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LEVEL 1 REVIEW ECONOMICS

STUDY SESSION 4:

Study session 4 in the CFA Level I curriculum covers microeconomic analysis and is composed of four readings (13-16). The material
on economics concludes in study session 5 with macroeconomic analysis and is worth 10% of your total exam score.

While the material may get detailed at points, larger concepts and ideas are the key for most of your points in the economics
section. The Institute isn’t expecting you to become a chief economist at some bank just by virtue of the curriculum. Get the big
picture down and how it affects the investment decision-making process and move on to the “core” topic areas like FRA and equity.

Intro to Demand and Supply

Understand the difference between substitutes and complements and how price and demand is affected. A price increase for a
substitute causes demand for the other product to increase while an increase for a complement drives down demand for the
product.

Shifts versus movement along the supply/demand curves is easily testable and a fundamental concept. Remember that a change in
price represents movement along the curves while changes in other variables (income, expectations, technology, number of
buyers/sellers, price of related goods) will cause a shift in the curve.

Figuring out the areas under the curve can be a pain but is also something that has shown up on the exams. Remember your basic
math: Area = ½ (base * height) and the terminology (consumer and producer surplus, deadweight loss, effects of a ceiling or floor on
prices)

Consumer Demand

The terminology and interaction here is probably the more important part. Remember the income effect and substitution effect
reacts from a change in price and how the changes are different for normal versus inferior goods

The Firm

Understanding how the terminology fits together mathematically is a big part of the reading (i.e. Total revenue minus explicit and
implicit costs equals economic profit). There is a lot here and figuring out all the curves can be a pain for those that did not get it in
their fundamental college course. For me, reading through the material only put me to sleep. The best way to understand the
material is to work through problems and use the answers to understand how everything fit together.

Firms will produce as long as their marginal revenue (MR) is greater than marginal costs (MC)

The breakeven price is the point at which economic profit equals the average total cost (P = AR = MR = ATC or where TR =
TC)

If MR is greater than MC then profit can be increased by increasing output

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If MR is less than MC then profit can be increased by decreasing output

When TR is less than TVC then the firm will shut down (short-run) and exit (long-run)

The differences between long-run and short-run decisions are important.

In the short-run, the firm can continue to operate even if TR is less than TFC and TVC. However, the industry will contract as existing
firms leave over the long-run. If TR is greater than TC then firms will continue to operate in the short-run but the industry will attract
competitors in the long-run.

The Firm and Market Structures

The reading is a huge relief after the previous one because the material is largely conceptual and fairly easy to grasp. The differences
between the four market structures is key and the best way to see how they compare is to make yourself a table with: number of
sellers, degree of differentiation, barriers to entry, pricing power of firm, non-price competition, firm demand, allocative efficiency
and long-run profits.

Along with the table, make a quick note on the characteristics and advantages of each structure.

Perfect competition: Free entry and exit to industry with low barriers, homogenous products and a large number of
buyers/sellers means sellers are price takers, efficient allocation of resources and only a normal profit

Monopolistic competition: many buyers/sellers with some product differentiation but entry/exit is low-cost, firms have
some control over price but must advertise

Oligopoly: few sellers offering similar or identical products (close substitutes), barriers to entry/exit are high and firms have
substantial control of price. Understand the terminology behind duopoly, collusion and cartels

Monopoly: single seller and product, high barriers to entry and significant control over resources/price.

While the material in monopolistic competition and oligopoly is important, the curriculum seems to focus more time on the
extremes and how they relate to supply/demand analysis.

STUDY SESSION 5:

Study session five in the CFA Level 1 curriculum covers macroeconomic analysis (reading 17-19). Again, the Institute is not expecting
you to become a star economist with these readings so do not get bogged down in the details. There are a few basic equations that
may be testable but you should focus on the concepts and definitions.

Aggregate Output, Prices and Economic Growth

This is largely a definitional reading to set up for further issues. Understand the components within GDP (household, business,
government, and net exports) and the issues with measuring it. Additionally, understand the components of GDP by the expenditure
method: consumer spending, business gross fixed investment, change in inventories, government spending, government gross fixed
investment, and net exports.
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Understand the difference between GDP and National Income and the components of NI: employee compensation, enterprise
profits before taxes, interest income, proprietor’s income, rent, and indirect business taxes.

A matrix is helpful to learn the short- and long-run changes in the aggregate supply/demand curve given various changes.
Understand the determinants of the curves and which way a shift will occur.

An increase in stock prices, housing prices, consumer or business confidence, capacity util, government spending, bank reserves, or
global growth will cause a rightward (higher) shift in aggregate demand.

An increase in labor supply, natural resources supply, human or physical capital, productivity or technology, expectations for future
prices, or subsidies will cause a rightward shift in the short-run aggregate supply though expectations and subsidies will not affect
the long-run curve (the others will affect both curves). An increase in nominal wages, input prices, and taxes will cause a leftward
shift in the short-run aggregate supply curve but will have no impact on the long-run.

Understand the sources of economic growth: labor, human and physical capital, technology, and natural resources (you will need to
know how they affect growth according to different theories in a future reading).

Understanding Business Cycles

A matrix chart is again useful here with economic activity on the vertical axis and cycle points on the horizontal.

Employment

Layoffs slow and net employment turns positive in early expansion (recovery) with businesses first turning to overtime and
temp workers

Full time hiring picks up and the unemployment rate falls in late expansion

The rate of hiring slows but the unemployment rate continues to fall at the peak

Hiring freezes and hours are cut followed by outright layoffs in contraction (recession)

Consumer and Business Spending

Cyclical sectors start to pick up in early expansion and consumer spending increases

Increase in spending is broad-based with construction and capital spending pickup in late expansion

Spending continues to expand but the growth rate of spending slows at peak

Industrial production, housing, consumer and durable goods fall first in recession

Inflation

Remains moderate and may continue to fall in early expansion

Starts to increase in late expansion

Accelerates at peak

Decelerates but with a lag in recession

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This list is abbreviated and you may want to expand it with further detail but remember to stick to the broader concepts.

Understand how an increase/decrease in foreign GDP growth should affect forex rates and trade (i.e. when the domestic currency
appreciates then imports should increase through cheaper foreign goods and decrease net exports).

The rest of the reading is devoted to a discussion on the various theories. Again, understand the definitions and how each theory
says the economy works as well as basic criticism of each. The most you will see (in my opinion) is definitional and comparison
questions on these rather than detailed procedural stuff.

Understand the definitions for unemployment and how it is calculated as well as issues with NARU AND NAIRU. Understand the
basic definitions for the components of leading, coincident and lagging indicators.

Monetary and Fiscal Policy

The quantity theory of money is easily testable but a pretty basic calculation. MV = PY or the quantity times the velocity of money
equals the average price level times real output. Understand the basic theory and what it means for inflation.

Lists like monetary policy tools are important on the exams because they cover broad conceptual ideas and are easily worked into
questions. Central banks have three primary tools: open market operations buying or selling government bonds, changing the policy
or discount rate, and changing the reserve requirement for banks. Understand the basic process behind using each of these and the
effect on the economy.

Lists of limitations to a policy or measure are also important. Understand the basics of monetary policy tools like problems with the
transmission mechanism, bond market vigilantes, deflationary traps and liquidity traps.

Fiscal policy and its effect on aggregate demand is important. Understand the difference between automatic stabilizers and
discretionary policy.

The key to the reading is the relationship between monetary and fiscal policy. Build out a chart with easy versus restrictive policy on
one axis and monetary/fiscal policy on the other.

Easy fiscal/tight monetary: higher output and rates with expansion in public sector

Tight fiscal/easy monetary: lower rates and expansion of private sector

Easy monetary/easy fiscal: higher aggregate demand and lower rates with both public and private sector growth

Tight monetary/tight fiscal: higher rates and lower aggregate demand

STUDY SESSION 6:

International Trade and Capital Flows

The reading is almost completely conceptual and just a series of lists, theories and competing models. The most testable material is
often the comparison between theories or models, so understand basic advantages/disadvantages of each.
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Understand the different impacts of tariffs, quotas and subsidies across the economy. Producer surplus increases while the
consumer surplus decreases under these trade policies. The effect on the government is mixed with an increase from tariffs,
decreasing revenue from an export subsidy and dependent results on import quotas.

Prices in the importing country increase under a tariff and quota system while domestic consumption falls under all three trade
policies. Domestic production generally increases though at the expense of national welfare.

Currency Exchange Rates

The material on foreign exchange rates can get tough but you have to build a good understanding. It is not only easily testable on
the Level I exam but will also be an important part of the curriculum in the other two exams. Failure to understand the basic
concepts here only means that you will need to spend the time to learn them in subsequent years.

Understand the differences between currency futures and forwards. As an exchange product, futures are available only at a fixed
contract amount and for settlement on fixed dates. Collateral (margin) must be posted and is marked-to-market on a daily basis.
Liquidity is much higher for futures and there is no counterparty risk. Forwards are OTC agreements between private parties so will
be much more flexible in terms of amount, settlement and collateral. They are not as liquid and include counterparty risk.

The real points here and through the other two exams, are in your ability to do the rate calculations. First understand the difference
between a direct and indirect quote. The direct quote will have the domestic currency last (i.e. after the slash) and in terms of one
unit of the currency. $1.37/Euro is the direct quote for euros in the US dollar. One euro costs $1.37 dollars.

Be able to calculate and determine depreciation/appreciation in a currency as well as the forward rate. Cross rates and arbitrage are
easily testable and will really test whether you understand forex quotes and calculations- triangular arbitrage

Beyond the basic function of the currency regimes, the advantages and disadvantages are the most important part here. A few times
drilling yourself on flash cards should be enough to be able to pick these out of a list if questioned on the exam.

The material on capital flows and currency rates is largely theoretical so understand the general concepts. Understand the difference
between the elasticity’s approach and the absorption approach. The basic idea behind the Marshall-Lerner condition is that demand
for imports and exports is price sensitive so that increases in relative prices will lead to a changing trade balance that can be
managed through devaluations of the domestic currency. Under the absorption approach, depreciation will improve the trade
balance only for a short period through the wealth effect, and that is only under an economy operating under full employment.