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CFA Level 1 - Economics flashcards | Quizlet

CFA Level 1 - Economics

241 terms Price Elasticity of Demand Formula Cross Elasticity of Demand Formula Income Elasticity of Demand Formula Price Elasticity of Supply Formula Elasticity of Demand Factors

Created by Jbotros

(% Change in Quantity Demanded) / (%t Change in Price) (% Change in Quantity Demanded) / (% Change in Price of Substitute or Complement) (% Change in Quantity Demanded) / (% Change in Income) (% Change in Quantity Supplied) / (% Change in Price) 1) Availability of Substitute; 2) Relative amount of income spent on the good; 3) Time SINCE price change 1) Available substitutes for resources (inputs) used to produce the goods; (2) the time that has elapsed since the price change Negative = Total Fixed Cost + Total Variable Cost Average Fixed Cost = TFC/Q Average Variable Cost= TVC/Q = AFC + AVC (Number of Unemployed) / (Labor Force) x 100 (Labor Force) / (Working-Age Population(16 or older) ) x 100 (Number of Employed) / (Working-Age Population) x 100 (Cost of Basket of Current Prices) / (Cost of Basket at Base Period Prices) x 100 % change in CPI (Current CPI- Year Ago CPI)/ (Year Ago CPI) X 100

Elasticity of Supply Factors

Income elasticity of an Inferior GoodPositive or Negative Total Cost Formula Average Fixed Cost Formula Average Variable Cost Formula Average Total Cost Formula Unemployment Rate Formula Labor Force Participation Rate Formula Employment to Population Ratio Formula CPI Formula Inflation Rate Formula

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Potential Deposit Expansion Multiplier Formula Potential Increase In Money Supply Formula Money Multiplier for a change in monetary base Formula Change in Quantity of Money Formula Equation of Exchange Formula Quantity Theory of Money Formula What does it mean if Cross elasticity is positive What does it mean if Price Elasticity of Demand is less than one in absolute value? What does it mean if Price Elasticity of Demand is greater than one in absolute value? Normal Goods Elasticity Total Revenue Test

= 1 / (required reserve ratio) = (Potential Deposit Expansion Multiplier) x (Increase in Excess Reserves) (1+c) / (d+c) c = currency as a % of deposits d = desired reserve ratio (Change in Quantity of Money) = (Change in Monetary Base) x (Money Multiplier) = (Money supply) x (Velocity) = GDP = (Price) x (Real Output) Price = M (V/Y) Two goods are reasonable substitutes for each other Inelastic Elastic

Positive Income Elasticity (greater than 1) Estimate elasticity of demand: P Up-> R Up (Inelastic); P Up -> D Down (Elastic) Positive Positive Negative A central authority determines resource allocation, is used in centrally planned economies and is also used within firms and in the military Government policies such as taxation and transfer payments are an example of this type of resource allocation Marginal Benefit to society (Demand) = Marginal Cost for the "last" unit of each good and service to be produced (Supply). (MC = MB)

Cross Elasticity of Substitutes- Positive or Negative Income Elasticity for normal goods- Positive or Negative Income Elasticity for inferior goods- Positive or Negative Command System

Majority Rule

Efficient allocation of resources

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Marginal Cost Formula Two Concepts of Robert Nozick's Anarchy, State, and Utopia (Symmetry)

(Change in Total Cost) / (Change in Output) 1) Governments must recognize and protect private property; 2) Private property must be given from one party to another only when it is voluntarily done HIGHER LOWER, suppliers will bear a higher burden Less TMI 1) Technological, 2) Informational, 3) Market Constraints Output from least inputs Output from least cost CI 1) Command System, 2) Incentive System Organization according to a managerial chain of command, eg US Military [Told what to do] Senior mangement creates a system of rewards intended to motivate workers to perform in such a way as to maximize profits [Motivated to do] Problems that arise when incentives and motivations or managers and workers (Agents) are not the same as the incentives and motivations of their firms. OIL 1) Ownership, 2) Incentive Pay, 3) Long-term contracts PPC 1) Proprietorships, 2) Partnerships, 3) Corporations PMOM 1) Perfect Competition, 2) Monopolitic Competition, 3) Oligopoly, 4) Monopoly The percentage of total industry sales made by the four largest firms in the industry. A highly competitive industry may have a four-firm concentration ratio near zero, while the ratio for monopoly is 100%, < 40% = Competitive Market, >60% is Oiligopy

When demand is less elastic than supplyconsumers bear higher or lower burden When supply is less elastic than demandconsumers bear higher or lower burden Inelastic means more or less DWL Three Constraints to Profit Maximization Technological Efficiency Economic Efficiency Two ways that firms can organize production Command Systems

Incentive System

Principal- Agent Problem

Three Methods used to reduce Principal-Agent Problem Three Types of Business Organizations Four Types of Economic Markets

Four-Firm Concentration Ratio

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Herfinhahl-Hirschman Index (HHI)

Calculated by summing the squared percentage market shares of the 50 largest firm in an industry (or all of the firms in the industry if there were less than 50). The HHI is very low in a highly competitive industry and increases to 10,000 (=100squared) for an industry with only one firm. An HHI between 1,000 and 1,800 is considered moderately competitive, while an HHI greater than 1,800 indicates that it is not competitive NOT Competitive Moderately Competitive Competitive Monopoly Competitve Oligopoly 1) Problems with defining the geographical scope of the market; 2) Barriers to entry and firm turnover are NOT considered; 3) Weak link between market and an industry Includes explicit costs Considers explicit and implicit costs Economic Profit= Total Revenue Opportunity Costs = Total Revenue (Explicit + Implicit Costs) Implied Rental Rate + Normal Profit Term used to describe the opportunity cost to a firm for using its own capital. Sum of Economic Depreciation and Foregone Interest Opportunity cost of Owners' entrepreneurship expertise. It represents what owners could have earned if they used their organizational decision-making and other entreprenurial skills is another activity such as running another business. Producing a given output at the lowest possible cost Using the least amount of inputs to produce a given output

HHI greater than 1,800 HHI between 1,000-1,800 HHI less than 1,000 Four-Firm Concentration Ratio 100% Four-Firm Concentration Ratio less than 40% Four-Firm Concentration Ratio greater than 60% Three limitations to the HHI and Four-Firm Concentration Ratio

Accounting Profits Economic Profit Economic Profit Formula

Implicit Costs Implied Rental Rate

Normal Profit

Economic Efficiency Technological Efficiency

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Income Elasticity of Demand > 0 "positive" Income Elasticity of Demand > 1 0 < Income Elasticity of Demand < 1 Income Elasticity of Demand < 0 = "negative" On Straight-line Demand Curve - High Elasticity On Straight-line Demand Curve - Low Elasticity

Normal Good Luxury Good Necessity Inferior Good Price Increase = Revenue Decrease E > 1 (absolute value) E > I -1 I Price Increase = Revenue Increase E < 1 (absolute value) E < I -1 I Price and Revenue move in the same direction Unitary Elasticity (E = -1) Relatively Inelastic, thus total expenditure on the good increases. Elastic Market Price, Command, Majority Rule, Contest, First-come, First-served, Lottery, Personal Characteristics, Force. 1) Price Control (ceilings & floors); 2) Taxes and trade restricitions (subsidies & quotas); 3) Monopoly; 4) External Costs; 5) External Benefit; 6) Public goods and common resources Difference between total value to consumer and total amount paid by the customer A consumer surplus occurs when the consumer is willing to pay more for a given product than the current market price. Difference between total cost of production and total amount received (market price). Minimum Supply Price Sum of consumer surplus & producer surplus is maximized Utilitarianism & Symmetry Equality of opportunity. economy is based on private property & voluntary exchange

On Straight-line Demand Curve - Greatest Revenue Large Price Increase = Smaller Demand Decrease Small Price Increase = Large Demand Decrease Allocation of Resources - Methods

Obstacles to efficient allocation of productive resources

Consumer Surplus

Producer Surplus Marginal Cost of production is When the efficient quantity is produced the: Fairness Principles Symmetry Principle

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Greatest good occurs to the greatest number of people when wealth is transferred from the rich to the poor to the point where everyone has the same wealth 1) everyone wants and needs the same thing; 2) Marginal benefit of a dollar is greatest for the poor than the rich 1. Excess demand results in Shortage 2. Black market prices > Ceiling Prices Long run impacts: Long waiting, Discrimination, Bribes, Lower Quality no impact no impact 1. Excess supply results in Surplus Long run impacts: Excess supply, substitution in consumption Results in DWL Increase price equilibriums & Decrease quantity equilibrium decrease in total surplus due to an inefficient level of production Refers to who is legally responsible for paying the tax Who actually bears the cost of the tax through an increase in the price paid (buyer) or decrease in the price received (sellers) Downward shift of the demand Increase in Price Equilibrium & Decrease in Demand Equilibrium Upward shift of the supply curve Increase in Price Equilibrium & Decrease in Demand Equilibrium Excess supply of labor; Decrease in non-monetary benefits; DWL from underproduction DWL: Underproduction Marginal Social Benefit (MSB) > Marginal Social Cost (MSC) DWL: Overproduction Marginal Social Benefit (MSB) < Marginal Social Cost (MSC) Increase Qe Decrease Pe to Consumers

Price Ceilings < Price Equilibrium

Price Ceilings > Price Equilibrium Price Floors < Price Equilibrium Price Floors > Price Equilibrium

Tax Impact

Deadweight Loss Statutory Incidence Actual Incidence of Tax

Statutory Incidence on the Buyer (Tax on Buyers) results in Statutory Incidence on the Seller (Tax on Seller) results in Minimum Wage > Price Equilibrium results in

Quotas < Quantity Equilibrium results in


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Tax Incidence if Demand is less elastic Tax Incidence if Supply is less elastic Market for Illegal Goods: Penalties on Sellers Market for Illegal Goods: Penalties on Buyer Market Coordination

Buyer bears higher burden Supplier/Seller bears higher burdern Decrease Supply Decrease Demand occurs when a firm employs resources outside the firm more efficiently than if they relied only on internal resources. (Eg. outsourcing & contracting) Management determines the flow of resources to determine what price to charge and how much to produce Lower transaction costs, economies of scale, scope, and team production. remain unchanged in short-run, therefore should NOT be considered in current decision making. Related to passage of time NOT production. Add'l cost of producing one more unit of output Marginal Product curve (MP) intersects Average Product curve (AP) @ its max. The Q at which AP = maximum = Q for which AVC is at its minimum. LRAC cost is decreasing MC = MR = Price AVC & ATC at their minimum. MC does NOT intersect AFC at min b/c AFC decreases as production increases due to allocation of fixed costs. 1) Homogeneous product; 2) Many small sellers; 3) No barriers to entry/exit; 4) Existing firms doe not have have advantage over new entrants; 5) Consumers and sellers are knowledgeable about prices. 1) small output relative to the market; 2) no influence on price; 3) Horizontal demand curve (perfectly elastic) Zero economic profits = normal return P = MC = ATC

Firm Coordination

Firm Coordination can be more efficient than Market due to: Fixed Costs aka Sunk Costs

Marginal Cost Regarding Cost of Production

Economies of Scale Max Profits - Perfectly Competitive markets produce at quantities Marginal Cost curve (MC) intersects

Features of Perfect Competition

Perfect Competition - Price takers

Perfect Competition - Output in the Long Run

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Perfect Competition - Increase in Demand

Increase in Pe & Qe -> Economic profit -> Firms expand -> New entrants -> LR: zero economic profit Lower (external economies) Higher (external diseconomies) Higher quantitiy, lower price LR: price = min ATC for the new technology -> zero economic profit 1) No good Substitues; 2) Distinguished by higher entry barriers - Legal barriers - gov't licensing & patents - Natural barriers- substantial economies of scale Produce Q where MR = MC Produce in the elastic range of demand curve Higher prices & lower quantities 1) Downward sloping demand curve; 2) Reduce price to increase sales; 3) MR < price 4) MR curve lies below the demand curve 1) DWL; 2) Smaller consumer surplus 3) Rent seeking 1) single-price; 2) price discrimination 1) Firm must have downward sloping demand; 2) Identifiable groups of consumers w/ diff price elasticities of demand 3)Prevent resale between groups 4) charge different prices Results in Higher Economic Profit Yes. 1) No DWL; 2) No consumer surplus; 3) Same quantity as perfect competition Increase output & social welfare May lead to loss, may need subsidy if MC < ATC Issues: Lack of information, quality deterioration, firm lacks incentive to reduce costs, political influence seeking. 1) Innovation incentive; 2) Economies of scale and scope

Perfect Competition - Long Run Price Equilibrium After Permanent Increase in Demand Perfect Competition - Technological changes:

Features of Monopoly

Monopoly - Profit Maximization

Monopoly - Price searcher

Monopoly vs. Perfect Competition Monopoly - Price-setting strategies Price Discrimination

Is Perfect Price Discrimination Efficient? Regulating Natural Monopolies - Average Cost Pricing: Regulating Natural Monopolies - Marginal Cost Pricing:

Gains from Monopoly

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Features of Monopolistic Competition

1) Large # of independent sellers; 2) Differentiated products; 3) Compete on price, quality, and marketing; 4) Low barriers to entry; 5) Downward sloping, highly elastic demand (due to lots of close substitutes) 1) Excess capacity: Q< efficient quantities; 2) Mark up:P>ATC 1) Produce where MR = MC; 2) SR economic profits; 3) LR- new firms enter - zero economic profits (like PC) but price is greater than marginal cost. Unclear b/c (cost vs. benefit) Social costs of not producing at P = MC Benefits due to: information, values from brand names, product innovation/differentiation and advertising. It is possible that the loss resulting form producing an inefficient quantity could be offset by the value gained form product variety.

Monopolistic Competition vs. Perfect Competition Monopolistic Competition - Output in the SR & LR

Monopolistic Competition - Efficiency

Features of Oligopoly

1) significant barriers to entry; 2) Small # of interdependent sellers with incentive to cooperate (faced with prisoners' dilemma) 3) Downward sloping demand curve Model used to analyze oligopoly output restrictions. Best course of action is to enter into a collusive agreement and cheat. 1) Kinked demand curve- follow price decrease only; 2) Dominant firm oligopoly-dominant firm sets price The addition to total revenue from selling one more unit of output The addition to total revenue from selling the additional output from employing one more unit of a productive resource(input) To maximize profits: MRP labor = Price labor 1) Increase in output price; 2) Increase in substitute price; 3) Decrease in complement price; 4) Advances in technology or new capital that increases labor's MP

Oligopoly - Prisoners' Dilemma

Two Oligopoly Models

Marginal Revenue (MR) Marginal Revenue Product (MRP)

Factors Increasing Demand for Labor

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Factors of Elasticity of Demand for Labor

1) Labor intensity (more the better/not automated process); 2) Elasticity of demand for output; 3) Input substitution [Demand for labor is more elastic in the LR vs. SR.] Higher wage results in less leisure, more labor supplied higher income results in more leisure, less labor supplied 1) Size of adult population; 2) Capital accumulation to allow more adults working outside. Labor Union: (collective bargaining/ only group of employees) increase wage rate and reduce employment Monopsony: (single buyer/employer) reduce wage rate and employment b/c MC of an add'l worker > wage. 1) Increase MP of labor via training; 2) Advertise to increase demand for union-made products; 3) Advocate trade restrictions on foreign goods that compete with union-made domestic goods; 4) Reducing the supply or increasing the price of substitutes for union labor (higher min wage & immigration restrictions) 1) PP&E; 2) Inventory (WIP & Finished goods) Pays for physical captial 1) Equity; 2) Debt Securities QD up when Interest Rate down QD down when Interest Rate up Reflect PV of MRP of physical capital in production Supplied by savings - [Increase/(Decrease)] 1) Interest Rates [up/(down)] ; 2) Current Incomes [up/(down)]; 3) Expected Future Income [down/(up)] 1) Elastic supply (horizontal); 2) QSupply determined by Demand; 3) Current Pirce is the PV of the expected price next period. e.g. oil

Supply of Labor - Substitution Effect Supply of Labor - Income Effect Shifts in Labor Supply caused by:

Labor Market Power - Labor Union vs. Monopsony

Labor Market Power - Increase Demand for Labor Union (to offset decrease in employment)

Physical Capital Financial Capital Financial Capital - Demand

Financial Capital - Supply

Natural Resources - Non-Renewable

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Natural Resources - Renewable Economic Rent Economic Rent - Supply Elasticities

1) Inelastic supply (vertical); 2) price is determined by demand e.g. water Difference between actual earnings and opportunity cost of a factor of production 1) Perfectly elastic supply (unskilled labor)no economic rent; 2) Perfectly inelastic supply (golf ability)- max economic rent; 3) Upward sloping supply curve -> some economic rent Money wages adjusted for changes in price level Total hours worked in a year by all employed people Actively looking for work, Laid off, waiting to be called back, Starting a job w/in 30 days 1) Frictional; 2) Structural; 3) Cyclical 1) Frictional; 2) Structural imperfect information and job searches taking time skills being in shortage and the economy changing associated with the business cycle Negative Cyclical may exist (SR) Real GDP > Potential GDP = levels of above full capacity Positive Cyclical Real GDP < Potential GDP = levels of undercapcity unemployment rate = natural rate of umemployment NO cyclical umemployment Real GDP = Potential GDP = # of employed + # of unemployed Includes all people who are either employed or actively seeking employment. DOES NOT include discouraged workers or those who are available for work but are neither employed nor actively seeking (i.e. housewives) Average price for a "basket" of goods and services purchased by a typical urban household (excludes food & fuel/energy)

Real wage rate Aggregate hours Unemployment Three Types of Unemployment: Natural Rate of Unemployment: Natural Rate of Unemployment - Frictional Natural Rate of Unemployment - Structural Unemployment - Cyclical

Economy is at full employment when

Labor Force

Consumer Price Index (CPI)

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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) Outlet substitution 1) Upward sloping supply curve (assumes fixed money wage); 2) Decreases (shifts) with rising wages or expected inflation; 3) Changes in price level are movements along SRAS curve (function of price level) 1) Vertical supply curve at potential GDP (independent of price level); 2) Full employment real output of economy; 3) Increases/(Decreases) with Increases/(Decreases) in quantity of labor, capital, and existing technology. Increases (Decreases) in 1) Quantity of labor; 2) Quantity of capital in the economy; 3)Technology the economy possess. Aggregrate Demand = (Consumption) + (Investment) + (Government Spending) + Net Exports 1) Expectation about incomes, Inflation, and profits; 2) Fiscal & Monetary Policy; 3) The growth rate of the world economy 1) Wealth effect - price increases, individual wealth decreases, therefore save more (spend less); 2) Intertemporal substitution - price level rises, interest rate rises, consumption later is substituted with consumption now. 1) Increases (Decreases) in Expected inflation, Income, Profits, Foreign incomes and (Decreases) Increases in Domestic exhcange rate. At price levels where AD intersects the LRAS. higher prices = excess supply & downward pressure on production and prices lower prices = excess demand & upward presssure on production and prices.

Short-Run Aggregate Supply (SRAS)

Long-Run Aggregate Supply (LRAS)

Increases (Decreases) in Long-Run Aggregate Supply (LRAS) due to: Aggregate Demand Formula (AD)

Aggregate Demand Factors

Aggregate Demand Curve is DownwardSloping Due To:

Increases (Decreases) in Aggregate Demand due to:

The Economy is in Long-Run Equilibrium

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The Economy is in Short-Run Equilibrium

At output levels above/below Full-employment GDP (LRAS) If below LRAS = recession & downward pressure on wages & prices. If above LRAS = inflationary pressure on wages & prices. Changes in Money Wages (and other resource prices) cause SAS to shift, bringing the economy back to LR equilibrium No inflation change and an increase in real GDP. recession combined with inflation a change in the SRAS curve, assuming workers' inflation expectations are unchanged. why? b/c result in more productive work force, increasing potential GDP. This will shift both the LRAS & SRAS curves. Assuming no change in the money wage rate, an increase in the price level will cause the quantity of real GDP that is supplied to increase, resulting in a movement along the same SRAS. Also, increase in Demand will result in a greater quantity supplied hence movement along the same SAS.

If aggregate demand and LRAS grow at the same rate, what should happen to Inflation & real GPD? Stagflation A change in the amount of capital in the economy will lead to

3 Schools of Macroeconomic Thoughts Classical

1) Classical; 2) Monetarists; 3) Keynesian & New Keynesian 1) Shifts in AS & AD are driven by changes in technology; 2)Money wages change to restore LRe @ Full employment; 3)Taxes are primary impediment to LRe (DWL) Economy is self-regulating 1) Unpredictables changes in monetary policy are the cause of deviations from full-employment GDP; 2) Recession due to inappropriate decreases in money supply; 3) Recommend: Follow steady and predictable monetary policy (steady growth of money supply) and taxes should be kept low Economy is self-regulating


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1) Shifts in AD are caused by changes in expectations (confidence & investments); 2)Business cycles caused by shift in AD; 3) Wages "downward sticky" not flexible so SAS adjusts slowly; 4) Recommend: Increases in AD to restore full employment via fiscal or monetary policy Prices of other factors also 'sticky' not flexible M1 = currency + Travellers' checks + checking accounts M2 = M1 + time & saving deposits + money market mutual funds 1) Create liquidity; 2) Act as financial intermediaries; 3) Pool default risks 1) fraction of deposit held in reserves; 2) Remainder can be loaned (excess reserves); 3) Quantity of money increases with a multiplier effect; Fed notes, coins, and banks' reserves deposits at the Fed. Size of monetary base restricts the total amount of money that can be created. change in monetary base x money multiplier greater money multiplier 1) Discount rate; 2) Reserve requirements (least used); 3) Open market operations (most used) Rate at which banks can borrow reserves from the Fed. - Lower discount rates increase money supply & decrease interest rates; - Higher discount rates decrease money supply & increase interest rates Least used Higher % decreases money supply & increase interest rates; Lower % increases money supply & decreases interest rates

New Keynesian Measures of Money M1 & M2

Function of Depository Institutions How Banks Create Money

Monetary base:

Change in Money Supply The lower the desired reserve ratio and the lower the currency drain results in Federal Reserve Policy Tools

Federal Reserve Policy Tools - Discount rate

Federal Reserve Policy Tools - Reserve Requirements

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Federal Reserve Policy Tools - Open market operations

Most used Fed buying & selling Treasury Securities. Fed purchases increases cash for lending, decreases interest rates. Fed sales remove cash, increasing interest rates Primarily Treasury securities, gold, deposits with other central banks, IMF special drawing rights, loans to banks at the discount rate US currency in circulation; bank reserve deposits 1) Interest rates (most critical); 2) Inflation (increases demand for nominal money); 3) Real GDP growth (increases the demand for nominal and real money). Determined by the central bank independent of interest rates. (vertical supply curve) 1) changes in economic environment; 2) Technology; 3) Regulation Reduce demand for money include: 1) ATM; 2) Internet Banking; 3) credit card usages; 1) keep inflation low (stable prices); 2) Maintain full employment; 3) Smooth business cycles; 4) Promote economic growth (Moderate long-term interest rates) Decrease nominal and real interest rates Cheaper current consumption and investments Dollar depreciates -> more exports Short run: AD, real GDP, and price levels increase Long run: full-employment GDP opportunity cost of holding money will increase and therefore demand decreases Money Supply (M) x Velocity (V) = Price (P) x Real output (Y) average # of times per year each dollar is used = GDP/ Money

Fed's Balance Sheet - Assets

Fed's Balance Sheet - Liabilities Determinants of Money Demand

Supply of Money Influences of Financial Innovations & Effect on Demand of Money

Goals & Targets of the Fed

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

If the interest rate increases Quantity Theory of Money equation Velocity =

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

an increase in the money supply will cause a proportional increase in price. in other words: growth in money supply in excess of the growth rate of real GDP is inflationary SR: Increase in real GDP, Employment and Price level LR: Increase in Price level only Results from an increase in aggregate demand -Increases in AD that increases equilibrium GDP above full-employment GDP in Short-run. Unemployment below natural rate, lead to increase in real wages. Increased wages shift (decrease) SRAS, resulting in new equilibrium of full-employment GDP @ higher prices. Demand-pull inflation will cont. if gov't continues fiscal or monetary policies that are increasing AD. Results from a decrease in aggregate supply -Unexpected increases in the real price of factor inputs such as wages or energy. SRAS decreases (***** up and to the left), results in SRe below full-employment GDP and higher prices. If gov&#039;t responds wiht monetary or fiscal policy to increase AD, equilibrium GDP can be increased to full-employment GDP but at higher prices. Sustained cost-push inflation happends when input costs cont. to increase and the gov&#039;t cont. to make policy changes that further increase AD. Higher inflation -> higher nominal rates Faster Money Supply (MS) growth -> higher nominal rates Actual Inflation= expected -> remain @ full employment (LRPC is vertical at full-employment real GDP= natural rate of unemployment) Actual Inflation> expected -> employment increases Actual Inflation< expected -> employment decreases

what is the LR & SR impact of an increase in monetary base while at full GDP? Demand-pull inflation

Cost-push inflation

Nominal Rate = Real Rate + Expected Inflation Inflation & Unemployment

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Mainstream Business Cycle Theory

Potential GDP (LAS) grows at a steady rate while AD growth fluctuates AD grows faster than LAS = expansion AD grows slower than LAS = contraction Includes Classical, Keynesian, and Monetarist schools of thoughts Short run Phillips curve, level of UNemployment is negatively related to inflation. (think N in unemployment = negatively related) HENCE employment is positively related to inflation. shift short-run phillips curve but NOT the long-run phillips curve. Think: "real random" Random fluctuations in productivity are the main source of economic fluctuations Government tax and spending Balanced budgets budget deficits -> dissavings budget surpluses -> savings 1) Income taxes reduce incentive to work (hence reduce supply of labor only); 2) Expenditure taxes reduce purchasing power of wages (hence reduce the real wage rate); 3) Reduce potential GDP Increases in tax rates increase tax revenue only up to some tax rate (difficult to determine) (Hence higher income tax rate may result in a decrease in tax revenue b/c it decreases the supply of labor) 1) Investment financed by gov't savings; 2) national savings; 3) borrowing from foreigners -Captial income tax reduce returns on investments. When gov't borrows to finance the federal budget deficit, tendency for businesses to reduce investment. In other words, increased deficits raise interest rates and reduce private investments.

Phillips Curve

Phillips Curve - change in expected inflation will Real Business Cycle Theory

Fiscal Policy =

Fiscal Policy Supply Side Effects

Laffer Curve

Fiscal Policy - Sources of Investment

Crowding out effect

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Generational Effects of Fiscal Policy

Gov't expenditures that are NOT funded by current taxes. Studies show that over half of fiscal imbalance will be paid by future generations (medicare) 1) Increase gov't spending and reduce tax rates during recession 2) Cut gov't spending and raise tax rates during inflationary period Expenditure multiplier (increased gov't spending increases AD) > tax multiplier (increase in tax decrease consumption) HENCE an equal increase in both taxes and expenditures will increase GDP. Therefore balanced budget multiplier is positive 1) Recognition delay (recognizing bubbles); 2) Administrative delay (passing laws); 3) Impact delay (too late) 1) Gov't purchase multiplier: $1 in gov't spending causes >$1 increase in AD; 2) Tax multiplier: less impact than gov't multiplier; 3) Balanced Budget multiplier: Increase in spending coupled with an equal increase in taxes = positive effect on AD. 1) Induced taxes: graduated tax = Econ boom -> higher tax bracket; Econ downturn -> lower tax bracket 2) Needs- tested spending: more money is paid out as umemployment increases 1) Instrument rule: Sets FFR based on current economic state. Taylor Rule: FFR = 2% + inflation + 0.5(inflation - 2%) + 0.5(output gap) 2) Targeting rule (Inflation) sets FFR so that the forecast of inflation is equal to the target inflation rate, 2% by focusing on 1) core inflation (differences between actual and target inflation rates; and 2) output gap (differences between acutal and potential GDP) 1) Increase in MS decreases Fed Funds Rate (FFR); 2) Decrease in MS increases FFR; 3) Implemented by open market operations

Discretionary fiscal policy (counter cyclical)

Fiscal Multiplier Effect

Fiscal Policy Limitation

Discretionary fiscal policy multiplier effect

Automatic stabilizers (counter cyclical)

Monetary Policy (Federal Reserve) Decision Making Strategies

How does the Fed operationalize their goals?

Monetary Policy (Federal Reserve)

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To maintain maximum employment when output is positive (negative):

positive output = inflationary gap, FED sell securities negative output = recessionary gap, Feds buy securities Monitor CPI which excludes food & fuel work to keep long-term real interest rates close to long-term nominal interest rates. 1) Fed buys Treasuries, excess reserves, FFR falls 2) Other short-term rates fall 3) Longer-term rates fall 4) Business expand investment (AD up) 5) Domestic currency value falls imports down/exports up (AD up) 6) Consumer (financed) purchases increase (AD up) Opposite during inflationary gap (positive output gap) supply of bank reserves 1) No link between FFR and LT rates (FFR closely linked to ST int. rates); 2) MS increase can increase inflation and LT rates; 3) Lag between monetary policy and effects can lead to expansion and contraction at wrong times 1) Targeting growth of monetary base (McCallum rule): cycles can still result from fluctuation in AD; 2) Targeting growth of money supply (Friedman's k-percent rule): result in fluctuation in AD and velocity; 3) Target the foreign exchange rate: inflation would be that of foreign countries; 4) Inflation targeting: less flexible, may or may not be better. A money targeting rule that works when demand for money is stable and predictable. If the demand for money is unpredictable, the money target rule becomes unreliable. 1) issuing currency; 2) setting monetary policy; 3) controlling the MS; 4) regulating the banking system; 5) assessing and reacting to economic and financial conditions Marginal Cost (MC) is at its Min

To determine price stability, the Feds: To moderate long-term interest rates, the Feds Open Market Operations (Transmission Mechanism) during recessionary gap (negative output gap)

Federal Reserve Open Market Operations determines the Limitations with Open Market Operations (trasmission mechanism)

Alternative Strategies/Drawbacks

Freidman's k-percent rule

The main functions of a central bank are

When Marginal Product (MP) is at its Max

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CFA Level 1 - Economics flashcards | Quizlet

Marginal Product (MP) intersects AP at AP is at its Max Describes the relationship between marginal cost (MC), average variable cost (AVC), marginal product (MP), and average product (AP) In the short run, if price is below average total cost (ATC) the firm will: An increase in the supply of capital, assuming no change in the demand for capital, will: A firm operating under perfect competition will experience economic losses when: A monopolist will continue expanding output as long as:

the point where AP is at it's maximum AVC is at its Minimum When MP = AP, MC = AVC.

keep running as long as it is covering its variable costs cause the equilibrium interest rate to fall. Market price is less than average total cost. P < ATC The optimum behavior of all firms is to produce until the point where MR = MC. So, the monopolist can increase total profit by increasing production as long as marginal revenue is greater than marginal costs. Total Revenue - Total Cost 1) Decrease in rate of unemployment; 2) Increase in rate of inflation; 3) Upward movement along the Phillips curve (SRPC)

When MR = MC = P, economic profit equals What would be the impact of an unanticipated increase in aggregate demand (AD) on an economy's rate of unemployment, rate of inflation, and the short-run Phillips curve (SRPC)?

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