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CFA Level 1 > Economics SS4 > Flashcards

Economics SS4 Flashcards

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1
Q

Define the impact of monetary policy :

a. Expansionary

b. Contractionary

A

Expansionary :

  • Increase the money supply
  • Decrease interest rates
  • Increase aggregate demand

Contractionary :

  • Decrease the money supply
  • Increase interest rates
  • Slow economic growth and inflation
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2
Q

What is Monetary Policy?

A

Management of the supply of money and credit

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3
Q

What is Fiscal Policy?

A

Government decisions on taxing and spending

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4
Q

What is the impact of _____ fiscal policy?

a. Expansionary
b. Contractionary

A

a. Expansionary :
- Increase spending
- Decreases taxes
- Increase the budget deficit
- Increase aggregate demand

b. Contractionary :
- Decrease spending
- Increase taxes
- Decrease the budget deficit
- Reduce aggregate demand

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5
Q

What is the function of money?

A
  • Medium of exchange
  • Unit of account
  • Store of value
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6
Q

What is fractional reverse banking system?

A

A bank is required to hold a fraction of its deposits in reserve; this fraction is the required reserve ratio.

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7
Q

What are the types of demand for money? Explain.

A
  • Transaction demand : Increase with GDP
  • Precautionary demand : Money held for unforeseen future needs, increases with GDP
  • Speculative demand : Money held to take advantage of future investment opportunities, smaller when current returns are high, greater when risk is perceived to be high.
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8
Q

Supply of money is set by who?

A

Monetary authority

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9
Q

What is the Fisher Effect?

A

Riskless nominal interest rate = real riskless rate + expected inflation

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10
Q

What are the roles of Central Banks? (6)

A
  • Issue currency
  • Banker to banks and government
  • Regulate banking and payments systems
  • Lender of last resort
  • Hold gold and foreign currency reserves
  • Conduct monetary policy
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11
Q

a. What is the main objective of Central banks?

b. What are the others objectives of Central banks? (4)

A

a. Price stability (low inflation rates)

b. - Maintain full employment
- Promote economic growth
- Keep exchange rate tables
- Keep long-term interest rate moderate

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12
Q

What are are the additional costs of unexpected inflation?

A

Shifts wealth from lenders to borrowers

Less reliable supply/demand information in price changes

  • Incorrect production decisions by firms
  • Less stable business cycles
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13
Q

Definition of policy rate

A

Interest rate central banks charge banks for borrowed reserves

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14
Q

Define the impact of _____ the policy rate.

a. Increasing

b. Decreasing

A

a. Increasing the policy rate discourages banks from borrowing reserves; thus, banks reduce their lending
b. Decreasing the policy rate tends to increase the amount of lending and the money supply.

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15
Q

Describe open market operations (buy, sell securities)

A
  • Central bank buys government securities for cash, reserves increase, money supply increases
  • Selling securities decreases the money supply
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16
Q

Describe required reserve ratio. (Reducing, increasing)

A
  • Reducing reserve percentage increases excess reserves and increases the money supply
  • Increasing required reserve ratio decreases the money supply
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17
Q

Describe Central Bank Characteristics

A
  1. Independent
  2. Credible
  3. Transparent
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18
Q

Impact when a central bank buys securities

A
  • Bank reserve increase
  • Interbank lending rates decrease
  • Short-term and long-term lending rates decrease
  • Businesses increase investment
  • Consumers increase durable goods purchases
  • Domestic currency depreciates, exports increase

Overall, aggregate demand increases

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19
Q

Define

a. Interest rate targeting
b. Inflation targeting
c. Exchange rate targeting

A

a. Increase (decrease) money supply growth when interest rates are above (below) targets

b. Target band for inflation rate (1%-3%)
- Increase money supply growth when inflation is below target band, decrease money supply growth when inflation is above target band
- Target inflation band > 0 to prevent deflation

c. Target band for currency exchange rate with developed country

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20
Q

a. Determine the neutral interest rate

b. Explain when we are in a contractionary or expansionary situation (Policy rate <> Neutral Rate)

A

a. Neutral interest rate = Trend growth rate of real GDP + target inflation rate

b. Policy rate > neutral rate : Contractionary
Policy rate < neutral rate : Expansionary

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21
Q

What are the limitations of monetary policy? (5)

A
  1. Long-term rates may move oppositely to short-term term rates because inflation expectations change
  2. If monetary tightening is extreme, expectations of recession may make long-term bonds more attractive, decreasing long-term rates
  3. If demand for money is very elastic, people will holds currency even as money supply increases referred to as liquidity trap.
  4. Banks may desire to increase capital and not increase lending in response to expansionary monetary policy
  5. Short-term rates cannot be below zero - limits a central bank’s ability to act against deflation.
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22
Q

Explain

a. Expansionary Fiscal Policy
b. Contractionary Fiscal Policy

A

a. - Increase government spending
- Decrease taxes or both
- Increase aggregate demand
- Increase budget deficit

b. - Decrease government spending
- Increase taxes or both
- Decreasing aggregate demand
- Decreasing the budget deficit

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23
Q

Definition of automatic stabilizers

A

Recessions : Taxes and transfer payments tend to increase deficits

Expansions : Taxes and transfer payments tend to decrease deficits during expansions.

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24
Q

What are the fiscal policy objectives?

A
  1. Influence aggregate demand and economic growth
  2. Redistribute wealth
  3. Affect the allocation of resources to different sectors of the economy
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25
Q

What are the fiscal tools (spending)?

A
  1. Transfer payments
  2. Current Spending
  3. Capital spending
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26
Q

Whare are the fiscal tools (Revenue)?

A
  • Direct taxes

- Indirect taxes

27
Q

Describe fiscal multiplier

A

Initial government spending has a multiplied effect as it creates more spending

1 / [(1 - MPC) ( (1-t)]

28
Q

Explain Ricardian Equivalence

A
  • If a tax decrease causes taxpayers to anticipate higher future taxes, the resulting decrease in spending will reduce the expansionary impact of a tax cut.
  • If the increase in saving (decrease in consumption) just offsets the tax decrease.
29
Q

Describe Government debt

A

Debt ratio = Government debt / GDP

  • If the real interest rate on government debt is less (greater) than the real rate of growth, debt ratio will decrease (increase) over time.
30
Q

Describe reasons to be concerned about deficits

A
  • Higher future taxes will decrease GDP growth
  • Government borrowing can drive up interest rates and reduce (crowd out) private investment
  • At some point, debt can become risky, interest rate rises, country may default or expand money supply and cause inflation.
31
Q

Describe arguments that deficits are NOT concerning

A
  • If deficit is to finance capital investment, future GDP will be higher
  • Deficits don’t matter if Ricardian equivalence holds
  • If the economy is operating below capacity government borrowing will not displace capital investment.
32
Q

What are the three fiscal policy lags? Describe them

A
  1. Recognition lag : To identify the need for fiscal policy change
  2. Action lag : To enact legislation
  3. Impact lag : For the policy change to have the intended effect

Lag can cause fiscal policy changes to be destabilizing rather than stabilizing.

33
Q

What are the fiscal policy limitations?

A
  • If economy is at full employment, fiscal stimulus will result in higher inflation
  • In economy is below full employment due to supply shortages, fiscal stimulus will lead to inflation rather than GDP growth
  • If the economy has high unemployment and high inflation (stagflation), fiscal policy connate address both
34
Q

Study Policy interaction slide 38

A
35
Q

Compare GDP and GNP

A

GDP :

  • Value of goods and services produced within a country’s borders
  • Includes capital owned by foreigners and earnings of foreigners working in the country

GNP :

  • Value of foods and services produced by a country’s citizens and their capital
  • Includes earnings of citizens working abroad and earnings on citizens’ capital outside the country
36
Q

Contrast absolute and comparative advantage.

A

Absolute advantage : Lower cost in therms of resources used

Comparative advantage : Lower opportunity cost to produce.

37
Q

Explain Ricardian model

A
  • Labor is the only factor of production

- Comparative advantage depends on relative labor productivity for different goods

38
Q

Explain Heckscher-Ohlin Model

A
  • Two factors of production : Capital and Labor
  • Comparative advantage depends on relative amount of each factor possessed by a country
  • The price of the more abundant resource will increase in each country.
39
Q

Define

a. Tarrif
b. Quota
c. Export subsidies
d. Minimum domestic content
d. Voluntary export restraint (VER)

A

a. Tax imposed on imported goods
b. Limitation on the quantity of goods imported
c. Payments by government to domestic exporters
d. Required proportion of product content to be sourced domestically
e. Agreement by one country to limit the quantity of goods it will export to another country

40
Q

What are the two primary goals of trade restrictions?

A
  1. Protecting domestic jobs

2. Protecting domestic producers

41
Q

Study chart Module 13.2 - Trade restriction slide 11

A
42
Q

What are the restriction on flow of financial capital?

A
  • Outright prohibition
  • Punitive taxation
  • Restrictions on repatriation
43
Q

What are the short-term benefit and the long-term cost of capital restriction?

A
  • Short-term benefit for developing countries : Reducing volatile capital inflows and outlows
  • Long-term costs of isolation from global capital markets.
44
Q

Decribe the five trading blocs

A
  1. Free trade area (FTA): Removes all barriers to trade between member countries (e.g., NAFTA)
  2. Customs Union (CU): FTA + common trade restrictions with non-members
  3. Common Market (CM): CU + removes barriers to movement of labor and
    capital among members
  4. Economic Union: CM + members establish common institutions and economic policy
  5. Monetary Union: Economic union + members adopt a common currency (e.g., euro zone)
45
Q

What are the objective of capital restrictions?

A
  • Reduce volatility
  • Maintain exchange rate target
  • Keep domestic interest rates low
  • Protect strategic industries
46
Q

Describe the three accounts in the balance of payments (BOP).

A
  1. Current Account: Merchandise/services purchases, foreign dividends and interest, and unilateral transfers
  2. Capital Account: Sales/purchases of physical assets, natural resources, intangible assets, debt forgiveness, death duties, and taxes
  3. Financial Account: Domestic-owned financial assets abroad (official reserve, government, private) and foreign-owned domestic financial assets

See chart in note p.22

47
Q

Describe the three International organizations

A
  1. International Monetary Fund (IMF)
    - Monetary cooperation
    - Growth of trade
    - Exchange stability
    - Multilateral system of payments
    - Over come temporary BOP difficulties
  2. World Bank
    - Fight poverty
    - Development and assistance
  3. World Trade Organization
    - Enforce global rules of trade
    - Ensure trade flows smoothly and freely
    - Dispute settlement process
    - Multilateral trading sustem - agreements
48
Q

Compare nominal and real exchange rate

A
  • Nominal exchange rate is the quoted rate at any point in time
  • Real exchange rate is the nominal exchange rate adjusted for
    inflation in each country compared to a base period
49
Q

Compare nominal and real exchange rate

A
  • Nominal exchange rate is the quoted rate at any point in time
  • Real exchange rate is the nominal exchange rate adjusted for
    inflation in each country compared to a base period
50
Q

Describe the market participants on the sell side.

A

Market makers : Largest ultinational banks

51
Q

Describe the market participants on the buy side.

A
  • Corporations
  • Investment accounts : Real money and leveraged
  • Governments, sovereign wealth funds, pension plans, central banks
  • Retail market : Households (e.g., tourism)
52
Q

What are the 8 exchange rate regimes?

A
  1. Formal dollarization
  2. Monetary union
  3. Currency board
  4. Conventional fixed peg
  5. Target zone
  6. Crawling peg (Active and passive)
  7. Managed floating
  8. Independently floating
53
Q

Explain formal dollarization

A

Uses other country’s currency

54
Q

Explain monetary union

A

Several countries use a common currency

55
Q

Explain currency board

A

Commits to a fixed rate of exchange of domestic for a foreign currency

56
Q

Explain conventional fixed peg

A

Maintain at peggedrate (± 1%) via direct intervention in the FX markets or indirectly via monetary policy changes

57
Q

Explain target zone

A

Gives flexibility to maintain the exchange rate within a wider range (e.g., ± 2%)

58
Q

Explain crawling peg (active and passive)

A

Allows exchange rate to move slowly with changes in fundamentals

  • Active : Announced and implemented
  • Passive : Managed but market driven
59
Q

Explain managed floating

A

No target exchange rate ; managed through direct intervention or monetary policy

60
Q

Explain independently floating

A

Market determined

61
Q

Explan Marshall-Lerner condition

A

If WXEX +WM(EM –1)>0, depreciation of domestic currency will decrease trade deficit

62
Q

Explain the J-Curve Effect

A

In the short run, due to existing contracts, export and import demand are relatively inelastic
- Currency depreciation initially leads to a larger trade deficit

In the long run, elasticities increase
- Currency depreciation leads to a reduction in the trade deficit

63
Q

Formula of real exchange rate (p/b)

A

Nominal exchange rate (p/b) x [ CPI (b) / CPI (p)]

64
Q

Formula of forward rate

A

F (p/b) = Spot (p/b) * [ (1+ib) / (1 + ip) ]

CFA Level 1 (4 decks)

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