CFA® Level I

Study Session #4

Topic: Investment Tools -

Macroeconomic Analysis and Policy

Instructor: Prof. John M. Veitch, CFA

2005 CFA®

REVIEWPROGRAMOFFERED BY SASF

Security Analysts of San Francisco

CFA Level I – Study Session #4

Modern Macroeconomics:

A Brief Overview

3

The Economy in the Long Run

1. All markets all clear, prices and quantities adjust.

2. Real Output, Y• Set by levels of capital, labor, and technology.• Production function Y = F(K, L); LRAS vertical.

3. Real Interest Rate, r• Determined by Loanable Funds Market equilibrium.• Savings from private and public (gov’t budget) sectors.• Investment demand from private firms.

4. Price level, P and Inflation rate, p• Quantity Theory: MV = PY• Price level determined by level of Money Supply.• Inflation rate = money growth – real output growth

4

The Economy in the Long Run

5. Nominal Interest rate, i

• Expected (or ex ante) Real interest rate determined by Loanable Funds market.

• Nominal Interest rate determined by Expected Real Interest Rate, re, and Expected Inflation, pe, as:

i = re + pe

6. Actual versus Expected Real Interest Rate

• Actual Real Interest rate, r, differs from Expected Real Interest rate, re, when expected inflation does not equal actual inflation.

re = i - pe vs. r = i - p

5

The Market for Loanable Funds

I1(r)

Real Interest

Rate, r

Loanable Funds0

r1

L1

S1 (r)Real Interest rate set by equilib. between savings and investment.

1

S2(r)

1. Increase in Budget Deficit reduces Public Saving, so Supply of Funds falls.

r222. Real interest rate rises.

L2

3

3. Savings/investment falls. “Crowding Out” as gov’t displaces private invest.

6

The Economy in the Short Run

1. Markets may not clear, prices are sticky.

2. Real Output, Y• Determined by downward-sloping Aggregate Demand, AD,

and upward-sloping SR Aggregate Supply, SRAS.• May have real GDP above or below LRAS level in SR.

3. Price level, P and Inflation rate, p• Determined by AD and SRAS equilibrium with Y.• Inflation rate also affected by expectations.

4. Real Interest Rate, r• Determined by Money Market equilibrium.

5. Monetary & Fiscal Policies• Gov’t policies may change AD and/or SRAS in SR.

7

Linking Economy in SR & LR

Price LevelP

Income, Output, Y

LRAS

P1LR

SRAS1

AD1

3.Pe

- increase in Pe shifts SRAS up. 3. Change in expected price

SRAS2

AD2

1. AD Curve shifts out- Price expectations fixed

1.

YSR

2. In SR: Higher YSR and PSR

PSR 2.

P2LR

4.4. In LR: back to YLR at

higher Price level.

YLR

CFA Level I – Study Session #4.1A

Economic Fluctuations, Unemployment, and Inflation

9

Business Cycle

a) explain the phases of the business cycle;

Business cycle – fluctuations in the general level of economic activity in an economy as measured by changes variables such as real GDP, employment, and unemployment. Business cycles consist of distinct phases:Business Peak: When most businesses in the economy are operating at capacity, real GDP is growing rapidly and unemployment has fallen. It is not sustainable over a long period and thus leads to;

Contraction: Aggregate business conditions slow, real GDP growth falls and may even turn negative, and unemployment begins to rise.Recessionary trough: Is the point at which the economic slowdown reaches its lowest. From this point onward aggregate economic activity tends to rise;Expansion: When aggregate economic activity completely recovers from the previous slowdown. Real GDP growth rises, firms begin to increase their capacity utilization, and unemployment begins to fall.

10

Measuring Unemployment

b) describe the key labor market indicators and discuss the problems in measuring unemployment;

Key labor market indicators are:Civilian Labor Force: Number of persons 16 years of age or greater who are either employed or are actively seeking work.

Unemployed: Person who is not currently employed who is either (1) actively looking for a job or (2) waiting to begin or return to a job.

Labor Force Participation Rate: Number of persons in the civilian labor force who are 16 years or older who are either employed or actively seeking work as a percentage of the total civilian population 16 years of age or older.

Unemployment Rate: Percentage of persons in the labor force who are currently unemployed.

Problems in measuring unemployment include; 1. do not count discouraged workers as unemployed because they have

given up looking for jobs; 2. do not adjust for underemployed workers, those working part-time who

would prefer to be working full-time, and 3. do not count non-market employment such as stay-at-home

fathers/mothers as employed, even though they would be considered “employed” if working as maids, cooks, or nannies.

11

Types of Unemployment

c) describe the three types of unemployment;Frictional Unemployment: Due to changes in the economy that prevent qualified workers from being immediately matched up with existing job openings. Frictional unemployment arises from incomplete information on the part of both employers and the unemployed.

Structural Unemployment: Due to the structural characteristics of the economy that make it difficult for job seekers to find employment and employers to hire workers. Generally arises as result of mismatches between existing labor force skills and employer skill needs.

Cyclical Unemployment: Due to business cycle fluctuations in overall economic activity. Unemployment rises during recessionary periods and falls during expansionary periods.

d) define and explain full employment and the natural rate of unemployment;

Full Employment: Level of employment that results from the efficient use of the labor force after making allowance for the normal rate of unemployment consistent with information costs, dynamic changes and structural characteristics of the economy.

Natural Rate of Unemployment: Long-run average level of unemployment due to frictional and structural conditions in the economy’s labor markets. This level is not set in stone but rather is affected by dynamic economic change and public policy over time.

12

Inflation

e) define inflation and calculate the inflation rate;

Inflation: The sustained rise in the general level of prices of goods and services in the economy. Annual inflation rate is calculated as the percent change in a chosen price index (PI).

1

1

Inflation rate 100t tt

t

PI PI

PI-

-

-= ´

13

Inflation

f) discuss the harmful consequences of inflation.

Anticipated Inflation: An increase in the general level of prices that was expected by most decision-makers on the economy.

Unanticipated Inflation: An increase in the general level of prices that was not expected by most decision-makers on the economy.

1. Unanticipated inflation alters the outcome of long-term projects, increases the risks of long-term investment activities, and reduces the amount of long-term investment. Less investment today is likely to lead to lowers levels and growth of output in the future.

2. Inflation distorts the information contained in prices. Distorts signals of scarcity or plenty contained in prices, reducing the effectiveness of markets and harming economic activity.

3. High and variable rates of inflation lead people try to protect themselves from inflation risk. This is likely to harm current production as resources are devoted to inflation protection.

CFA Level I – Study Session #4.1B

Fiscal Policy

15

Fiscal Policy

a)a) explainexplain the process by which fiscal policy affects aggregate demand and aggregate supply;

• Fiscal policy affects AD directly through gov’t spending & indirectly through effects of taxes on consumption and investment.

• Taxes may affect AS by changing incentives for workers and firms.

• Fiscal policy can be restrictive (i.e. lowers AD) or expansionary (raises AD).

b)b) explainexplain the importance of the timing of changes in fiscal policy and the difficulties in achieving proper timing;

• Recognition lag, implementation lag before policy passed, effectiveness lag before policy works. If timed correctly can stabilize economy, if not policy will bring more instability (usually in opposite direction).

16

Fiscal Policy

c)c) discussdiscuss the impact of expansionary and restrictive fiscal policy based on the basic Keynesian model, the crowding-out model, the new classical model, and the supply-side model;

1. Keynesian model assumes SRAS upward-sloping. If economy is in recession (below LRAS), expansionary fiscal policy shifts out AD, moves economy back to LRAS.

2. Crowding out model similar but notes expansionary fiscal policy raises gov’t deficit, which changes interest rates and exchange rates. These changes lower investment and net exports, partly offsetting expansionary fiscal policy.

3. New Classical model believes fiscal policy has no effect because any change in deficit (from spending or tax changes) is offset by changes in private savings behavior.

4. Supply-side model believes tax changes affect productivity and so can increase equilibrium output in long run.

17

Fiscal Policy

d) explain how and why budget deficits and trade deficits tend to be linked.

• Nat’l Income identity Y = C + I + G + NX– Rearrange yields: Y- C - G = I + NX or (Y-C-T) + (T-G) = I + NX(Y-C-T) + (T-G) = I + NX

– Where Y-C-T = Private Saving = S, T-G = Budget Balance

• If S and I fixed, then increase in Budget Deficit, {(T-G) more negative}, implies that NX more negative, ie. larger Current Account Deficit.

e)e) identifyidentify automatic stabilizers and explainexplain how they work , etc.

• Automatic stabilizers are fiscal policies that automatically promote budget deficits during recessions and surpluses during booms.

• Examples are unemployment compensation, corporate profits tax, and progressive income tax. These policies affect AD in ways that offset economic fluctuations.

18

Fiscal Policy

f)f) discussdiscuss the supply-side effects of fiscal policy.• Changes in tax rates, particularly marginal tax rates, affect aggregate supply

through their impact on the relative attractiveness of productive activity in comparison top leisure and tax avoidance.

• Supply-side tax cuts are a long-term growth-oriented strategy that will eventually increase both SRAS and LRAS.

g)g) explainexplain the relationships among budget deficits, inflation, and real interest rates;

• In theory, higher gov’t budget deficits should lead to higher real interest rates by loanable funds market analysis. In practice effect is not as strong as expected.

• Higher gov’t budget deficits may lead to higher inflation rates if gov’t finances deficit by printing money.

CFA Level I – Study Session #4.1C

Money and the Banking System

20

Money & the Banking System

a)a) definedefine and explainexplain the three basic functions of money;

• At a theoretical level, money supply consists of assets that acts as:

– Medium of Exchange - facilitates transactions (liquidity).– Unit of Account - used to quote prices.– Store of Value - transfer purchasing power to future.

b)b) definedefine the money supply;

• At a practical level, U.S. money supply defined by 3 widely-used measures: M1, M2, M3;

1.1. M1M1 = Currency + Traveler’s Checks + Demand Deposits + Other Checkable Deposits

2.2. M2M2 = M1 + Savings Deposits + Small Time Deposits + Money Mkt. Mutual Funds

3.3. M3M3 = M2 + Large Time Deposits + Term Repo’s

21

c) describe the fractional reserve banking system;• Commercial Bank activities:

• Accept Deposits : Hold Reserves : Make LoansAccept Deposits : Hold Reserves : Make Loans • Reserves are vault cash or deposits at central bank,

• required by central bank to hold minimum level against deposits.

• Reserve requirement, rr. Required Reserves = rr x Deposits• Bank activities summarized by a Bank Balance Sheet

Deposits = $100Reserves = $10

Loans = $90

Assets Liabilities

Commercial Bank

(rr = .10)

Money & the Banking System

22

Fractional Reserve Banking

Reserves

Loans

Deposits

Assets LiabilitiesBANK ONE

Reserves

Loans

Deposits

Assets Liabilities

$160

$640

Reserves

Loans

Deposits

Assets Liabilities

BANK TWO

BANK THREE

$800

$128

$512

“Money Multiplier”

Process

$1,000 1 M=+$1,000$200

$800

Reserve Requirementrr = .2

2 M=(1-rr)(1000) = 800

$640

3 M=(1-rr)2(1000) = 640

23

Banks and Money Creation

a) Banks accept deposits, hold fraction in reserve, lend out rest.

b) Reserve-deposits ratio minimum is regulated: reserve requirement, rr.

c) New loans made create new deposits, increasing the money supply.

d) Process is known as financial intermediation.

MONEY CREATION PROCESSMONEY CREATION PROCESS

Original Deposit = 1,000

Bank One Lending = (1-rr)x1000

Bank Two Lending = (1-rr)2 x1000

Bank Three Lending = (1-rr)3 x1000

and so on _____________

Total Total MMss = [1 + (1-rr) + (1-rr)2

+ (1-rr)3 + …] x $1,000

= (1/rr) x $1,000(1/rr) x $1,000 = $5,000= $5,000

a) In a fractional reserve banking system, banks create money.

24

d)d) explainexplain the relationship between reserve ratio, potential deposit expansion multiplier, and actual deposit expansion multiplier.

1. Potential Deposit Expansion Multiplier = 1/(Reserve Requirement)

– Maximum potential increase in the money supply as a ratio of new reserves injected into the banking system

2. Actual Deposit Expansion Multiplier

– Multiple by which a change in reserves changes the money supply

– Inversely related to the reserve requirement

– Smaller than the Potential Deposit Expansion Multiple to the extent that:

i. Persons hold currency rather than deposit it in the banking system

ii. Banks fail to lend out all excess reserves, i.e. banks choose to hold reserves in excess of the legal minimum required.

Money & the Banking System

25

e)e) describe describe the tools the central bank can use to control the money supply and explainexplain how a central bank can use monetary tools to implement monetary policy and explain .

1. Open Market Operations• Purchase or sale of gov’t bonds by the central bank.• Open Market purchase of bonds by central bank increases reserves

at banks, banks lend excess reserves, and money supply increases.

2. Reserve Requirements • Gov’t regulates banks’ minimum reserve-deposit ratios.• Increase in reserve requirements, lowers money multiplier, and so

decrease money supply as banks call loans to build up reserves.

3. Discount Rate• Interest rate on reserves borrowed from central bank.• Lower discount rate, cheaper borrowed reserves, more reserves

borrowed by banks, banks increase loans, which increases deposits in banking system, thus increasing money supply.

Money & the Banking System

26

f)f) discussdiscuss potential problems in measuring an economy’s money supply.

• Growth rate of money supply generally used to gauge monetary policy. Money supply measures subject to changes due to structural shifts & financial innovations.

1. Use of U.S. $ outside of U.S. – US$ acts as international vehicle currency in international transactions, illegal activities, dollarisation, etc.

2. Shifts from interest-bearing checking accounts to MMDA’s – checking accounts in M1 but MMDA’s only in M2. Distorts M1 vs. M2 measures.

3. Increased availability of low-fee stock and bond mutual funds – Not counted in money measures but increasingly liquid, act as near-money.

4. Debit cards and electronic money – Reduce reasons to hold currency, may transfer transaction balances outside banking system.

Money & the Banking System

CFA Level I – Study Session #4.1D

Monetary Policy

28

Monetary Policy

a)a) discussdiscuss the determinants of the demand for and supply of money;

• Market for Money:

• Money Supply: Ms= M0

• Set by the Central Bank using monetary policy instruments.

• Money Demand: Md= P*L(r, Y)• Interest rate is opportunity cost of holding money.• Transaction demand depends on Real GDP, Y and on the level of

prices, P, in the economy.

• Equilibrium: M/P = L(r, Y)• Keynesian Theory of Liquidity Preference says real interest rate

moves to equate demand and supply at any level of real GDP, Y.

29

Effects of Monetary Policy

MD(P0)AD0

P0

Y0

MS0

r0

InterestRate

Money Output

PriceLevelMS1

1.

r1

2.

AD1

SRASLRAS

YSR

3.

PSR3.

Real

PLR

4.

4.

30

b)b) discussdiscuss how anticipation of the effects of monetary policy can reduce the policy’s effectiveness;

• To the extent that the effects of monetary policy are fully anticipated, they exert little impact on real activity, only nominal variables change.

• Expectations of inflation will affect nominal interest rates quickly, keeping real interest rate constant, reducing impact on AD.

• Escalator clauses in wages automatically raise costs, shifting SRAS & economy more quickly back towards LRAS.

Monetary Policy

31

c)c) identifyidentify the components of the equation of exchange, and discuss the implications of the equation for monetary policy.

• Quantity Equation states MV = PY – Y = Real GDP, P = Implicit GDP Price Deflator, M = Money

Supply, Velocity = V = # times per year $1 used to buy output.

• Assume Velocity is constant– Then a change in the money supply, M, must result in the same

proportionate change in Nominal GDP, PY. – This is equivalent to saying that expansionary monetary policy

shifts out the aggregate demand curve. – How this increase is split between a price increase and an increase

in output depends on the slope of the Short Run Aggregate Supply curve.

Monetary Policy

32

Inflation is everywhere and always a monetary phenomenon” Milton Friedman, Nobel Laureate Economics

d)d) describedescribe the quantity theory of money, and discuss its implications for the determination of inflation;

1. Quantity Equation states:

m + v = p + yy = growth of real GDP p = inflationm = growth rate of money supply v = growth rate of velocity

2. Quantity Theory assumes:– Velocity is constant (or that growth rate of velocity = v is constant).

3. Implications for Long Run Inflation Rate: – Monetary policy affects only price level and inflation assuming

velocity constant or varies predictably. – Real Output, Y, determined by other factors.

4. LR inflation rate equals growth rate of money in excess of the growth rate of real GDP i.e. p = m – y

33

e)e) compare and contrastcompare and contrast the impact of monetary policy on major economic variables in the short-run and long-run, when the effects are anticipated or unanticipated;

1. See Fig. 4.1C (previous) for SR vs. LR effects of monetary policy on economy when policies are initially unanticipated.

2. When policies are anticipated SR effects are less and LR effects occur more rapidly.

3. Unanticipated Expansionary Monetary Policy Effects: • Real Output, Y

• SR – Increase in Real GDP LR – Returns to LRAS.• Inflation Rate, p

• SR – Prices (inflation) riseLR – Prices (inflation) rise further.• Real Interest rate, r

• SR – Decrease in r. LR – Returns to original level.

Monetary Policy

CFA Level I – Study Session #4.1E

Stabilization Policy, Output,

and Employment

35

Leading Indicators & Forecasts

a.a. describedescribe the composition and use of the index of leading economic indicators;

• The index of leading indicators is a composite index of 11 key variables that generally turn down prior to a recession and turn up prior to a recovery. Changes in the index are used to forecast future changes in the state of the economy but there is significant variability in the lead time of the index, and hence the index is not always an accurate indicator of the economy’s future.

1. Length of the average work week in hours.

2. Initial weekly claims for unemployment compensation.

3. New manufactures orders. 4. % of companies receiving slower deliveries from suppliers.

5. Contracts & orders for new plant & equipment.

6. Permits for new housing starts.

7. Change in unfilled orders for durable goods.

8. Change in sensitive materials prices.

9. Change in S&P 500 index. 10. Change in money supply (M2).

11. Index of consumer expectations

36

Time Lags & Policy Effects

b.b. discussdiscuss the time lags that may influence the performance of discretionary monetary and fiscal policy;

1. Recognition lag: – Time between when policy needed to stabilize and when need recognized by

policymakers. – Length of this lag is the same for both monetary and fiscal policy and depends on

ability of economic forecasters to accurately predict future state of the economy.2. Administrative or implementation lag:

– Time between when the need for the policy is recognized and when the policy is actually implemented.

– Monetary policy tends to be implemented quickly, therefore it has a short implementation lag.

– Fiscal policy is implemented by Congress and the President, therefore it tends to have a long implementation lag.

3. Impact or Effectiveness lag: – Time period after a policy is implemented but before the policy actually begins to

affect the economy. – Monetary policy tends to have a long and variable impact lag. – Fiscal policy affects the economy immediately thus it has a short impact lag.

• If timed correctly can stabilize economy, if not policy will bring more instability (usually in opposite direction).

37

c)c) explainexplain the role expectations play in determining the effectiveness of fiscal and monetary policy;

1. Adaptive Expectations hypothesis: – Individuals base their future expectations on actual outcomes in the

recent past. (Backward-looking)

2. Rational Expectations hypothesis: – Individuals weigh all available evidence, including information

about probable effects of current & future economic policy, when forming expectations about future economic events. (Forward-looking)

a) Expectations determine how quickly SRAS adjusts to changes in AD Curve, leading the economy back to LRAS.

• Fiscal & monetary policies (expansionary & restrictive) will be less effective when people anticipate their effect on prices more quickly.

Stabilization Policy

38

c)c) explainexplain a non-activist strategy for monetary and fiscal policy.

1. Monetary Policy Rules: MV=PY• Money Growth Target:Money Growth Target: Money growth should be determined by

Quantity Theory (Monetarists).• Nominal GDP Target:Nominal GDP Target: Money growth adjusted to keep Nominal

GDP growing at target rate.• Price Level Target:Price Level Target: Money growth adjusted to keep Price level

within some target range of growth.

2. Fiscal Policy Rules:• Balanced Budget Rule:Balanced Budget Rule: Fiscal Policy sets Budget Deficit = 0.

Problem is makes economy more unstable.• Stabilizing GDP:Stabilizing GDP: Fiscal policy sets automatic stabilizers (income

taxes, transfers). Cyclical Deficits and Surpluses.

Stabilization Policy

CFA Level I – Study Session #4.1F

The Phillips Curve: Is There a Trade-off between Inflation and Unemployment

40

Inflation & Unemployment

a.a. describedescribe the Phillips Curveb.b. discussdiscuss the trade-off between unemployment and inflation in the

context of expectations.• See the slides that follow this one for discussion of Phillips Curve.• Unanticipated higher inflation reduces real wages, expands production, reduces

unemployment below natural rate, UN. • Once the higher inflation is recognized, real wage adjusts back to normal,

unemployment returns to UN and output returns to LRAS.• Under Adaptive Expectations, individuals underestimate future inflation when

rate is rising. • Temporary trade-off of higher inflation & lower unemployment.. • Once the higher inflation is recognized, trade-off disappears.

• Under Rational Expectations, individuals do not systematically under- or over-estimate future inflation.

• Very temporary trade-off of higher inflation & lower unemployment.. • Higher inflation recognized very rapidly and trade-off disappears.

41

Shift in AD Curve: SR vs LR

Price LevelP

Income, Output, Y

LRAS

P1LR

SRAS1

AD1

3.Pe

- increase in Pe shifts SRAS up. 3. Change in expected price

SRAS2

AD2

1. AD Curve shifts out- Price expectations fixed

1.

YSR

2. In SR: Higher YSR and PSR

PSR 2.

P2LR

4.4. In LR: back to YLR at

higher Price level.

YLR

42

Phillips Curve “Tradeoff”

Inflation

Unemployment, U

1

1. In the SR there is a tradeoff betweeninflation and unemployment.

uN

= e0 + (u - uN) +

2. Tradeoff depends on e fixed in SR.

e0

e1

3. In LR, if actual different from e thene adjusts to actual , shifting curve.

= e1 + (u - uN) +

i.e.e1e

0

43

Details of the Phillips Curve

1. Sources of shifts in Phillips Curve trade-off:

p = pp = pee - b(u - u - b(u - uNN) + u b > 0) + u b > 0

2. Changes in inflation expectations, ppee.• Adaptive expectations: p pee = p = p-1-1 inertia in Phillips

curve.• Rational Expectations: use all info. available to set pe

including expected fiscal & monetary policy.3. “Demand-Pull” inflation, (u - u(u - uNN). ).

• Higher aggregate demand leads to lower cyclical unemployment and higher inflation.

4. “Cost-Push” Inflation, uu.• Adverse supply shock (u > 0) tends to raise inflation.