Economics CFA" PROGRAM CURRICULUM + VOLUME 2 A® PROGRAM CURRICULU! fe nase 2012onomics A” PROGRAM CURRICULUM * VOLUME 2 (EARLS 2012 ALKA PEARSONCover photograph courtesy of Hector Emanuel. Copyright © 2012, 2011, 2010, 2009, 2008, 2007, 2006 by CFA Institute All rights reserved. ‘This copyright covers material written expressly for this volume by the editor/s as well as the compilation itself. It does net cover the individual selections herein that first appeared elsewhere. Permission to reprint these has been obtained by Pearson Learning Solutions for this edition only. Further reproduction by any means, electronic or mechanical, including photocopying and recording, or by any information storage or retrieval system, must be arranged with the individual copyright holders noted. CFA®, Chartered Financial Analyst®, AIMR-PPS®, and GIPS® are just a few of the trademarks owned by CFA Institute. 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All trademarks, service marks, registered trademarks, and registered service marks are the property of their respective owners and are used herein for identification purposes only. 123456789 10 V313 16 15 14 13 12 11 000200010270652604 AG/IW Please visit our website at www.pearsoned.com TAI AELOINIE sen 10: 0-558-92933-8, ISBN 13: 978-0-558-92933-6CONTEN ECONOMICS STUDY SESSION 4 MICROECONOMIC ANALYSIS 3 READING 1 3 DEMAND AND SUPPLY ANALYSIS: INTRODUCTION 5 INTRODUCTION 6 TYPES OF MARKETS: 7 BASIC PRINCIPLES AND CONCEPTS 9 “The Demand Function and the Demand Curve ° Changes in Demand yz. Movements along the Demand Oure hn The Supply Function and the Supply Curve 8 CChangecin Supply vx Mavement along the Supply Carve B Aggregading the Demand and Supp Functions 0 Market Equilibrium 20 The Market Mechanism: Ierating toward Equilbsium—or Not 3 Aucions ata Way to Find Equilbsium Price ” Consumer Surpis- Value minus Expendiure a Producer Surphus—Revenue minos Variable Cost 33 ‘oul Surplus Value minus Tol Variable Cost % Markets Maximize Socieq's Toul Surplus 36 Market Interference: The Negaive Impact on Total Surplus a DEMAND ELASTICITIES: 44 ‘Ovn-Prie Esty of Demand 4“ (Own Price Elatciy of Demand: Impact on Tol Expendtare « Income Elastic of Demand: Normal and terior Goods a Groseprice Elasticity of Demand: Substitutes and Complement 2 Galcalaing Demand Elaiies from Deinand Functions 33 SUMMARY 38 PRACTICE PROBLEMS FOR READING 13 37 SOLUTIONS FOR READING 13 fl reapine 14 DEMAND AND SUPPLY ANALYSIS: CONSUMER DEMAND os INTRODUCTION 65 CONSUMER THEORY: FROM PREFERENCES TO DEMAND FUNCTIONS 6 UTILITY THEORY: MODELING PREFERENCES AND TASTES. 87 ‘Axioms of the Theory of Consumer Choice 67reavine 15 reaoinc 16 Contents Representing the Preference of a Consumer: The Utility Function Indifference Curves: The Graphical Portrayal of the Utility Function Indifference Curve Maps Gains from Voluntary Exchang : Creating Wealth through Trade THE OPPORTUNITY SET: CONSUMPTION, PRODUCTION, AND INVESTMENT CHOICE ‘The Budget Constraint ‘The Production Opportunity Set ‘The Invesunent Opporuunity Set CONSUMER EQUILIBRIUM: MAXIMIZING UTILITY SUBJECT TO THE BUDGET CONSTRAINT Determining the Consumer's Equilibrium Bundle of Goods Consumer Response to Changes in Income: Normal and Inferior Goods How the Consumer Responds to Changes in Price REVISITING THE CONSUMER’S DEMAND FUNCTION ‘Consumer's Demand Gurve from Preferences and Budget Constraints Substitution and Income Effects for a Normal Good. Income and Substitution Effects for an Inferior Good Negative Income Effect Larger than Substitution Effect Giffen Goods Veblen Goods: Another Possibility for a Positively Sloped Demand Curve SUMMARY PRACTICE PROBLEMS FOR READING 14 SOLUTIONS FOR READING 14 DEMAND AND SUPPLY ANALYSIS: THE FIRM INTRODUCTION OBJECTIVES OF THE FIRM ‘Types of Profit Measures Comparison of Profit Measures ANALYSIS OF REVENUE, COSTS, AND PROFITS Profit Maximization Productivity SUMMARY PRACTICE PROBLEMS FOR READING 15 SOLUTIONS FOR READING 15 THE FIRM AND MARKET STRUCTURES. INTRODUCTION ANALYSIS OF MARKET STRUCTURES Economists’ Four Types of Structure Factors That Determine Market Structure PERFECT COMPETITION Demand Analysis in Perfectly Competitive Markets Supply Analysis in Perfecdy Competitive Markets, Optimal Price and Output in Perfectly Competitive Markets Factors Affecting Long-Run Equilibrium in Perfectly Competitive Markets MONOPOLISTIC COMPETITION Demand Analysis in Monopolistically Competitive Markets Supply Analysis in Monopolistically Competitive Markets BBB 76 81 81 83 84 35 85, 89 90 9 93 9% 7 9 100 101 105 106 106 136 146 148 158 161 170 174 176 Ww 178STUDY SESSION 5 reaoinc 17 reapinc 18 Contents ‘Optimal Price and Output in Monopolistically Competitive Markets Factors Affecting Long-Run Equilibrium in Monopolistically Competitive Markets OLIGOPOLY Demand Analysis and Pricing Strategies in Oligopoly Markets Supply Analysis in Oligopoly Markets ‘Optimal Price and Output in Oligopoly Markets Factors Affecting Long-Run Equilibrium in Oligopoly Markets MONOPOLY Demand Analysis in Monopoly Markets Supply Analysis in Monopoly Markets ‘Optimal Price and Output in Monopoly Markets Price Discrimination and Consumer Surplus Factors Affecting Long-Run Equilibrium in Monopoly Markets IDENTIFICATION OF MARKET STRUCTURE Econometric Approaches Simpler Measures SUMMARY REFERENCES PRACTICE PROBLEMS FOR READING 16 SOLUTIONS FOR READING 16 MACROECONOMIC ANALYSIS AGGREGATE OUTPUT, PRICES, AND ECONOMIC GROWTH INTRODUCTION AGGREGATE OUTPUT AND INCOME Gross Domestic Product The Components of CDP GDP, Nasional Income, Personal Income, and Personal Dispostbe Income AGGREGATE DEMAND, AGGREGATE SUPPLY, AND EQUILIBRIUM. ‘Aggregate Demand Aggregate Supply Shifts in Aggregate Demand! and Supply Equilibrium GDP and Prices ECONOMIC GROWTH AND SUSTAINABILITY The Production Function and Potential GDP Sources of Economic Grow Measures of Sustainable Growth SUMMARY REFERENCES: PRACTICE PROBLEMS FOR READING 17 SOLUTIONS FOR READING 17 UNDERSTANDING BUSINESS CYCLES INTRODUCTION OVERVIEW OF THE BUSINESS CYCLE Phases of the Business Cycle Resource Use through the Business Cycle 178 179 180 180 187 188 189 190 191 192 194 196 198 199 199 200 202 203, 204 208 a a3 24 215 216 293, 287 | 232 233 245 247 260 on a 274 278 285, 288 289 204 297 207 298 303vi reaoinc 19 stupy session 6 reapinc 20 Contents Housing Sector Behavior External Trade Sector Behavior ‘THEORIES OF THE BUSINESS CYCLE Neoclassical and Austrian Schools Keynesian and Monetarist Schools The New Classical Schoo! UNEMPLOYMENT AND INFLATION Unemployment Inflation ECONOMIC INDICATORS Popular Economic Indicators ‘Other Variables Used as Economic Indicators SUMMARY REFERENCES PRACTICE PROBLEMS FOR READING 18 SOLUTIONS FOR READING 18 MONETARY AND FISCAL POLICY INTRODUCTION MONETARY POLICY Money ‘The Roles of Central Banks ‘The Objectives of Monetary Policy Contractionary and Expansionary Monetary Policies and the Neutral Rate Limitations of Monetary Policy FISCAL POLICY Roles and Objectives of Fiscal Policy Fiscal Policy Tools and the Macroeconomy Fiscal Policy Implementation: Active and Discretionary Fiscal Policy THE RELATIONSHIP BETWEEN MONETARY AND FISCAL POLICY Factors Influencing the Mix of Fiscal and Monetary Policy ‘Quantitative Easing and Policy Interaction ‘The Importance of Credibility and Commitment SUMMARY REFERENCES PRACTICE PROBLEMS FOR READING 19 SOLUTIONS FOR READING 19 ECONOMICS IN A GLOBAL CONTEXT INTERNATIONAL TRADE AND CAPITAL FLOWS, INTRODUCTION INTERNATIONAL TRADE Basic Terminology Pawterns and Trends in International Trade and Capital Flows Benefits and Costs of International Trade 310 312 313 313, 315 318. 322 322 326 339 339 429 431 431 492 492 496 439reaping 21 Contents Comparative Advantage and the Gains from Trade TRADE AND CAPITAL FLOWS: RESTRICTIONS AND AGREEMENTS: Tavis Quotas Export Subsidies ‘Trading Bloc, Common Markets, and Economic Unions Capital Restrictions THE BALANCE OF PAYMENTS Balance of Payments Accounts Balance of Payment Components Paired Transactions in the BOP Bookkeeping System ‘National Economic Accounts and the Balance of Payments TRADE ORGANIZATIONS International Monetary Fund World Bank Group World Trade Organization SUMMARY REFERENCES PRACTICE PROBLEMS FOR READING 20 SOLUTIONS FOR READING 20 CURRENCY EXCHANGE RATES INTRODUCTION ‘THE FOREIGN EXCHANGE MARKET ‘Market Functions Market Participants Market Size and Composition CURRENCY EXCHANGE RATE CALCULATIONS Exchange Rate Quotations ‘Cross Rate Calculations Forward Calculations EXCHANGE RATE REGIMES ‘The Ideal Currency Regime Historical Perspective on Currency Regimes A Taxonomy of Currency Regimes EXCHANGE RATES, INTERNATIONAL TRADE, AND CAPITAL FLOWS Exchange Rates and the Trade Balance: The Elasticities Approach Exchange Rates and the Trade Balance: The Absorption Approach SUMMARY REFERENCES PRACTICE PROBLEMS FOR READING 21 SOLUTIONS FOR READING 21 GLOSSARY INDEX vii 452 453, 455 459 467 467 an a4 479 480 482 483 486 489 498 497 497 499 505 on 514 517 517 521 525, 533 583, 534 536 545 546 551 556 558 559 562 Gi HHOW TO USE THE CFA PROGRAM CURRICULUM ‘ongratulations on your decision to enter the Chartered Financial Analyst (CFA®) Program. This exciting and rewarding program of study reflects your desire to ‘become a serious investment professional. You are embarking on a program noted for its high ethical standards and the breadth of knowledge, skills, and abilities it develops. Your commitment to the CFA Program should be ‘educationally and professionally rewarding. The credential you seck is respected around the world as a mark of accom- plishment and dedication, Each level of the program represents a distinct achievement in professional development. Successful completion of the program is rewarded with membership in a prestigious global community of investment professionals. GFA charterholders are dedicated to life-long learning and maintaining currency with the ever-changing dynamics of a challenging profession. The CFA Program represents the first step towards a careerlong. commitment to professional education. ‘The CFA examination measures your degree of mastery of the assigned CFA Program curriculum. Therefore, the key to your success on the examination is to master the Candidate Body of Knowledge (CBOK™), which can be accomplished by reading and studying the CFA Program curriculum, The CBOK contains the core knowledge, skills, and abilities (competencies) that are generally accepted and applied by investment professionals. These competencies are used in practice in a generalist context and are expected to be demonstrated by a recently qualified CFA charterholder. The remaining sections provide background on the CBOK, the organization of the curriculum, and tips for developing an effective study program, Curriculum Development ‘The CFA Program curriculum is grounded in the practice of the investment profession. Utilizing the Global Body of Investment Knowledge (GBIK) collaborative website, CFA Institute performs a continuous practice analysis with, investment professionals around the world to determine the knowledge, skills, and abilities that are relevant to the profession. Regional expert panels and targeted surveys are conducted annually to verify and reinforce the continuous feedback from the GBIK collaborative website. The practice analysis process ultimately defines the CBOK. The CBOK consists of four components: » Abroad topic outline that lists the major top-level topic areas (CBOK Topic Outline) > Topic area weights that indicate the relative exam weightings of the top-level topic areas > Leaming outcome statements (1,OS) that advise candidates about the specific knowledge, skills, and abilities they should acquire from readings covering a topic area (LLOS are provided in online study sessions and at the beginning of each reading) » The curriculum of material (readings and end-of reading questions) that candidates receive upon exam registration and are expected to master A committee consisting of practicing charterholders, in conjunction with GFA Institute staff, designs the CFA Program curriculum to deliver the CBOK to candidates. The examinations, also written by practicing charterholders, areiD Ke WY: How to Use the CFA Program Curriculum designed to allow you to demonstrate your mastery of the CBOK as set forth in the CFA Program curriculum. As you structure your personal study program, you should emphasize mastery of the CBOK and the practical application of that knowledge. For more information on the practice analysis, CBOK, and develop- ‘ment of the CFA Program curriculum, please visit www.cfainstitute.org. Organization of the Curriculum The Level I CFA Program curriculum is organized into 10 topic areas. Each topic area begins with a brief statement of the material and the depth of knowl- edge expected. Each topic area is then divided into one or more study sessions. These study sessions—18 sessions in the Level I curriculum—should form the basic structure of your reading and preparation. Each study session includes a statement of its structure and objective, and is farther divided into specific reading assignments. The outline on the inside front cover of each volume illustrates the organization of these 18 study sessions. The reading assignments are the basis for all examination questions, and are selected ‘or developed specifically to teach the knowledge, skills, and abilities relected in the CBOK. These readings are drawn from CFA Program-commissioned content, textbook chapters, professional journal articles, research analyst reports, and cases. All readings include problems and solutions as well as appendices to help you understand and master the topic areas. Reading-specific Learning Outcome Statements (LOS) are listed at the beginning of each reading. These LOS indicate what you should be able to accomplish after studying the reading. The LOS, the reading, and the end-of reading questions are dependent on each other, with the reading and questions providing context for understanding the scope of the LOS. You should use the LOS to guide and focus your study, as each examination question is based on an assigned reading and one or more LOS. The readings provide context for the LOS and enable you to apply a principle or concept in a variety of scenarios. The candidate is responsible for the entirety of all of the required material in a study session, the assigned readings as well as the end-of- reading questions and problems. ‘We encourage you to review the material on LOS, including the descriptions of LOS “command words,” at www.cfainstitute.org. Features of the Curriculum > Required vs. Optional Segments - You should read all of an assigned reading. In some cases, however, we have reprinted an entire chapter or article and marked certain parts as “optional.” The CFA examination is based only on the required segments, and the optional segments are included only when they might help you to better understand the required segments (by seeing the required material in its full context). When an optional segment begins, you will see an icon and a solid vertical bar in the ‘outside margin that will continue until the optional segment ends, accompanied by another icon. Unless the material is specifically marked as optional, you should assume itis required. You should rely on the required segments and the reading-specific LOS in preparing for the examination. > Problems/Solutions - AU! questions and problems in the readings as well as their solutions (which are provided directly following the problems) are part of the curriculum and required material for the exam. When appropriate, we have included problems within and after the readings to demonstrate practical application and reinforce your understanding of the concepts presented,How to Use the CFA Program Curriculum ‘The questions and problems are designed to help you learn these concepts and may serve as a basis for exam questions. Many of these questions are adapted from past CFA examinations > Margins - The wide margins in each volume provide space for your note-taking, > Six-volume Structure - For portability of the curriculum, the material is spread over six volumes. > Glossary and Index -For your convenience, we have printed a comprehensive glossary and volume-specific index in each volume. Throughout the curriculum, a bolded blue word in a reading denotes a term defined in the glossary. > Source Material - The authorship, publisher, and copyright owners are given for each reading for your reference. We recommend that you use this CFA Institute curriculum rather than the original source materials because the curricuhm may include only selected pages from outside readings, updated sections within the readings, and contains problems and solutions tailored to the CFA Program. » LOS Self-check - We have inserted checkboxes next to each LOS that you can use to track your progress in mastering the concepts in each reading. Designing Your Personal Study Program Create a Schedule - An orderly, systematic approach to examination preparation is critical. You should dedicate a consistent block of time every week to reading and studying, Complete all reading assignments and the associated problems and solutions in each study session. Review the LOS both before and after you study each reading to ensure that you have mastered the applicable content and can demonstrate the knowledge, skill, or ability described by the LOS and the assigned reading. Use the LOS selfcheck to track your progress and highlight areas of ‘weakness for later review. You will receive periodic email communications that contain important study tips and preparation strategies. Be sure to read these carefully. Curriculum errata are periodically updated and posted on the study session page at \www.cfainsticute.org. You may also sign up for an RSS feed to alert you to the latest errata update. Successful candidates report an average of 300 hours preparing for each exam. ‘Your preparation time will vary based on your prior education and experience. For ‘each level of the curriculum, there are 18 study sessions, so a good plan is to devote 15-20 hours per week, for 18 weeks, to studying the material. Use the final four to six weeks before the exam to review what you've leamed and practice with sample and mock exams. This recommendation, however, may substantially underestimate the hours needed for appropriate examination preparation depending on your individual circumstances, relevant experience, and academic background. You will undoubiedly adjust your study time to conform to your own strengths and weak- nesses, and your educational and professional background, You will probably spend more time on some study sessions than on others, but on average you should plan on devoting 15 hours per study session. You should allow ample time for both in-depth study ofall topic areas and additional concentration on those topic areas for which you feel least prepared. Online Sample Examinations - CFA Institute online sample examinations are intended to assess your exam preparation as you progress toward the end of your study. After each question, you will receive immediate feedback noting the correct response and indicating the relevant assigned reading, so you'll be able to identify areas of weakness for further study. The 120-minute sample examinationsxii How to Use the CFA Program Curriculum reflect the question formats, topics, and level of difficulty of the actual CFA exam- inations. Aggregate data indicate that the CFA examination pass rate was higher among candidates who took one or more online sample examinations than among candidates who did not take the online sample examinations. For more information on the online sample examinations, please visit www.cfainstitute.ong. Online Mock Examinations - In response to candidate requests, CFA Institute has developed mock examinations that mimic the actual CFA examinations not only in question format and level of difficulty, but also in length. The three-hour online mock exams simulate the morning and afiernoon sessions of the actual CEA exam, and are intended to be taken after you complete your study of the fall curriculum, so you can test your understanding of the CBOK and your readiness, for the exam. To further differentiate, the mock exams are available in a printable PDF format with feedback provided at the end of the exam, rather than after ‘each question as with the sample exams. CFA Institute recommends that you take these mock exams at the final stage of your preparation toward the actual CFA examination. For more information on the online mock examinations, please visit wun cfainstitute-org. Preparatory Providers - Afier you enroll in the CFA Program, you may receive numerous solicitations for preparatory courses and review materials, When considering a prep course, make sure the provider is in compliance with the CFA Institute Prep Provider Guidelines Program (www.cfainstitute org/partners/examprep/pages/cfa_prep_provider_prog_participants.aspx). Just remember, there are no shortcuts to success on the GFA examinations; reading ‘and studying the CFA curriculum is the key to success on the examination. The CFA examinations reference only the CFA Institute assigned curriculum—no Preparatory course oF review course materials are consulted or referenced. ‘very question on the CFA examination is based on specific pages nthe required readings and on ane or more LOS. Frequently, an examination question is also tied to 2 specific exemple highlighted within a reading, of to 2 specific end-of-reading ‘question and/or problem and its solution, To make effective use of the curriculum, please remember these key points, 1. All pages printed in the Custom Curticulum are required reading for the examination except for occasional sections marked as optional. You may read ‘optional pages as background, but you will nt be tested on them. 2, All questions, problems, and their solutions - printed at the end of readings - are part of the curriculum and tequired study material for the examination. 3. You should make appropriate use of the online sample/mock examinations and other resources available at www.cfainsttute.org, 4. You should schedule and commit sufficient study time to cover the 18 study sessions, review the materials, and take sample/mack examinations, 5. Note: Some of the concepts in the study sessions may be superseded by updated rulings and/or pronouncements issued after a reading was published. Candidates ‘are expected to be familiar with the overall analytical framework contained in the ee ec ein ie ence force He a the material was written.How to Use the CFA Program Curriculum Feedback AU CFA Institute, we are committed to delivering a comprehensive and rigorous curriculum for the development of competent, ethically grounded investment professionals. We rely on candidate and member feedback as we work to incorpo- rate content, design, and packaging improvements, You can be assured that we will continue to listen to your suggestions. Please send any comments or feedback to curriculum@cfainstitute.org. Ongoing improvements in the curriculum will help you prepare for success on the upcoming examinations, and fora lifetime of earning as.a serious investment professional. xiiiECONOMICS STUDY SESSIONS Study Session 4 Microeconomic Analysis Study Session 5 Macroeconomic Analysis Study Session 6 Economics in a Global Context Reade eun areca The candidate should be able to: demonstrate a thorough knowledge of macroeconomic and microeconomic principles, including the key components of economic activity, and macroeconomic theory andSTUDY SESSION 4 ECONOMICS: Nitec stont uae Ure study session focuses on the microeconomic principles used to describe the marketplace behavior of consumers and firms. The first reading explains the concepts and tools of demand and supply analysis—the study of how buyers and sellers interact to determine transaction prices and quantities. The second reading covers the theory of the consumer, which addresses the demand for goods and services by individuals who make decisions that maximize the satisfaction received from present and future consumption. The third reading deals with the theory of the firm, focusing on the supply of goods and services by profit-maximizing firms. ‘That reading provides the basis for understanding the cost side of firms’ profit equation. The fourth and final reading completes the picture by addressing revenue and explains the types of markets in which firms sell output. Overall, the study session provides the economic tools for understanding how product and resource markets function and the competitive characteristics of diferent industries. READING ASSIGNMENTS Reading 13. Demand and Supply Analysis: Introduction by Richard V. Eastin and Gary L. Arbogast, CFA Reading 14 Demand and Supply Analysis: Consumer Demand by Richard V. Eastin and Gary L. Arbogast, CFA Reading 15 Demand and Supply Analysis: The Firm by Gary L. Arbogast, CFA and Richard V. Eastin Reading 16 The Firm and Market Structures by Richard G. Fritz and Michele Gambera, CFA