Economics for investment decision makers

ECONOMICS FOR

INVESTMENT

DECISION

MAKERS

CFA Institute is the premier association for investment professionals around the world, with

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ECONOMICS FOR

INVESTMENT

DECISION

MAKERS

Micro, Macro, and International Economics

Christopher D. Piros, CFA

Jerald E. Pinto, CFA

Cover Design: Leiva-Sposato

Cover Image: ª Maciej Noskowski / iStockphoto

Copyright ª 2013 by CFA Institute. All rights reserved.

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Library of Congress Cataloging-in-Publication Data:

Economics for investment decision makers : micro, macro, and international economics / Christopher

D. Piros and Jerald E. Pinto, editors.

p. cm. — (CFA institute investment series)

Includes bibliographical references and index.

ISBN 978-1-118-10536-8 (cloth); ISBN 978-1-118-41880-2 (ebk);

ISBN 978-1-118-53316-1 (ebk); ISBN 978-1-118-41624-2 (ebk)

1. Supply and demand. 2. Microeconomics. 3. Macroeconomics. 4. Investments.

I. Piros, Christopher Dixon. II. Pinto, Jerald E.

HB171.5.E3356 2013

330—dc23

2012034395

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

CONTENTS

Foreword xiii

Acknowledgments xvii

About the CFA Institute Investment Series xix

CHAPTER 1

Demand and Supply Analysis: Introduction 1

Learning Outcomes 1

1. Introduction 2

2. Types of Markets 3

3. Basic Principles and Concepts 4

3.1. The Demand Function and the Demand Curve 5

3.2. Changes in Demand versus Movements along the Demand Curve 7

3.3. The Supply Function and the Supply Curve 10

3.4. Changes in Supply versus Movements along the Supply Curve 11

3.5. Aggregating the Demand and Supply Functions 13

3.6. Market Equilibrium 17

3.7. The Market Mechanism: Iterating toward Equilibrium—or Not 19

3.8. Auctions as a Way to Find Equilibrium Price 24

3.9. Consumer Surplus—Value minus Expenditure 28

3.10. Producer Surplus—Revenue minus Variable Cost 30

3.11. Total Surplus—Total Value minus Total Variable Cost 32

3.12. Markets Maximize Society’s Total Surplus 32

3.13. Market Interference: The Negative Impact on Total Surplus 34

4. Demand Elasticities 40

4.1. Own-Price Elasticity of Demand 41

4.2. Own-Price Elasticity of Demand: Impact on Total Expenditure 46

4.3. Income Elasticity of Demand: Normal and Inferior Goods 47

4.4. Cross-Price Elasticity of Demand: Substitutes and Complements 48

4.5. Calculating Demand Elasticities from Demand Functions 49

5. Summary 51

Practice Problems 53

v

CHAPTER 2

Demand and Supply Analysis: Consumer Demand 59

Learning Outcomes 59

1. Introduction 59

2. Consumer Theory: From Preferences to Demand Functions 60

3. Utility Theory: Modeling Preferences and Tastes 60

3.1. Axioms of the Theory of Consumer Choice 61

3.2. Representing the Preference of a Consumer: The Utility Function 62

3.3. Indifference Curves: The Graphical Portrayal of the Utility Function 63

3.4. Indifference Curve Maps 66

3.5. Gains from Voluntary Exchange: Creating Wealth through Trade 66

4. The Opportunity Set: Consumption, Production, and Investment Choice 70

4.1. The Budget Constraint 70

4.2. The Production Opportunity Set 72

4.3. The Investment Opportunity Set 74

5. Consumer Equilibrium: Maximizing Utility Subject to the Budget Constraint 75

5.1. Determining the Consumer’s Equilibrium Bundle of Goods 75

5.2. Consumer Response to Changes in Income: Normal and

Inferior Goods 76

5.3. How the Consumer Responds to Changes in Price 77

6. Revisiting the Consumer’s Demand Function 78

6.1. Consumer’s Demand Curve from Preferences and Budget Constraints 78

6.2. Substitution and Income Effects for a Normal Good 79

6.3. Income and Substitution Effects for an Inferior Good 82

6.4. Negative Income Effect Larger than Substitution Effect:

Giffen Goods 83

6.5. Veblen Goods: Another Possibility for a Positively Sloped

Demand Curve 85

7. Summary 86

Practice Problems 87

CHAPTER 3

Demand and Supply Analysis: The Firm 89

Learning Outcomes 89

1. Introduction 89

2. Objectives of the Firm 90

2.1. Types of Profit Measures 91

2.2. Comparison of Profit Measures 95

3. Analysis of Revenue, Costs, and Profits 96

3.1. Profit Maximization 97

3.2. Productivity 127

4. Summary 135

Practice Problems 136

vi Contents

CHAPTER 4

The Firm and Market Structures 143

Learning Outcomes 143

1. Introduction 143

2. Analysis of Market Structures 144

2.1. Economists’ Four Types of Structure 144

2.2. Factors That Determine Market Structure 146

3. Perfect Competition 149

3.1. Demand Analysis in Perfectly Competitive Markets 149

3.2. Supply Analysis in Perfectly Competitive Markets 158

3.3. Optimal Price and Output in Perfectly Competitive Markets 159

3.4. Factors Affecting Long-Run Equilibrium in Perfectly

Competitive Markets 161

4. Monopolistic Competition 163

4.1. Demand Analysis in Monopolistically Competitive Markets 166

4.2. Supply Analysis in Monopolistically Competitive Markets 166

4.3. Optimal Price and Output in Monopolistically Competitive Markets 167

4.4. Factors Affecting Long-Run Equilibrium in Monopolistically

Competitive Markets 168

5. Oligopoly 169

5.1. Demand Analysis and Pricing Strategies in Oligopoly Markets 169

5.2. Supply Analysis in Oligopoly Markets 176

5.3. Optimal Price and Output in Oligopoly Markets 178

5.4. Factors Affecting Long-Run Equilibrium in Oligopoly Markets 178

6. Monopoly 179

6.1. Demand Analysis in Monopoly Markets 181

6.2. Supply Analysis in Monopoly Markets 182

6.3. Optimal Price and Output in Monopoly Markets 184

6.4. Price Discrimination and Consumer Surplus 185

6.5. Factors Affecting Long-Run Equilibrium in Monopoly Markets 187

7. Identification of Market Structure 188

7.1. Econometric Approaches 189

7.2. Simpler Measures 189

8. Summary 191

Practice Problems 192

CHAPTER 5

Aggregate Output, Prices, and Economic Growth 197

Learning Outcomes 197

1. Introduction 198

2. Aggregate Output and Income 198

2.1. Gross Domestic Product 200

2.2. The Components of GDP 208

Contents vii

2.3. GDP, National Income, Personal Income, and Personal

Disposable Income 211

3. Aggregate Demand, Aggregate Supply, and Equilibrium 217

3.1. Aggregate Demand 217

3.2. Aggregate Supply 230

3.3. Shifts in Aggregate Demand and Supply 232

3.4. Equilibrium GDP and Prices 245

4. Economic Growth and Sustainability 256

4.1. The Production Function and Potential GDP 257

4.2. Sources of Economic Growth 259

4.3. Measures of Sustainable Growth 264

5. Summary 270

Practice Problems 273

CHAPTER 6

Understanding Business Cycles 279

Learning Outcomes 279

1. Introduction 279

2. Overview of the Business Cycle 280

2.1. Phases of the Business Cycle 280

2.2. Resource Use through the Business Cycle 284

2.3. Housing Sector Behavior 292

2.4. External Trade Sector Behavior 293

3. Theories of the Business Cycle 294

3.1. Neoclassical and Austrian Schools 295

3.2. Keynesian and Monetarist Schools 296

3.3. The New Classical School 299

4. Unemployment and Inflation 303

4.1. Unemployment 304

4.2. Inflation 307

5. Economic Indicators 319

5.1. Popular Economic Indicators 320

5.2. Other Variables Used as Economic Indicators 325

6. Summary 327

Practice Problems 328

CHAPTER 7

Monetary and Fiscal Policy 333

Learning Outcomes 333

1. Introduction 334

2. Monetary Policy 335

2.1. Money 336

2.2. Roles of Central Banks 348

viii Contents

2.3. Objectives of Monetary Policy 351

2.4. Contractionary and Expansionary Monetary Policies

and the Neutral Rate 367

2.5. Limitations of Monetary Policy 369

3. Fiscal Policy 374

3.1. Roles and Objectives of Fiscal Policy 374

3.2. Fiscal Policy Tools and the Macroeconomy 382

3.3. Fiscal Policy Implementation: Active and Discretionary

Fiscal Policy 388

4. The Relationship between Monetary and Fiscal Policy 392

4.1. Factors Influencing the Mix of Fiscal and Monetary Policy 393

4.2. Quantitative Easing and Policy Interaction 394

4.3. The Importance of Credibility and Commitment 395

5. Summary 396

Practice Problems 397

CHAPTER 8

International Trade and Capital Flows 403

Learning Outcomes 403

1. Introduction 403

2. International Trade 404

2.1. Basic Terminology 404

2.2. Patterns and Trends in International Trade and Capital Flows 407

2.3. Benefits and Costs of International Trade 411

2.4. Comparative Advantage and the Gains from Trade 415

3. Trade and Capital Flows: Restrictions and Agreements 424

3.1. Tariffs 424

3.2. Quotas 427

3.3. Export Subsidies 427

3.4. Trading Blocs, Common Markets, and Economic Unions 430

3.5. Capital Restrictions 435

4. The Balance of Payments 436

4.1. Balance of Payments Accounts 438

4.2. Balance of Payments Components 438

4.3. Paired Transactions in the Balance of Payments

Bookkeeping System 440

4.4. National Economic Accounts and the Balance of Payments 445

5. Trade Organizations 451

5.1. International Monetary Fund 451

5.2. World Bank Group 453

5.3. World Trade Organization 454

6. Summary 457

Practice Problems 459

Contents ix

CHAPTER 9

Currency Exchange Rates 465

Learning Outcomes 465

1. Introduction 465

2. The Foreign Exchange Market 467

2.1. Market Functions 473

2.2. Market Participants 478

2.3. Market Size and Composition 482

3. Currency Exchange Rate Calculations 484

3.1. Exchange Rate Quotations 484

3.2. Cross-Rate Calculations 488

3.3. Forward Calculations 492

4. Exchange Rate Regimes 500

4.1. The Ideal Currency Regime 500

4.2. Historical Perspective on Currency Regimes 501

4.3. A Taxonomy of Currency Regimes 503

5. Exchange Rates, International Trade, and Capital Flows 511

5.1. Exchange Rates and the Trade Balance: The Elasticities Approach 512

5.2. Exchange Rates and the Trade Balance: The Absorption Approach 517

6. Summary 521

Practice Problems 524

CHAPTER 10

Currency Exchange Rates: Determination and Forecasting 527

Learning Outcomes 527

1. Introduction 528

2. Foreign Exchange Market Concepts 530

2.1. Arbitrage Constraints on Spot Exchange Rate Quotes 533

2.2. Forward Markets 538

3. A Long-Term Framework for Exchange Rates 547

3.1. International Parity Conditions 549

3.2. Assessing an Exchange Rate’s Equilibrium Level 565

3.3. Tying It Together: A Model That Includes Long-Term Equilibrium 568

4. The Carry Trade 569

5. The Impact of Balance of Payments Flows 573

5.1. Current Account Imbalances and the Determination of Exchange Rates 574

5.2. Capital Flows and the Determination of Exchange Rates 577

6. Monetary and Fiscal Policies 585

6.1. The MundellFleming Model 585

6.2. Monetary Models of Exchange Rate Determination 588

6.3. The Taylor Rule and the Determination of Exchange Rates 589

6.4. Monetary Policy and Exchange Rates—The Historical Evidence 591

6.5. Fiscal Policy and the Determination of Exchange Rates 595

x Contents

7. Exchange Rate Management: Intervention and Controls 597

8. Currency Crises 602

9. Shorter-Term Forecasting Tools 605

9.1. Technical Analysis 606

9.2. Order Flow, Sentiment, and Positioning 608

10. Summary 611

11. Appendix: Currency Codes Used in This Chapter 615

Practice Problems 615

CHAPTER 11

Economic Growth and the Investment Decision 621

Learning Outcomes 621

1. Introduction 622

2. Growth in the Global Economy: Developed versus

Developing Countries 622

2.1. Savings and Investment 625

2.2. Financial Markets and Intermediaries 626

2.3. Political Stability, Rule of Law, and Property Rights 626

2.4. Education and Health Care Systems 626

2.5. Tax and Regulatory Systems 627

2.6. Free Trade and Unrestricted Capital Flows 627

2.7. Summary of Factors Limiting Growth in Developing Countries 628

3. Why Potential Growth Matters to Investors 631

4. Determinants of Economic Growth 635

4.1. Production Function 635

4.2. Capital Deepening versus Technological Progress 637

4.3. Growth Accounting 640

4.4. Extending the Production Function 641

4.5. Natural Resources 642

4.6. Labor Supply 645

4.7. Labor Quality: Human Capital 649

4.8. Capital: ICT and Non-ICT 650

4.9. Technology 653

4.10. Public Infrastructure 657

4.11. Summary 657

5. Theories of Growth 663

5.1. Classical Model 664

5.2. Neoclassical Model 664

5.3. Endogenous Growth Theory 677

5.4. Convergence Debate 680

6. Growth in an Open Economy 684

7. Summary 694

Practice Problems 696

Contents xi

CHAPTER 12

Economics of Regulation 703

Learning Outcomes 703

1. Introduction 703

2. Overview of Regulation 704

2.1. Classification of Regulations and Regulators 704

2.2. Economic Rationale for Regulation 707

2.3. Regulatory Tools 710

3. Regulation of Commerce 715

4. Regulation of Financial Markets 719

5. Cost-Benefit Analysis of Regulation 720

6. Analysis of Regulation 722

6.1. Effects of Regulations 724

7. Summary 728

Practice Problems 729

Glossary 731

References 745

About the Editors 751

About the CFA Program 753

Index 755

xii Contents

FOREWORD

The opportunity to learn economics from a book sponsored by CFA Institute is a special

privilege.

Most economics textbooks are written by one or two authors who decide what subjects

should appear in them. The results invariably reflect the values and life experiences of the

authors, who usually are academics. Academic authors have written many truly excellent

economics textbooks on their own, but these sometimes do not speak to the needs of learners

whose interest in economics stems from a desire to understand and solve practical economic

problems that they regularly encounter, or expect to encounter, in their working lives.

In contrast, highly respected practicing financial analysts and senior academic economists

worked together to select the topics that appear in this book. The topics were chosen from the

body of knowledge that the CFA Institute Education Advisory Committee identified as topics

that CFA Program candidates need to learn for earning the well-regarded Chartered Financial

Analyst (CFA) designation. The Candidate Body of Knowledget consists of the knowledge,

skills, and abilities that are necessary to analyze and solve common practical problems that

arise in investing, valuing investments or companies, and managing portfolios.

This volume is an edited compilation of readings on economics from the CFA Program

curriculum. The chapters are written by highly regarded economists and practitioners

who were asked to present the topics in a way that is readily accessible to everyone. The

authors were chosen by CFA Institute for the depth of their understanding of the topics

assigned to them and also for their proven ability to effectively teach the topics.

The readings in the CFA Program curriculum always start with a set of learning outcome

statements (LOS) that briefly and clearly state what candidates should know after completing

the reading. The editors have included the LOS associated with each topic covered in this

text to assist you with your learning. If you can confidently and honestly say that you

understand the knowledge described in the various learning outcome statements, you will have

mastered the knowledge presented in this book.

The CFA Program curriculum also includes practice problems at the end of every reading.

These problems allow CFA Program candidates to practice solving practical problems and to

measure their learning progress. The editors have included many of these problems (and some

others as well) in a workbook to help you learn the material.

For students interested in possibly earning the CFA charter, this book is an excellent

introduction to what would be in the CFA Program curriculum. If that is not your objective,

don’t fret. The topics presented in this volume are of universal interest, and it provides an

excellent introduction to economics for all readers.

xiii