CFA Level 1 - Economics Flashcards _ Quizlet

CFA Level 1 - Economics Created by Jbotros 241 terms

Price Elasticity of Demand Formula (% Change in Quantity Demanded) / (%tChange in Price)

Cross Elasticity of Demand Formula (% Change in Quantity Demanded) / (%Change in Price of Substitute or Complement)

Income Elasticity of Demand Formula (% Change in Quantity Demanded) / (%Change in Income)

Price Elasticity of Supply Formula (% Change in Quantity Supplied) / (%Change in Price)

Elasticity of Demand Factors 1) Availability of Substitute; 2) Relativeamount of income spent on the good; 3) TimeSINCE price change

Elasticity of Supply Factors 1) Available substitutes for resources (inputs)used to produce the goods; (2) the time thathas elapsed since the price change

Income elasticity of an Inferior Good-Positive or Negative

Negative

Total Cost Formula = Total Fixed Cost + Total Variable Cost

Average Fixed Cost Formula Average Fixed Cost = TFC/QAverage Variable Cost Formula Average Variable Cost= TVC/QAverage Total Cost Formula = AFC + AVC

Unemployment Rate Formula (Number of Unemployed) / (Labor Force) x100

Labor Force Participation Rate Formula (Labor Force) / (Working-Age Population(16or older) ) x 100

Employment to Population Ratio Formula (Number of Employed) / (Working-AgePopulation) x 100

CPI Formula (Cost of Basket of Current Prices) / (Cost ofBasket at Base Period Prices) x 100

Inflation Rate Formula % change in CPI(Current CPI- Year Ago CPI)/ (Year Ago CPI)X 100

CFA Level 1 - Economics flashcards | Quizlet http://quizlet.com/7758902/cfa-level-1-economics-flash-cards/

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Potential Deposit Expansion MultiplierFormula

= 1 / (required reserve ratio)

Potential Increase In Money Supply Formula = (Potential Deposit Expansion Multiplier) x(Increase in Excess Reserves)

Money Multiplier for a change in monetarybase Formula

(1+c) / (d+c)c = currency as a % of depositsd = desired reserve ratio

Change in Quantity of Money Formula (Change in Quantity of Money) = (Change inMonetary Base) x (Money Multiplier)

Equation of Exchange Formula = (Money supply) x (Velocity) = GDP =(Price) x (Real Output)

Quantity Theory of Money Formula Price = M (V/Y)What does it mean if Cross elasticity ispositive

Two goods are reasonable substitutes foreach other

What does it mean if Price Elasticity ofDemand is less than one in absolute value?

Inelastic

What does it mean if Price Elasticity ofDemand is greater than one in absolutevalue?

Elastic

Normal Goods Elasticity Positive Income Elasticity (greater than 1)Total Revenue Test Estimate elasticity of demand:

P Up-> R Up (Inelastic);P Up -> D Down (Elastic)

Cross Elasticity of Substitutes- Positive orNegative

Positive

Income Elasticity for normal goods- Positiveor Negative

Positive

Income Elasticity for inferior goods- Positiveor Negative

Negative

Command System A central authority determines resourceallocation, is used in centrally plannedeconomies and is also used within firms andin the military

Majority Rule Government policies such as taxation andtransfer payments are an example of this typeof resource allocation

Efficient allocation of resources Marginal Benefit to society (Demand) =Marginal Cost for the "last" unit of each goodand service to be produced (Supply). (MC =MB)


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Marginal Cost Formula (Change in Total Cost) / (Change in Output)Two Concepts of Robert Nozick's Anarchy,State, and Utopia (Symmetry)

1) Governments must recognize and protectprivate property; 2) Private property must begiven from one party to another only when itis voluntarily done

When demand is less elastic than supply-consumers bear higher or lower burden

HIGHER

When supply is less elastic than demand-consumers bear higher or lower burden

LOWER, suppliers will bear a higher burden

Inelastic means more or less DWL Less

Three Constraints to Profit Maximization TMI 1) Technological, 2) Informational, 3)Market Constraints

Technological Efficiency Output from least inputs

Economic Efficiency Output from least cost

Two ways that firms can organize production CI 1) Command System, 2) Incentive SystemCommand Systems Organization according to a managerial chain

of command, eg US Military [Told what todo]

Incentive System Senior mangement creates a system ofrewards intended to motivate workers toperform in such a way as to maximize profits[Motivated to do]

Principal- Agent Problem Problems that arise when incentives andmotivations or managers and workers(Agents) are not the same as the incentivesand motivations of their firms.

Three Methods used to reducePrincipal-Agent Problem

OIL 1) Ownership, 2) Incentive Pay, 3)Long-term contracts

Three Types of Business Organizations PPC 1) Proprietorships, 2) Partnerships, 3)Corporations

Four Types of Economic Markets PMOM 1) Perfect Competition, 2)Monopolitic Competition, 3) Oligopoly, 4)Monopoly

Four-Firm Concentration Ratio The percentage of total industry sales madeby the four largest firms in the industry. Ahighly competitive industry may have afour-firm concentration ratio near zero, whilethe ratio for monopoly is 100%,< 40% = Competitive Market,>60% is Oiligopy


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Herfinhahl-Hirschman Index (HHI) Calculated by summing the squaredpercentage market shares of the 50 largestfirm in an industry (or all of the firms in theindustry if there were less than 50). The HHIis very low in a highly competitive industryand increases to 10,000 (=100squared) for anindustry with only one firm.An HHI between 1,000 and 1,800 isconsidered moderately competitive, while anHHI greater than 1,800 indicates that it is notcompetitive

HHI greater than 1,800 NOT Competitive

HHI between 1,000-1,800 Moderately Competitive

HHI less than 1,000 Competitive

Four-Firm Concentration Ratio 100% Monopoly

Four-Firm Concentration Ratio less than 40% Competitve

Four-Firm Concentration Ratio greater than60%

Oligopoly

Three limitations to the HHI and Four-FirmConcentration Ratio

1) Problems with defining the geographicalscope of the market; 2) Barriers to entry andfirm turnover are NOT considered; 3) Weaklink between market and an industry

Accounting Profits Includes explicit costs

Economic Profit Considers explicit and implicit costs

Economic Profit Formula Economic Profit= Total Revenue -Opportunity Costs = Total Revenue -(Explicit + Implicit Costs)

Implicit Costs Implied Rental Rate + Normal Profit

Implied Rental Rate Term used to describe the opportunity cost toa firm for using its own capital. Sum ofEconomic Depreciation and Foregone Interest

Normal Profit Opportunity cost of Owners' entrepreneurshipexpertise. It represents what owners couldhave earned if they used their organizationaldecision-making and other entreprenurialskills is another activity such as runninganother business.

Economic Efficiency Producing a given output at the lowestpossible cost

Technological Efficiency Using the least amount of inputs to produce agiven output


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Income Elasticity of Demand > 0 "positive" Normal Good

Income Elasticity of Demand > 1 Luxury Good

0 < Income Elasticity of Demand < 1 Necessity

Income Elasticity of Demand < 0 ="negative"

Inferior Good

On Straight-line Demand Curve - HighElasticity

Price Increase = Revenue DecreaseE > 1 (absolute value) E > I -1 I

On Straight-line Demand Curve - LowElasticity

Price Increase = Revenue IncreaseE < 1 (absolute value) E < I -1 IPrice and Revenue move in the samedirection

On Straight-line Demand Curve - GreatestRevenue

Unitary Elasticity(E = -1)

Large Price Increase = Smaller DemandDecrease

Relatively Inelastic, thus total expenditure onthe good increases.

Small Price Increase = Large DemandDecrease

Elastic

Allocation of Resources - Methods Market Price, Command, Majority Rule,Contest, First-come, First-served, Lottery,Personal Characteristics, Force.

Obstacles to efficient allocation of productiveresources

1) Price Control (ceilings & floors); 2) Taxesand trade restricitions (subsidies & quotas);3) Monopoly; 4) External Costs; 5) ExternalBenefit; 6) Public goods and commonresources

Consumer Surplus Difference between total value to consumerand total amount paid by the customerA consumer surplus occurs when theconsumer is willing to pay more for a givenproduct than the current market price.

Producer Surplus Difference between total cost of productionand total amount received (market price).

Marginal Cost of production is Minimum Supply Price

When the efficient quantity is produced the: Sum of consumer surplus & producer surplusis maximized

Fairness Principles Utilitarianism & Symmetry

Symmetry Principle Equality of opportunity.economy is based on private property &voluntary exchange


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Utilitarism Greatest good occurs to the greatest numberof people when wealth is transferred from therich to the poor to the point where everyonehas the same wealth 1) everyone wants andneeds the same thing; 2) Marginal benefit of adollar is greatest for the poor than the rich

Price Ceilings < Price Equilibrium 1. Excess demand results in Shortage2. Black market prices > Ceiling PricesLong run impacts: Long waiting,Discrimination, Bribes, Lower Quality

Price Ceilings > Price Equilibrium no impact

Price Floors < Price Equilibrium no impact

Price Floors > Price Equilibrium 1. Excess supply results in SurplusLong run impacts: Excess supply, substitutionin consumption

Tax Impact Results in DWLIncrease price equilibriums & Decreasequantity equilibrium

Deadweight Loss decrease in total surplus due to an inefficientlevel of production

Statutory Incidence Refers to who is legally responsible forpaying the tax

Actual Incidence of Tax Who actually bears the cost of the tax throughan increase in the price paid (buyer) ordecrease in the price received (sellers)

Statutory Incidence on the Buyer (Tax onBuyers) results in

Downward shift of the demandIncrease in Price Equilibrium & Decrease inDemand Equilibrium

Statutory Incidence on the Seller (Tax onSeller) results in

Upward shift of the supply curveIncrease in Price Equilibrium & Decrease inDemand Equilibrium

Minimum Wage > Price Equilibrium results in Excess supply of labor; Decrease innon-monetary benefits; DWL fromunderproduction

Quotas < Quantity Equilibrium results in DWL: UnderproductionMarginal Social Benefit (MSB) > MarginalSocial Cost (MSC)

Subsidies DWL: OverproductionMarginal Social Benefit (MSB) < MarginalSocial Cost (MSC)Increase QeDecrease Pe to Consumers


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Tax Incidence if Demand is less elastic Buyer bears higher burden

Tax Incidence if Supply is less elastic Supplier/Seller bears higher burdern

Market for Illegal Goods: Penalties on Sellers Decrease Supply

Market for Illegal Goods: Penalties on Buyer Decrease Demand

Market Coordination occurs when a firm employs resourcesoutside the firm more efficiently than if theyrelied only on internal resources. (Eg.outsourcing & contracting)

Firm Coordination Management determines the flow of resourcesto determine what price to charge and howmuch to produce

Firm Coordination can be more efficient thanMarket due to:

Lower transaction costs, economies of scale,scope, and team production.

Fixed Costs aka Sunk Costs remain unchanged in short-run, thereforeshould NOT be considered in currentdecision making. Related to passage of timeNOT production.

Marginal Cost Add'l cost of producing one more unit ofoutput

Regarding Cost of Production Marginal Product curve (MP) intersectsAverage Product curve (AP) @ its max. TheQ at which AP = maximum = Q for whichAVC is at its minimum.

Economies of Scale LRAC cost is decreasing

Max Profits - Perfectly Competitive marketsproduce at quantities

MC = MR = Price

Marginal Cost curve (MC) intersects AVC & ATC at their minimum.MC does NOT intersect AFC at min b/c AFCdecreases as production increases due toallocation of fixed costs.

Features of Perfect Competition 1) Homogeneous product; 2) Many smallsellers; 3) No barriers to entry/exit; 4)Existing firms doe not have have advantageover new entrants; 5) Consumers and sellersare knowledgeable about prices.

Perfect Competition - Price takers 1) small output relative to the market; 2) noinfluence on price; 3) Horizontal demandcurve (perfectly elastic)

Perfect Competition - Output in the Long Run Zero economic profits = normal returnP = MC = ATC


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Perfect Competition - Increase in Demand Increase in Pe & Qe -> Economic profit ->Firms expand -> New entrants -> LR: zeroeconomic profit

Perfect Competition - Long Run PriceEquilibrium After Permanent Increase inDemand

Lower (external economies)Higher (external diseconomies)

Perfect Competition - Technological changes: Higher quantitiy, lower priceLR: price = min ATC for the new technology-> zero economic profit

Features of Monopoly 1) No good Substitues; 2) Distinguished byhigher entry barriers- Legal barriers - gov't licensing & patents- Natural barriers- substantial economies ofscale

Monopoly - Profit Maximization Produce Q where MR = MCProduce in the elastic range of demand curveHigher prices & lower quantities

Monopoly - Price searcher 1) Downward sloping demand curve; 2)Reduce price to increase sales; 3) MR < price4) MR curve lies below the demand curve

Monopoly vs. Perfect Competition 1) DWL; 2) Smaller consumer surplus 3) Rentseeking

Monopoly - Price-setting strategies 1) single-price; 2) price discriminationPrice Discrimination 1) Firm must have downward sloping demand;

2) Identifiable groups of consumers w/ diffprice elasticities of demand 3)Prevent resalebetween groups 4) charge different pricesResults in Higher Economic Profit

Is Perfect Price Discrimination Efficient? Yes. 1) No DWL; 2) No consumer surplus; 3)Same quantity as perfect competition

Regulating Natural Monopolies - AverageCost Pricing:

Increase output & social welfare

Regulating Natural Monopolies - MarginalCost Pricing:

May lead to loss, may need subsidy if MC ATC

Monopolistic Competition - Output in the SR& LR

1) Produce where MR = MC; 2) SR economicprofits; 3) LR- new firms enter - zeroeconomic profits (like PC) but price is greaterthan marginal cost.

Monopolistic Competition - Efficiency Unclear b/c (cost vs. benefit)Social costs of not producing at P = MCBenefits due to: information, values frombrand names, productinnovation/differentiation and advertising.

It is possible that the loss resulting formproducing an inefficient quantity could beoffset by the value gained form productvariety.

Features of Oligopoly 1) significant barriers to entry; 2) Small # ofinterdependent sellers with incentive tocooperate (faced with prisoners' dilemma) 3)Downward sloping demand curve

Oligopoly - Prisoners' Dilemma Model used to analyze oligopoly outputrestrictions.Best course of action is to enter into acollusive agreement and cheat.

Two Oligopoly Models 1) Kinked demand curve- follow pricedecrease only;2) Dominant firm oligopoly-dominant firmsets price

Marginal Revenue (MR) The addition to total revenue from selling onemore unit of output

Marginal Revenue Product (MRP) The addition to total revenue from selling theadditional output from employing one moreunit of a productive resource(input)To maximize profits: MRP labor = Price labor

Factors Increasing Demand for Labor 1) Increase in output price; 2) Increase insubstitute price; 3) Decrease in complementprice; 4) Advances in technology or newcapital that increases labor's MP


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Factors of Elasticity of Demand for Labor 1) Labor intensity (more the better/notautomated process); 2) Elasticity of demandfor output; 3) Input substitution[Demand for labor is more elastic in the LRvs. SR.]

Supply of Labor - Substitution Effect Higher wage results in less leisure, morelabor supplied

Supply of Labor - Income Effect higher income results in more leisure, lesslabor supplied

Shifts in Labor Supply caused by: 1) Size of adult population; 2) Capitalaccumulation to allow more adults workingoutside.

Labor Market Power - Labor Union vs.Monopsony

Labor Union: (collective bargaining/ onlygroup of employees) increase wage rate andreduce employmentMonopsony: (single buyer/employer) reducewage rate and employment b/c MC of anadd'l worker > wage.

Labor Market Power - Increase Demand forLabor Union (to offset decrease inemployment)

1) Increase MP of labor via training; 2)Advertise to increase demand for union-madeproducts; 3) Advocate trade restrictions onforeign goods that compete with union-madedomestic goods; 4) Reducing the supply orincreasing the price of substitutes for unionlabor (higher min wage & immigrationrestrictions)

Physical Capital 1) PP&E; 2) Inventory (WIP & Finishedgoods)

Financial Capital Pays for physical captial1) Equity; 2) Debt Securities

Financial Capital - Demand QD up when Interest Rate downQD down when Interest Rate upReflect PV of MRP of physical capital inproduction

Financial Capital - Supply Supplied by savings - [Increase/(Decrease)]1) Interest Rates [up/(down)] ; 2) CurrentIncomes [up/(down)]; 3) Expected FutureIncome [down/(up)]

Natural Resources - Non-Renewable 1) Elastic supply (horizontal); 2) QSupplydetermined by Demand; 3) Current Pirce isthe PV of the expected price next period. e.g.oil


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Natural Resources - Renewable 1) Inelastic supply (vertical); 2) price isdetermined by demand e.g. water

Economic Rent Difference between actual earnings andopportunity cost of a factor of production

Economic Rent - Supply Elasticities 1) Perfectly elastic supply (unskilled labor)-no economic rent; 2) Perfectly inelasticsupply (golf ability)- max economic rent;3) Upward sloping supply curve -> someeconomic rent

Real wage rate Money wages adjusted for changes in pricelevel

Aggregate hours Total hours worked in a year by all employedpeople

Unemployment Actively looking for work, Laid off, waitingto be called back, Starting a job w/in 30 days

Three Types of Unemployment: 1) Frictional; 2) Structural; 3) CyclicalNatural Rate of Unemployment: 1) Frictional; 2) StructuralNatural Rate of Unemployment - Frictional imperfect information and job searches taking

time

Natural Rate of Unemployment - Structural skills being in shortage and the economychanging

Unemployment - Cyclical associated with the business cycleNegative Cyclical may exist (SR)Real GDP > Potential GDP = levels of abovefull capacityPositive CyclicalReal GDP < Potential GDP = levels ofundercapcity

Economy is at full employment when unemployment rate = natural rate ofumemploymentNO cyclical umemploymentReal GDP = Potential GDP

Labor Force = # of employed + # of unemployedIncludes all people who are either employedor actively seeking employment. DOES NOTinclude discouraged workers or those who areavailable for work but are neither employednor actively seeking (i.e. housewives)

Consumer Price Index (CPI) Average price for a "basket" of goods andservices purchased by a typical urbanhousehold(excludes food & fuel/energy)


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Biases in CPI Data Tend to overstate inflation by ~ 1%Does not account for the following:1) New Goods; 2) Quality change; 3)Commodity substitution; 4) Outletsubstitution

Short-Run Aggregate Supply (SRAS) 1) Upward sloping supply curve (assumesfixed money wage); 2) Decreases (shifts) withrising wages or expected inflation; 3) Changesin price level are movements along SRAScurve (function of price level)

Long-Run Aggregate Supply (LRAS) 1) Vertical supply curve at potential GDP(independent of price level); 2) Fullemployment real output of economy; 3)Increases/(Decreases) withIncreases/(Decreases) in quantity of labor,capital, and existing technology.

Increases (Decreases) in Long-Run AggregateSupply (LRAS) due to:

Increases (Decreases) in 1) Quantity of labor;2) Quantity of capital in the economy;3)Technology the economy possess.

Aggregate Demand Formula (AD) Aggregrate Demand = (Consumption) +(Investment) + (Government Spending) + NetExports

Aggregate Demand Factors 1) Expectation about incomes, Inflation, andprofits; 2) Fiscal & Monetary Policy; 3) Thegrowth rate of the world economy

Aggregate Demand Curve is Downward-Sloping Due To:

1) Wealth effect - price increases, individualwealth decreases, therefore save more (spendless);2) Intertemporal substitution - price levelrises, interest rate rises, consumption later issubstituted with consumption now.

Increases (Decreases) in Aggregate Demanddue to:

1) Increases (Decreases) in Expectedinflation, Income, Profits, Foreign incomesand (Decreases) Increases in Domesticexhcange rate.

The Economy is in Long-Run Equilibrium At price levels where AD intersects theLRAS.higher prices = excess supply & downwardpressure on production and priceslower prices = excess demand & upwardpresssure on production and prices.


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The Economy is in Short-Run Equilibrium At output levels above/belowFull-employment GDP (LRAS)If below LRAS = recession & downwardpressure on wages & prices.If above LRAS = inflationary pressure onwages & prices.Changes in Money Wages (and other resourceprices) cause SAS to shift, bringing theeconomy back to LR equilibrium

If aggregate demand and LRAS grow at thesame rate, what should happen to Inflation &real GPD?

No inflation change and an increase in realGDP.

Stagflation recession combined with inflation

A change in the amount of capital in theeconomy will lead to

a change in the SRAS curve, assumingworkers' inflation expectations are unchanged.why?

b/c result in more productive work force,increasing potential GDP. This will shift boththe LRAS & SRAS curves. Assuming nochange in the money wage rate, an increase inthe price level will cause the quantity of realGDP that is supplied to increase, resulting ina movement along the same SRAS. Also,increase in Demand will result in a greaterquantity supplied hence movement along thesame SAS.

3 Schools of Macroeconomic Thoughts 1) Classical; 2) Monetarists; 3) Keynesian &New Keynesian

Classical 1) Shifts in AS & AD are driven by changesin technology; 2)Money wages change torestore LRe @ Full employment; 3)Taxes areprimary impediment to LRe (DWL)Economy is self-regulating

Monetarist 1) Unpredictables changes in monetary policyare the cause of deviations fromfull-employment GDP; 2) Recession due toinappropriate decreases in money supply; 3)Recommend: Follow steady and predictablemonetary policy (steady growth of moneysupply) and taxes should be kept lowEconomy is self-regulating


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Keynesian 1) Shifts in AD are caused by changes inexpectations (confidence & investments);2)Business cycles caused by shift in AD; 3)Wages "downward sticky" not flexible soSAS adjusts slowly; 4) Recommend:Increases in AD to restore full employmentvia fiscal or monetary policy

New Keynesian Prices of other factors also 'sticky' notflexible

Measures of Money M1 & M2 M1 = currency + Travellers' checks +checking accountsM2 = M1 + time & saving deposits + moneymarket mutual funds

Function of Depository Institutions 1) Create liquidity; 2) Act as financialintermediaries; 3) Pool default risks

How Banks Create Money 1) fraction of deposit held in reserves; 2)Remainder can be loaned (excess reserves);3) Quantity of money increases with amultiplier effect;

Monetary base: Fed notes, coins, and banks' reserves depositsat the Fed.Size of monetary base restricts the totalamount of money that can be created.

Change in Money Supply - change in monetary base x money multiplier

The lower the desired reserve ratio and thelower the currency drain results in

greater money multiplier

Federal Reserve Policy Tools 1) Discount rate; 2) Reserve requirements(least used); 3) Open market operations (mostused)

Federal Reserve Policy Tools - Discount rate Rate at which banks can borrow reservesfrom the Fed.- Lower discount rates increase money supply& decrease interest rates;- Higher discount rates decrease moneysupply & increase interest rates

Federal Reserve Policy Tools - ReserveRequirements

Least usedHigher % decreases money supply & increaseinterest rates;Lower % increases money supply &decreases interest rates


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Federal Reserve Policy Tools - Open marketoperations

Most usedFed buying & selling Treasury Securities.Fed purchases increases cash for lending,decreases interest rates.Fed sales remove cash, increasing interestrates

Fed's Balance Sheet - Assets Primarily Treasury securities, gold, depositswith other central banks, IMF special drawingrights, loans to banks at the discount rate

Fed's Balance Sheet - Liabilities US currency in circulation; bank reservedeposits

Determinants of Money Demand 1) Interest rates (most critical); 2) Inflation(increases demand for nominal money); 3)Real GDP growth (increases the demand fornominal and real money).

Supply of Money Determined by the central bank independentof interest rates. (vertical supply curve)

Influences of Financial Innovations & Effecton Demand of Money

1) changes in economic environment; 2)Technology; 3) RegulationReduce demand for money include:1) ATM; 2) Internet Banking; 3) credit cardusages;

Goals & Targets of the Fed 1) keep inflation low (stable prices); 2)Maintain full employment; 3) Smoothbusiness cycles; 4) Promote economic growth(Moderate long-term interest rates)

Effect of Money on Real GDP (LRAS) -Increase in Money Supply will:

Decrease nominal and real interest ratesCheaper current consumption and investmentsDollar depreciates -> more exportsShort run: AD, real GDP, and price levelsincreaseLong run: full-employment GDP

If the interest rate increases opportunity cost of holding money willincrease and therefore demand decreases

Quantity Theory of Money equation Money Supply (M) x Velocity (V) = Price (P)x Real output (Y)

Velocity = average # of times per year each dollar isused= GDP/ Money


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Quantity Theory of Money (assumingvelocity & real output does NOT change)

an increase in the money supply will cause aproportional increase in price.in other words: growth in money supply inexcess of the growth rate of real GDP isinflationary

what is the LR & SR impact of an increase inmonetary base while at full GDP?

SR: Increase in real GDP, Employment andPrice levelLR: Increase in Price level only

Demand-pull inflation Results from an increase in aggregate demand-Increases in AD that increases equilibriumGDP above full-employment GDP inShort-run.Unemployment below natural rate, lead toincrease in real wages.Increased wages shift (decrease) SRAS,resulting in new equilibrium offull-employment GDP @ higher prices.Demand-pull inflation will cont. if gov'tcontinues fiscal or monetary policies that areincreasing AD.

Cost-push inflation Results from a decrease in aggregate supply-Unexpected increases in the real price offactor inputs such as wages or energy.SRAS decreases (***** up and to the left),results in SRe below full-employment GDPand higher prices.If gov't responds wiht monetary orfiscal policy to increase AD, equilibriumGDP can be increased to full-employmentGDP but at higher prices.Sustained cost-push inflation happends wheninput costs cont. to increase and thegov't cont. to make policy changes thatfurther increase AD.

Nominal Rate = Real Rate + ExpectedInflation

Higher inflation -> higher nominal ratesFaster Money Supply (MS) growth -> highernominal rates

Inflation & Unemployment Actual Inflation= expected -> remain @ fullemployment (LRPC is vertical atfull-employment real GDP= natural rate ofunemployment)

Actual Inflation> expected -> employmentincreasesActual Inflation< expected -> employmentdecreases


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Mainstream Business Cycle Theory Potential GDP (LAS) grows at a steady ratewhile AD growth fluctuatesAD grows faster than LAS = expansionAD grows slower than LAS = contractionIncludes Classical, Keynesian, and Monetaristschools of thoughts

Phillips Curve Short run Phillips curve, level ofUNemployment is negatively related toinflation.(think N in unemployment = negativelyrelated)HENCE employment is positively related toinflation.

Phillips Curve - change in expected inflationwill

shift short-run phillips curve but NOT thelong-run phillips curve.

Real Business Cycle Theory Think: "real random"Random fluctuations in productivity are themain source of economic fluctuations

Fiscal Policy = Government tax and spendingBalanced budgetsbudget deficits -> dissavingsbudget surpluses -> savings

Fiscal Policy Supply Side Effects 1) Income taxes reduce incentive to work(hence reduce supply of labor only); 2)Expenditure taxes reduce purchasing powerof wages (hence reduce the real wage rate); 3)Reduce potential GDP

Laffer Curve Increases in tax rates increase tax revenueonly up to some tax rate (difficult todetermine) (Hence higher income tax rate mayresult in a decrease in tax revenue b/c itdecreases the supply of labor)

Fiscal Policy - Sources of Investment 1) Investment financed by gov't savings; 2)national savings; 3) borrowing from foreigners-Captial income tax reduce returns oninvestments.

Crowding out effect When gov't borrows to finance the federalbudget deficit, tendency for businesses toreduce investment.In other words, increased deficits raiseinterest rates and reduce private investments.


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Generational Effects of Fiscal Policy Gov't expenditures that are NOT funded bycurrent taxes.Studies show that over half of fiscalimbalance will be paid by future generations(medicare)

Discretionary fiscal policy (counter cyclical) 1) Increase gov't spending and reduce taxrates during recession2) Cut gov't spending and raise tax ratesduring inflationary period

Fiscal Multiplier Effect Expenditure multiplier (increased gov'tspending increases AD) > tax multiplier(increase in tax decrease consumption)HENCE an equal increase in both taxes andexpenditures will increase GDP.Therefore balanced budget multiplier ispositive

Fiscal Policy Limitation 1) Recognition delay (recognizing bubbles);2) Administrative delay (passing laws); 3)Impact delay (too late)

Discretionary fiscal policy multiplier effect 1) Gov't purchase multiplier: $1 in gov'tspending causes >$1 increase in AD; 2) Taxmultiplier: less impact than gov't multiplier;3) Balanced Budget multiplier: Increase inspending coupled with an equal increase intaxes = positive effect on AD.

Automatic stabilizers (counter cyclical) 1) Induced taxes: graduated tax = Econ boom-> higher tax bracket; Econ downturn -> lowertax bracket2) Needs- tested spending: more money ispaid out as umemployment increases

Monetary Policy (Federal Reserve) DecisionMaking Strategies

1) Instrument rule: Sets FFR based on currenteconomic state. Taylor Rule:FFR = 2% + inflation + 0.5(inflation - 2%) +0.5(output gap)2) Targeting rule (Inflation) sets FFR so thatthe forecast of inflation is equal to the targetinflation rate, 2%

How does the Fed operationalize their goals? by focusing on 1) core inflation (differencesbetween actual and target inflation rates; and2) output gap (differences between acutal andpotential GDP)

Monetary Policy (Federal Reserve) 1) Increase in MS decreases Fed Funds Rate(FFR); 2) Decrease in MS increases FFR; 3)Implemented by open market operations


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To maintain maximum employment whenoutput is positive (negative):

positive output = inflationary gap, FED sellsecuritiesnegative output = recessionary gap, Feds buysecurities

To determine price stability, the Feds: Monitor CPI which excludes food & fuel

To moderate long-term interest rates, the Feds work to keep long-term real interest ratesclose to long-term nominal interest rates.

Open Market Operations (TransmissionMechanism) during recessionary gap(negative output gap)

1) Fed buys Treasuries, excess reserves, FFRfalls2) Other short-term rates fall3) Longer-term rates fall4) Business expand investment (AD up)5) Domestic currency value falls importsdown/exports up (AD up)6) Consumer (financed) purchases increase(AD up)Opposite during inflationary gap (positiveoutput gap)

Federal Reserve Open Market Operationsdetermines the

supply of bank reserves

Limitations with Open Market Operations(trasmission mechanism)

1) No link between FFR and LT rates (FFRclosely linked to ST int. rates); 2) MSincrease can increase inflation and LT rates;3) Lag between monetary policy and effectscan lead to expansion and contraction atwrong times

Alternative Strategies/Drawbacks 1) Targeting growth of monetary base(McCallum rule): cycles can still result fromfluctuation in AD; 2) Targeting growth ofmoney supply (Friedman's k-percent rule):result in fluctuation in AD and velocity; 3)Target the foreign exchange rate: inflationwould be that of foreign countries; 4) Inflationtargeting: less flexible, may or may not bebetter.

Freidman's k-percent rule A money targeting rule that works whendemand for money is stable and predictable.If the demand for money is unpredictable, themoney target rule becomes unreliable.

The main functions of a central bank are 1) issuing currency; 2) setting monetarypolicy; 3) controlling the MS; 4) regulatingthe banking system; 5) assessing and reactingto economic and financial conditions

When Marginal Product (MP) is at its Max Marginal Cost (MC) is at its Min


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Marginal Product (MP) intersects AP at the point where AP is at it's maximumAP is at its Max AVC is at its Minimum

Describes the relationship between marginalcost (MC), average variable cost (AVC),marginal product (MP), and average product(AP)

When MP = AP, MC = AVC.

In the short run, if price is below average totalcost (ATC) the firm will:

keep running as long as it is covering itsvariable costs

An increase in the supply of capital, assumingno change in the demand for capital, will:

cause the equilibrium interest rate to fall.

A firm operating under perfect competitionwill experience economic losses when:

Market price is less than average total cost.P < ATC

A monopolist will continue expanding outputas long as:

The optimum behavior of all firms is toproduce until the point where MR = MC. So,the monopolist can increase total profit byincreasing production as long as marginalrevenue is greater than marginal costs.

When MR = MC = P, economic profit equals Total Revenue - Total Cost

What would be the impact of an unanticipatedincrease in aggregate demand (AD) on aneconomy's rate of unemployment, rate ofinflation, and the short-run Phillips curve(SRPC)?

1) Decrease in rate of unemployment; 2)Increase in rate of inflation; 3) Upwardmovement along the Phillips curve (SRPC)


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CFA Level 1 - Economics Flashcards _ Quizlet