CFA Economics

Question 1

Explain the two approaches to measuring gross domestic product and calculate GDP using each approach

Answer 1

One way GDP can be measured is the expenditure approach, which is derived from the total expenditures on final goods and services produced throughout the year. The expenditure approach has four components: personal consumption expenditures, gross private domestic investment, government consumption, and net export to foreigners

A second way of calculating GDP is the resource cost income approach, which is the sum of all of the income payments to the resource suppliers and the other costs of producing those goods and services. This approach tracks the flow of income payments and indirect costs and is the sum of aggregate income, non income cost items (such as indirect business taxes and depreciation) and the net income of foreigners.

Question 2

Distinguish between GDP & GNP

Answer 2

GNP is the total market value of all final goods and services produced by the citizens of a country no matter where they are residing

GDP is a measure of the output produced domestically

Question 3

Explain the difference between real and nominal GDP

Answer 3

Nominal GDP is expressed in current dollars, while Real GDP has been adjusted by a price index for inflation

Question 4

Distinguish between the GDP deflator and the CPI

Answer 4

The CPI is an indicator of general price levels, as indicated by a basket of typical goods purchased by households. The GDP deflator is a broader measure of prices than the CPI and also includes prices for capital goods and other goods and services purchased by businesses and governments. CPI and GDP deflator are two different measures and are NOT interchangeable.

Question 5

Discuss three self correcting mechanisms that may help to stabilise a market economy

Answer 5

Consumption Demand
Real Interest Rates
Resource Prices

Question 6

Consumption Demand

Answer 6

Demand is relatively stable over the business cycle

Question 7

Real Interest Rates

Answer 7

Changes in real interest rates will help to stabilise aggregate demand and redirect economic fluctuations

Question 8

Resource Prices

Answer 8

Changes in real resource prices will direct economic fluctuations

Question 9

Distinguish between classical economics and Keynesian Economics

Answer 9

Classical economists stressed the importance of aggregate supply.

Keynesian economics stresses the importance of aggregate demand in determining the overall level of output in the economy. If spending decreases due to pessimism on the part of consumers and investors, business will respond by cutting output. At this point, the argument is precisely the same as that used in the classical AD/AS model. But the classical AD/AS model depends on a subsequent reduction in resource prices to restore long run equilibrium, namely a reduction n wages, were highly inflexible in a downward direction. Hence, in Keynes’ view, the economy would languish for an extended period of time with high unemployment.

Question 10

Explain the major components of the Keynesian model

Answer 10

Real GDP = planed expenditures = planned (C + I + G + NX)

Where:
Consumption (C): As disposable income increases, current consumption expenditures rise, but by a smaller amount. Considered the most important component of the model

Investment (I): Includes expenditures on fixed assets, as well as changes in inventories or raw materials and unsold finished goods.

Planned Govt Expenditures (G): Determined by political process, and not necessarily dependent upon tax revenues.

Planned Net Exports (NX): Level of Imports increases with income, as consumers buy more domestic and foreign goods.

Question 11

Explain Keynesian macro equilibrium

Answer 11

Keynesian macro equilibrium is achieved when planned aggregate output expenditures equal the value of current production, and can be stated as:

Total Output = planned C + I + G + NX

Note that the left side of the equation is real GDP and the right side of the equation is planned aggregate expenditures. At the point of equilibrium, businesses are able to sell their exact output of goods and services. If the economy is out of equilibrium, for example, if supply exceeds demand (right side of the equation) output will then decrease (left side of the equation) until equilibrium is once again achieved.

Question 12

Define and calculate the marginal propensity to consume and the expenditure multiplier

Answer 12

The marginal propensity to consume (MPC) is the proportion of additional income that households will choose to spend on consumption rather than saving. The greater the MPC, the more spent on consumption. The formula is:

MPC = additional consumption / additional income

The expenditure multiplier is the ratio of change in equilibrium output to the independent change in investment, consumption, or government spending that effects the change. The formula is:

Expenditure multiplier = 1 /( 1 - MPC)

Question 13

Explain the importance of the expenditure multiplier within the framework of the Keynesian model

Answer 13

The expenditure multiplier states that one individual’s expenditures will become the income of another. The income recipient in turn will spend a portion on consumption, becoming the income of yet another individual and so on. It can be defined as the change in total income divided by expenditure changed caused by the larger income. According to the Keynesian model, autonomous expenditures (spending unrelated to income) will cause a shift in aggregate expenditures, which in turn will increase income

Question 14

Discuss the Keynesian view of the business cycle

Answer 14

Keynesian economists believe that if left alone, a market economy is unstable and is subject to long periods of recession. Autonomous changes in expenditures, in conjunction with the expenditure multiplier, are major destabilising factors in the economy. Governments have the power to use tax and fiscal policies to stabilise aggregate expenditures and assure full employment

Question 15

Explain the phases of the business cycle

Answer 15

The business cycle is a pattern over time of shifts from economic expansion to economic contraction. A business peak is when businesses are operating at capacity and real GDP is growing rapidly. As business slows, unemployment increases, and GDP grows at a slow pace or declines, it is called the contraction, or recessionary phase of the cycle. The bottom of the phase is the recessionary trough. As economic conditions begin to improve again, marked by growth in GDP and a decline in unemployment, the EXPANSION phase begins. The expansionary period will grow into a business peak, thus beginning a new business cycle.

Question 16

Describe the key labour market indicators and discuss the problems in measuring unemployment

Answer 16

The CIVILIAN LABOUR FORCE are at least 16 years old and either currently employed or actively seeking employment

The LABOUR FORCE PARTICIPATION RATE is the number of persons 16 years or older who are either employed or actively seeking employment as a percentage of the civilian population 16n years or older

The RATE OF UNEMPLOYMENT is the percent of people in the civilian labour force who are unemployed

UNEMPLOYED WORKERS include those classified as (1). laid off, (2) re-entrants into the labour force (3) new entrants (4) left last job willingly and (5) fired or terminated.

Measurement problems include:

Workers waiting recall
Discouraged Workers
Part-time workers

Question 17

Define and explain full employment and the natural rate of unemployment

Answer 17

FULL EMPLOYMENT is the economic condition that exists when cyclical unemployment is zero. Note however, that there is some level of unemployment that is expected when the country is at FULL employment

The NATURAL RATE OF UNEMPLOYMENT is that rate of unemployment present when the economy is at its full employment rate of production or output. The natural rate of unemployment can persist for an indefinite period of time and is typically associated with the economy’s maximum long run rate of output.

Question 18

Define inflation and calculate the inflation rate

Answer 18

Inflation is defined as a continuing rise in the general level of prices of goods and services. Because of higher prices, a dollar will purchase less goods and services in periods of inflation.

Question 19

Define the harmful consequences of inflation

Answer 19

Inflation will increase the risks of and slow the level of activity in long-term projects. Unanticipated inflation will negatively impact the outcome of long term capital investments, and therefore these types of projects may be postponed or cancelled

Inflation distorts the information delivered by prices. Some prices will respond to inflationary pressure more quickly than others, therefore giving a distorted picture of overall price levels until inflation stabilizes

In periods of high or variable inflation, productivity will decline. People will spend more time trying to protect themselves from inflation rather than producing goods and services.

Question 20

Explain the process by which fiscal policy affects aggregate demand and aggregate supply.

Answer 20

Fiscal policy refers to government budgeting, ie taxing and spending. Expansionary policy means more spending or lower taxes (note that this means budget deficits). Restrictive policy means less spending or higher taxes. Keynesians believe that fluctuations in aggregate expenditures are the main source of economic disruptions. According to the Keynesian view, expansionary fiscal policy can stimulate aggregate expenditures, while restrictive policy can act as a brake on inflationary pressures. Thus fiscal policy can be used to smooth the effects of fluctuations in economic cycles. According to supply side economists, marginal tax rates can affect aggregate supply. Lower tax rates reduce purely tax motivated investments, encouraging more efficient allocation of capital resources

Question 21

Explain the importance of timing of changes in fiscal policy and the difficulties in achieving proper timing.

Answer 21

Fiscal policy can be used to stimulate or restrain economic activity. If a stimulus is applied to an economy that is already growing or at full employment, the effects could be inflationary. Similarly, applying restrictive policies to an economy in recession could worsen economic conditions. Timing is difficult for three reasons: (1) forecasts of future macroeconomic conditions are imperfect, (2) decisions relating to changes in fiscal policy take time, (3) the policy change takes time to have an effect. If fiscal policy is implemented based on an incorrect forecast, or if conditions change during the time it takes to decide on a policy change and execute that change, then the policy change is less likely to achieve the desired goal.

Question 22

Describe the impact of expansionary and restrictive fiscal policies based on the basic Keynesian model, the crowding out model, the new classical model, and the supply side model.

Answer 22

Basic Keynesian Model: An increase in government spending &/or reduction in taxes will be magnified by the multiplier process and lead to a substantial increase in aggregate demand. This will stimulate the economy to lead to increases in the level of employment and output.

Crowding Out Model: The potency of expansionary fiscal policy will be dampened because borrowing to finance the budget deficit will push up interest rates and crowd out private spending.

New Classical Model: The potency of expansionary fiscal policy will be dampened because households will anticipate the higher future taxes implied by the debt and reduce their spending in order to pay them. Like current taxes, this future tax debt will crowd out private spending.

Supply Side Model: A reduction in marginal tax rates will increase the incentive to earn and improve the efficiency of resource use, leading to an increase in aggregate supply (output) in the long run.

Question 23

Explain how and why budget deficits and trade deficits tend to be linked.

Answer 23

A budget deficit occurs when total government spending exceeds total government revenues. A trade deficit is an excess of imports relative to exports. Larger budget deficits will push up interest rates, which will then attract a greater inflow of foreign capital into the economy. In turn, increased foreign exchange demand for the dollar will cause it to appreciate, which will reduce both net exports and net demand.

Question 24

Identify automatic stabilisers and explain how such stabilisers work

Answer 24

Automatic stabilisers are built in fiscal devices that ensure deficits in a recession and surpluses during booms. Automatic stabilisers minimise the problem of proper timing.

Question 25

What are the three Automatic Stabilisers

Answer 25

Unemployment Compensation

Corporate Profit Taxes

Progressive Personal Income Taxes

Question 26

Explain Unemployment Compensation

Answer 26

During a recession unemployment is high so the government will pay out more in unemployment compensation at the exact time that tax receipts from corporations and individuals are low. This will increase the size of the deficit and also maintain aggregate demand during recessionary periods.

Question 27

Explain Corporate Profit Taxes

Answer 27

During expansions corporate profit taxes are automatically high producing government surpluses. The opposite is true during recessions.

Question 28

Progressive Personal Income Taxes

Answer 28

During expansions, taxes increase faster than incomes, and the government moves to a surplus. During a recession the opposite takes place creating a deficit.

Question 29

Discuss the supply-side effects of fiscal policy

Answer 29

Supply side economics says that a reduction in marginal tax rates will give individuals and businesses the incentive to (1) invest and save (2) work and increase their productivity in projects which provide taxable income (3) reduce leisure time activities and participation in tax shelter programmes. These behavioural changes will increase aggregate supply, increase output, decrease unemployment and reduce prices. High taxes retard output because

1. They discourage work effort and reduce productive efficiency of labour
2. They adversely affect the rate of capital formation and the efficiency of its use
3. They encourage individuals to substitute less desirable tax deductible goods for more desirable non-deductible goods.

Question 30

Identify the three basic functions of money

Answer 30

Medium of Exchange

Unit of Account

Store of Value

Question 31

Explain the three basic functions of money

Answer 31

Medium of Exchange - Money simplifies and reduces the cost of transactions

Unit of Account - Money serves as a unit of measure by which the value of goods can be compared

Store of Value - Money enables value tp be stored and transported. It is also a liquid asset, meaning that it can be easily converted into other goods.

Question 32

Define the money supply

Answer 32

M1 is the narrowest definition of money. The money supply is defined as currency in circulation (coins and paper), checkable deposits maintained in depository institutions and travellers cheques

M2 equals M1 plus savings deposits and time deposits less than $100,000 held in depository institutions plus money-market mutual fund shares.

Question 33

Describe the fractional reserve banking system

Answer 33

Under a fractional reserve banking system, banks are allowed to maintain less than 100% of their deposits on reserve. A fractional reserve banking system works as follows:

1. funds are deposited in a bank
2. the bank is required to hold only a portion of those funds (determined by the reserve requirement as established by the Fed), and may loan out the rest.
3. the loaned out funds may be deposited in another bank, which again is required to hold only a portion in reserve. The process repeats itself until the total money supply is expanded by the deposit expansion multiplier, which equals the reciprocal of the reserve requirement.

Question 34

Explain the relationship among the required reserve ratio, potential deposit expansion multiplier, and actual deposit expansion multiplier.

Answer 34

The potential deposit expansion multiplier will be reduced if some people decide to hold currency rather than deposit it into the bank. Also the actual deposit expansion multiplier may be less than expected if the banks refuse to loan out excess reserves. It is important to note that money is created only when banks make loans. A single bank can only lend out its excess reserves. It is the banking system as a whole that expands the money supply.

Question 35

Describe the role of a country central bank and 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.

Answer 35

The Fed sets the required reserve ratio. As the required reserve ratio drops, each dollar of excess reserves can be multiplied more times.

The Fed’s most important tool is OPEN MARKET OPERATIONS. Here, the Fed buys and sells treasury bonds, notes, and bills as a way to control the monetary base.

The Fed sets the interest rate that it charges banks when they borrow from the Fed. The interest rate is called the discount rate. As the discount rate falls, it becomes more attractive for banks to borrow from the Fed to meet reserve requirements. So, as the discount rate falls, the money supply rises.

Question 36

Discuss potential problems in measuring an economy’s money supply

Answer 36

There is widespread use of the US dollar outside of the US. As much as two thirds of US currency is held abroad, this substantially reduces the reliability of M1.

The increasing availability of low fee stock and bond mutual funds has caused a shift in funds out of M2 components of the money supply.

Debit card ad electronic money make it easier to transfer funds without the use of money. As the public holds less currency reserves will accumulate in the banks causing the money supply to grow rapidly if the Fed does not take offsetting action.

Question 37

Discuss the determinants of the demand for and the supply of money

Answer 37

The demand for money is based on the amounts needed to execute transactions on a day to day basis. The demand for money is inversely related to interest rates - as rates rise, the cost of holding money rises, and people will try to minimise the amounts they need to carry out daily transactions.

The supply of money is determined by monetary authorities (the Fed in the US). Once supply is set, interest rates shift to bring supply and demand into balance.

Question 38

Explain how monetary policy affects interest rates and employment

Answer 38

An unanticipated shift to a more expansionary monetary policy will temporarily stimulate output and employment

Whether monetary policy can act as a stabilising influence on the economy depends on economic conditions at the time, e.g. if the economy is operating at full employment, any demand stimulus will be inflationary.

Persistent expansion of the monetary at a rate higher than the rate of economic growth will cause inflation.

There is a direct relationship between money interest rates and the rate of inflation.

There is only a weak year to year relationship changes in monetary policy and changes in output and prices.

Question 39

Discuss how anticipations of the effects of monetary policy can influence the policy’s effectiveness

Answer 39

When policy is fully anticipated, contracts will reflect expected higher prices. Hence, both prices and interest rates will rise rapidly to their long run equilibrium levels, leaving output unchanged. Many labour contracts in anticipation of inflation write escalator clauses (cost of living agreements) into the wage agreement. These clauses adjust money wage rates upward as the price level rises.

Question 40

Calculate real GDP, given normal GDP and the GDP deflator

Answer 40

real GDP (current period) = nominal GDP (current period) x (GDP Deflator (base yr) / GDP Deflator (current period))

Question 41

Explain the laws of supply and demand

Answer 41

The law of supply states that there is a direct relationship between supply and price: as prices increase (decrease), producers will bring more (less) of their product to market.

The law of demand states that there is an inverse relationship between price and buyer demand: as prices increase (decrease), consumers will purchase less (more) goods and services

Question 42

Differentiate between shifts in and movements along supply curves and demand curves.

Answer 42

A change in quantity demanded is simply a movement along a demand curve from one point to another. Changes in demand, caused by changes in factors such as income, number of consumers, or prices of substitute goods, will cause a shift in the entire demand curve.

A change in quantity supplied is a movement along a supply curve from one point to another.

Changes in supply, caused by changes in factors such as resource prices, technology, taxes, and natural and political events, will cause a shift in the entire supply curve.

Question 43

Discuss the factors that cause a demand curve to shift

Answer 43

Change in consumer income: Consumers can purchase more goods

Changes in the number of consumers in the market: Fewer customers = demand curve shift

Changes in the price of a related good: Changes in prices of similar products influence consumer’ choices

Changes in expectations: Consumers’ expectations about the future can affect a product’s demand

Demographic changes: Demand for products is influences by demographic composition of the market

Changes in consumer tastes and preferences: Consumer preferences change as people learn and change

Question 44

Discuss the factors that cause a supply curve to shift

Answer 44

Changes in resource prices: Higher production costs lead to decrease production

Changes in technology : Improvements reduce production costs and stimulate production

Elements of nature: Favourable weather can lead to number crops, where natural disasters (flood and drought) can considerably reduce yield.

Political disruptions: War and changing political conditions can alter supply

Changes in taxes: Can increase (decrease) costs of production.

Question 45

Define short run and long run market equilibrium

Answer 45

Markets have an automatic tendency to gravitate toward equilibrium, which occurs when there is a state of balance between two opposing forces. Changes in either supply or demand will lead to changes in equilibrium, and will not be instantaneous, but over time. In the short run, firms do not have enough time to react to a change in price. The long run is defined as a period of time that is lengthy enough for decision makers to fully adjust to a market change.

Question 46

Discuss how markets respond to changes in supply and demand.

Answer 46

An increase in supply (the supply curve shifts to the right) will lead to a subsequent decrease in prices. Lower prices tend to whet consumers appetites and cause demand to increase . Producer then will supply more products to meet the increase demand. These two reactions will tend to force quantity supplied and quantity demanded back to a state of equilibrium. A decrease in supply will lead to the opposite reaction.

An increase in demand (the supply curve shifts to the right) will lead to a subsequent increase in prices. At a higher price, consumers tend to seek substitute goods and services, &/or producers will supply a larger quantity of product. Again, these two reactions will tend to force quantity demanded and quantity supplied back to a state of equilibrium. When a decrease in demand occurs, the opposite chain of events will occur.

Question 47

Explain how shortages and surpluses affect the analysis of equilibrium prices

Answer 47

Price ceilings are legally set maximum prices that sellers may charge. Ceilings are usually initiated during inflationary periods. Ceilings prevent the producer from increasing the selling price to cover rising costs. This will lead to a reduction in supply that will cause a shortage.

Price Floors are legally established minimum prices that buyers must pay for a good price. Price floors will stimulate production, since producers are receiving more than the equilibrium price. Buyers, however, will shift their consumption to lower price alternatives causing supply to exceed demand, causing a surplus.

Question 48

Explain how the “invisible hand” principle works

Answer 48

The invisible hand principle describes the tendency of competitive markets to direct the actions of self-interested individuals toward those actions that also promote economic progress (economic well being of society). Market prices do this by:

Relaying information to decision makers
Coordinating choices of buyers and sellers
Establishing a reward system to motivate parties to cooperate and work efficiently.