocity = price * real output

MV = PY

If V and Y remain constant, an increase in the money supply will increase price. Velocity = GDP / money supply

Question 95

Fisher effect

Answer 95

The Fisher effect holds that all nominal interest rates include a premium for expected inflation.Nominal interest rate = real interest rate + expected inflation (+ risk premium)

Question 96

Federal funds rate

Answer 96

The rate banks charge each other on the overnight loaning of reserves

Question 97

Discount rate

Answer 97

The rate the Fed charges banks who need to borrow to meet shortfalls in their reserves. For the ECB this is the “refinancing rate”. Bank of England does it through repurchases, and has “two-week repo rate”.

Question 98

Neutral interest rate

Answer 98

Growth rate of money supply that neither increases nor decreases the economic growth rate

neutral interest rate = real trend rate of economic growth + inflation target

Real trend rate: An economy’s long-term sustainable real growth rate.

Question 99

Liquidity trap

Answer 99

Keynesian. A situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to avoid bonds and keep their funds in savings because of the prevailing belief that interest rates will soon rise. Because bonds have an inverse relationship to interest rates, many consumers do not want to hold an asset with a price that is expected to decline.

Question 100

Fiscal multiplier

Answer 100

The potential increase in aggregate demand (spending) resulting from an increase in govt spending

FM = 1 / (1 - MPC*(1 - tax))

Remember order of operations.MPC = marginal propensity to consume

Question 101

Ricardian Equivalence

Answer 101

When taxpayers increase current savings just enough to offset expected cost of higher future taxes.

Hypothesis holding that consumers internalize the government’s budget constraint: as a result, the timing of any tax change does not affect their level of spending. Consequently, Ricardian equivalence suggests that it does not matter whether a government finances its spending with debt or a tax increase, because the effect on the total level of demand in the economy is the same.

Question 102

Govt budget surplus indication of fiscal policy

Answer 102

Increase in govt budget surplus is indicative of a contractionary fiscal policy. Increase in a govt revenue item (ie sales tax) is contractionary.Increase in govt budget deficit is indicative of an expansionary fiscal policy. Increase in a govt spending item (eg public construction) is expansionary.

Question 103

Ricardian vs. Heckscher-Ohlin models of trade

Answer 103

Ricardian: One factor of production, labor. Source of comparative advantages is difference in labor productivity.

Heckscher-Ohlin: two factors of production, capital and labor. Comparative advantage arises from differences in relative amounts of each factor.

Question 104

Components of the balance of payments

Answer 104

A record of all transactions made between one country and all other countries during a period.

1. Current account: Measures flows of goods/services. Includes (a) merchandise and services; (b) income receipts; (c) unilateral transfers. A deficit in this account (imports > exports) must be offset by surpluses in other two accounts.
2. Capital account: (a) capital transfers; (b) sales and purchases of non-financial assets
3. Financial account: records investment flows. Includes (a) Govt-owned assets abroad; (b) Foreign owned assets

Question 105

Balance of payments equation

Answer 105

exports - imports = private savings + government savings - domestic investments

Eg, low private/public domestic saving would require higher foreign investment to fund domestic investments.

Question 106

Real exchange rate formula

Answer 106

Real exchange rate = nominal exchange rate * (CPI foreign / CPI domestic)

This takes into account changes due to inflation in prices levels and reflects the “real” rate now as compared to the base exchange rate.

Question 107

Cross rate

Answer 107

The exchange rate between two currencies implied by their exchange rates with a common foreign currency.

A/C = (A/B) * (B/C)A/C = (A/B) / (C/B)

Question 108

No-arbitrage relationship between forward and spot exchange rates (interest rate parity)

Answer 108

forward / spot = (1 + interest rate numerator) / (1 + interest rate denominator)

forward = spot * (1 + interest rate numerator) / (1 + interest rate denominator)

NB: numerator [domestic] / denominator [foreign]

Question 109

Elasticities approach to effect of exchange rate on balance of payments (Marshall-Lerner condition)

Answer 109

How exchange rate changes affect total expenditures on imports and exports. Depends on elasticity of demand for product. More elastic demand means that when the domestic currency depreciates (imports become more expensive) people will switch to domestic goods.

Marshall-Lerner condition:

WxEx + Wm(Em - 1) > 0

Wx = proportion of trade that is exports

Ex = price elasticity of demand for exports

Wm = proportion of trade that is imports

Em = price elasticity of demand for imports

Question 110

Absorption approach to effect of exchange rate on balance of payments

Answer 110

Focuses on capital flows. The absorption approach to analyzing the balance of trade implies that national saving must increase relative to domestic investment for a currency devaluation to narrow a trade deficit, which in turn depends on whether the economy is producing at maximum capacity (full employment or potential GDP) when the devaluation occurs.

Balance of Trade = Y - EY = domestic production of goods/services (or national income)

E = domestic absorption of goods and services (total expenditure)

Question 111

J-Curve

Answer 111

Shows how trade deficit may worsen in the short run after currency depreciation because import/export quantities are insensitive in the short run. Over time, importers adjust and the trade balance improves.

Question 112

Foreign currency forward quotation

Answer 112

Given in points. MUST DIVIDE POINTS BY 10,000. Eg, a forward quote of +25.3 when USD/EUR is 25.3/10,000 = 0.00253. Therefore, 1.458 + 0.00”253” = 1.41”833” USD/EUR.

Question 113

% change in currency relative to another currency

Answer 113

% change calculated based on base currency (denominator) of forex quotation

Question 114

Determining arbitrage profits on currencies

Answer 114

Arbitrage profit is whatever difference arises between the left and right side of the following equation:

Left side: Amount of domestic currency * (1 + domestic IR) = forward value of domestic currency

Right side: (Amount of domestic currency * exchange rate) * (1 + foreign IR) = Forward value of foreign currency

Forward value of foreign currency * (forward exchange rate) = forward value of foreign currency exchanged to domestic currency

Difference between these sides is any arbitrage profit.