ECONOMICS FOR

INVESTMENT
DECISION
MAKERS
Micro, Macro, and International Economics

Christopher D. Piros, CFA

Jerald E. Pinto, CFA

Wl LEY

CONTENTS
Foreword

xiii

Acknowledgments

xvii

About the CFA Institute Investment Series

xix

CHAPTER 1
Demand and Supply Analysis: Introduction
Learning Outcomes
1. Introduction
2. Types of Markets
3. Basic Principles and Concepts
3.1. The Demand Function and the Demand Curve
3.2. Changes in Demand versus Movements along the Demand Curve
3.3. The Supply Function and the Supply Curve
3.4. Changes in Supply versus Movements along the Supply Curve
3.5. Aggregating the Demand and Supply Functions
3.6. Market Equilibrium
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3.7. The Market Mechanism: Iterating toward Equilibriumor Not
3.8. Auctions as a Way to Find Equilibrium Price
3.9. Consumer SurplusValue minus Expenditure
3.10. Producer SurplusRevenue minus Variable Cost
3.11. Total SurplusTotal Value minus Total Variable Cost
3.12. Markets Maximize Society's Total Surplus
3.13. Market Interference: The Negative Impact on Total Surplus
4. Demand Elasticities
4.1. Own-Price Elasticity of Demand
4.2. Own-Price Elasticity of Demand: Impact on Total Expenditure
4.3. Income Elasticity of Demand: Normal and Inferior Goods
4.4. Cross-Price Elasticity of Demand: Substitutes and Complements
4.5. Calculating Demand Elasticities from Demand Functions
5. Summary
Practice Problems

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Contents

CHAPTER 2
Demand and Supply Analysis: Consumer Demand
Learning Outcomes
1. Introduction
2. Consumer Theory: From Preferences to Demand Functions
3. Utility Theory: Modeling Preferences and Tastes
3.1. Axioms of the Theory of Consumer Choice
3.2. Representing the Preference of a Consumer: The Utility Function
3.3. Indifference Curves: The GraphicaTPortrayal of the Utility Function
3.4. Indifference Curve Maps
3.5. Gains from Voluntary Exchange: Creating Wealth through Trade
4. The Opportunity Set: Consumption, Production, and Investment Choice
4.1. The Budget Constraint
4.2. The Production Opportunity Set
4.3. The Investment Opportunity Set
5. Consumer Equilibrium: Maximizing Utility Subject to the Budget Constraint
5.1. Determining the Consumer's Equilibrium Bundle of Goods
5.2. Consumer Response to Changes in Income: Normal and
Inferior Goods
5.3. How the Consumer Responds to Changes in Price
6. Revisiting the Consumer's Demand Function
6.1. Consumer's Demand Curve from Preferences and Budget Constraints
6.2. Substitution and Income Effects for a Normal Good
6.3. Income and Substitution Effects for an Inferior Good
6.4. Negative Income Effect Larger than Substitution Effect:
Giffen Goods
6.5. Veblen Goods: Another Possibility for a Positively Sloped
Demand Curve
7. Summary
Practice Problems

CHAPTER 3
Demand and Supply Analysis: The Firm
Learning Outcomes
1. Introduction
2. Objectives of die Firm
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2.1. Types of Profit Measures

2.2. Comparison of Profit Measures

3. Analysis of Revenue, Costs, and Profits
3.1. Profit Maximization
3.2. Productivity
4. Summary
Practice Problems

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CHAPTER 4
The Firm and Market Structures
Learning Outcomes
1. Introduction
2. Analysis of Market Structures
2.1. Economists'Four Types of Structure
2.2. Factors That Determine Market Structure
3. Perfect Competition
3.1. Demand Analysis in Perfectly Competitive Markets
3.2. Supply Analysis in Perfectly Competitive Markets
3.3. Optimal Price and Output in Perfecdy Competitive Markets
3.4. Factors Affecting Long-Run Equilibrium in Perfecdy
Competitive Markets
4. Monopolistic Competition
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4.1. Demand Analysis in Monopolistically Competitive Markets
4.2. Supply Analysis in Monopolistically Competitive Markets
4.3. Optimal Price and Output in Monopolistically Competitive Markets
4.4. Factors Affecting Long-Run Equilibrium in Monopolistically
Competitive Markets
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5. Oligopoly
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5.1. Demand Analysis and Pricing Strategies in Oligopoly Markets
5.2. Supply Analysis in Oligopoly Markets
5.3. Optimal Price and Output in Oligopoly Markets
5.4. Factors Affecting Long-Run Equilibrium in Oligopoly Markets
6. Monopoly
6.1. Demand Analysis in Monopoly Markets
6.2. Supply Analysis in Monopoly Markets
6.3. Optimal Price and Output in Monopoly Markets
6.4. Price Discrimination and Consumer Surplus
6.5. Factors Affecting Long-Run Equilibrium in Monopoly Markets
7. Identification of Market Structure
7.1. Econometric Approaches
7.2. Simpler Measures
8. Summary
Practice Problems

CHAPTER 5
Aggregate Output, Prices, and Economic Growth
Learning Outcomes
1. Introduction
2. Aggregate Output and Income
2.1. Gross Domestic Product
2.2. The Components of GDP

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Contents
2.3.

GDP, National Income, Personal Income, and Personal

Disposable Income
3. Aggregate Demand, Aggregate Supply, and Equilibrium
3.1. Aggregate Demand
3.2. Aggregate Supply
3.3. Shifts in Aggregate Demand and Supply
3.4. Equilibrium GDP and Prices
4. Economic Growth and Sustainability
4.1. The Production Function and-Potential GDP
4.2. Sources of Economic Growth
4.3. Measures of Sustainable Growdi
5. Summary
Practice Problems

CHAPTER 6
Understanding Business Cycles
Learning Outcomes
1. Introduction
2. Overview of the Business Cycle
2.1. Phases of the Business Cycle
2.2. Resource Use through the Business Cycle
2.3. Housing Sector Behavior
2.4. External Trade Sector Behavior
3. Theories of the Business Cycle
3.1. Neoclassical and Austrian Schools
3.2. Keynesian and Monetarist Schools
3.3. The New Classical School
4. Unemployment and Inflation
4.1. Unemployment
4.2. Inflation
5. Economic Indicators
5.1. Popular Economic Indicators
5.2. Other Variables Used as Economic Indicators
6. Summary
Practice Problems

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328

CHAPTER 7
Monetary and Fiscal Policy

333

Learning Outcomes
1. Introduction
2. Monetary Policy
2.1. Money
2.2. Roles of Central Banks

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Contents
2.3. Objectives of Monetary Policy
2.4. Contractionary and Expansionary Monetary Policies
and die Neutral Rate
2.5. Limitations of Monetary Policy
3. Fiscal Policy
3.1. Roles and Objectives of Fiscal Policy
3.2. Fiscal Policy Tools and die Macroeconomy
3.3. Fiscal Policy Implementation: Active and Discretionary
Fiscal Policy
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4. The Relationship between Monetary and Fiscal Policy
4.1. Factors Influencing die Mix of Fiscal and Monetary Policy
4.2. Quantitative Easing and Policy Interaction
4.3. The Importance of Credibility and Commitment
5. Summary
Practice Problems
'

CHAPTER 8
International Trade and Capital Flows
Learning Outcomes
1. Introduction
2. International Trade
2.1. Basic Terminology
2.2. Patterns and Trends in International Trade and Capital Flows
2.3. Benefits and Costs of International Trade
2.4. Comparative Advantage and die Gains from Trade
3. Trade and Capital Flows: Restrictions and Agreements
3.1. Tarifrs
3.2. Quotas
3.3. Export Subsidies
3.4. Trading Blocs, Common Markets, and Economic Unions
3.5. Capital Restrictions
4. The Balance of Payments
4.1. Balance of Payments Accounts
4.2. Balance of Payments Components
4.3. Paired Transactions in die Balance of Payments
Bookkeeping System
4.4. National Economic Accounts and the Balance of Payments
5. Trade Organizations
5.1. International Monetary Fund
5.2. World Bank Group
5.3. World Trade Organization
6. Summary
Practice Problems

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Contents

CHAPTER 9
Currency Exchange Rates
Learning Outcomes
1. Introduction
2. The Foreign Exchange Market
2.1. Market Functions
2.2. Market Participants
2.3. Market Size and Composition
3. Currency Exchange Rate Calculations
~
3.1. Exchange Rate Quotations
3.2. Cross-Rate Calculations
3.3. Forward Calculations
4. Exchange Rate Regimes
4.1. The Ideal Currency Regime
*
4.2. Historical Perspective on Currency Regimes
4.3. A Taxonomy of Currency Regimes
5. Exchange Rates, International Trade, and Capital Flows
5.1. Exchange Rates and the Trade Balance: The Elasticities Approach
5.2. Exchange Rates and the Trade Balance: The Absorption Approach
6. Summary
Practice Problems

CHAPTER 10
Currency Exchange Rates: Determination and Forecasting
Learning Outcomes
1. Introduction
2. Foreign Exchange Market Concepts
2.1. Arbitrage Constraints on Spot Exchange Rate Quotes
2.2. Forward Markets
3. A Long-Term Framework for Exchange Rates
3.1. International Parity Conditions
3.2. Assessing an Exchange Rate's Equilibrium Level
3.3. Tying It Together: A Model That Includes Long-Term Equilibrium
4. The Carry Trade
5. The Impact of Balance of Payments Flows
5.1. Current Account Imbalances and the Determination of Exchange Rates
5.2. Capital Flows and the Determination of Exchange Rates
6. Monetary and Fiscal Policies
6.1. The Mundell-Fleming Model
6.2. Monetary Models of Exchange Rate Determination
6.3. The Taylor Rule and the Determination of Exchange Rates
6.4. Monetary Policy and Exchange RatesThe Historical Evidence
6.5. Fiscal Policy and the Determination of Exchange Rates

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Contents

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7. Exchange Rate Management: Intervention and Controls

8. Currency Crises
9. Shorter-Term Forecasting Tools
9.1. Technical Analysis
9.2. Order Flow, Sentiment, and Positioning
10. Summary
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11. Appendix: Currency Codes Used in This Chapter
Practice Problems

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CHAPTER 11
Economic Growth and the Investment Decision

621

Learning Outcomes
1. Introduction
*
2. Growth in the Global Economy: Developed versus
Developing Countries
2.1. Savings and Investment
2.2. Financial Markets and Intermediaries
2.3. Political Stability, Rule of Law, and Property Rights
2.4. Education and Health Care Systems
2.5. Tax and Regulatory Systems
2.6. Free Trade and Unrestricted Capital Flows
2,7. Summary of Factors Limiting Growth in Developing Countries
3. Why Potential Growth Matters to Investors
4. Determinants of Economic Growth
4.1. Production Function
4.2. Capital Deepening versus Technological Progress
4.3. Growth Accounting
4.4. Extending the Production Function
4.5. Natural Resources
4.6. Labor Supply
4.7. Labor Quality: Human Capital
4.8. Capital: ICT and Non-ICT
4.9. Technology
4.10. Public Infrastructure
4.11. Summary
5. Theories of Growth
5.1. Classical Model
5.2. Neoclassical Model
5.3. Endogenous Growth Theory
5.4. Convergence Debate
6. Growth in an Open Economy
7. Summary
Practice Problems

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xii

Contents

CHAPTER 12
Economics of Regulation
Learning Outcomes
1. Introduction
2. Overview of Regulation
2.1. Classification of Regulations and Regulators
2.2. Economic Rationale for Regulation
2.3. Regulatory Tools
3. Regulation of Commerce
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4. Regulation of Financial Markets
5. Cost-Benefit Analysis of Regulation
6. Analysis of Regulation
6.1. Effects of Regulations
7. Summary
*
Practice Problems

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Glossary

731

References

745

About the Editors

751

About the CFA Program

753

Index

755