Economics for Investment Decision Makers

CHRISTOPHER D. PIROS, PHD, CFA, is the Managing Director of Investment Strategy and Chairman of the Investment Policy Committee at Hawthorn, a member of the PNC Financial Services Group, Inc., which is dedicated to serving the needs of individuals and families with investable assets in excess of $20 million. Prior to joining PNC, Mr. Piros served on the team responsible for the curriculum underlying the Chartered Financial Analyst® designation. He also has served as Director of Investment Strategy & Portfolio Management at Prudential Investments LLC, the wealth management services arm of Prudential Financial. And he was a global fixed-income portfolio manager and head of fixed-income quantitative analysis at MFS Investment Management. JERALD E. PINTO, PHD, CFA, is Director, Curriculum Projects, in the education division of the CFA Institute. Prior to joining CFA Institute, he consulted with corporations, foundations, and partnerships in investment planning, portfolio analysis, valuation, and quantitative analysis. Pinto also worked in the investment and banking industries in New York, and taught finance at NYU Stern School of Business. He holds an MBA from Baruch College, a PhD in finance from the Stern School, and is a member of CFA Virginia. CFA INSTITUTE is a global, not-for-profit organization comprising the world's largest association of investment professionals. With over 100,000 members, and regional societies around the world, CFA Institute is dedicated to developing and promoting the highest educational, ethical, and professional standards in the investment industry. CFA Institute offers a range of educational and career resources, including the Chartered Financial Analyst (CFA) and the Certificate in Investment Performance Measurement (CIPM) designations, and is a leading voice on global issues of fairness, market efficiency, and investor protection.

• Foreword xiiiAcknowledgments xviiAbout the CFA Institute Investment Series xixCHAPTER 1 Demand and Supply Analysis: Introduction 1Learning Outcomes 11. Introduction 22. Types of Markets 33. Basic Principles and Concepts 43.1. The Demand Function and the Demand Curve 53.2. Changes in Demand versus Movements along the Demand Curve 73.3. The Supply Function and the Supply Curve 103.4. Changes in Supply versus Movements along the Supply Curve 113.5. Aggregating the Demand and Supply Functions 133.6. Market Equilibrium 173.7. The Market Mechanism: Iterating toward Equilibrium—or Not 193.8. Auctions as a Way to Find Equilibrium Price 243.9. Consumer Surplus—Value minus Expenditure 283.10. Producer Surplus—Revenue minus Variable Cost 303.11. Total Surplus—Total Value minus Total Variable Cost 323.12. Markets Maximize Society’s Total Surplus 323.13. Market Interference: The Negative Impact on Total Surplus 344. Demand Elasticities 404.1. Own-Price Elasticity of Demand 414.2. Own-Price Elasticity of Demand: Impact on Total Expenditure 464.3. Income Elasticity of Demand: Normal and Inferior Goods 474.4. Cross-Price Elasticity of Demand: Substitutes and Complements 484.5. Calculating Demand Elasticities from Demand Functions 495. Summary 51Practice Problems 53CHAPTER 2 Demand and Supply Analysis: Consumer Demand 59Learning Outcomes 591. Introduction 592. Consumer Theory: From Preferences to Demand Functions 603. Utility Theory: Modeling Preferences and Tastes 603.1. Axioms of the Theory of Consumer Choice 613.2. Representing the Preference of a Consumer: The Utility Function 623.3. Indifference Curves: The Graphical Portrayal of the Utility Function 633.4. Indifference Curve Maps 663.5. Gains from Voluntary Exchange: Creating Wealth through Trade 664. The Opportunity Set: Consumption, Production, and Investment Choice 704.1. The Budget Constraint 704.2. The Production Opportunity Set 724.3. The Investment Opportunity Set 745. Consumer Equilibrium: Maximizing Utility Subject to the Budget Constraint 755.1. Determining the Consumer’s Equilibrium Bundle of Goods 755.2. Consumer Response to Changes in Income: Normal and Inferior Goods 765.3. How the Consumer Responds to Changes in Price 776. Revisiting the Consumer’s Demand Function 786.1. Consumer’s Demand Curve from Preferences and Budget Constraints 786.2. Substitution and Income Effects for a Normal Good 796.3. Income and Substitution Effects for an Inferior Good 826.4. Negative Income Effect Larger than Substitution Effect: Giffen Goods 836.5. Veblen Goods: Another Possibility for a Positively Sloped Demand Curve 857. Summary 86Practice Problems 87CHAPTER 3 Demand and Supply Analysis: The Firm 89Learning Outcomes 891. Introduction 892. Objectives of the Firm 902.1. Types of Profit Measures 912.2. Comparison of Profit Measures 953. Analysis of Revenue, Costs, and Profits 963.1. Profit Maximization 973.2. Productivity 1274. Summary 135Practice Problems 136CHAPTER 4 The Firm and Market Structures 143Learning Outcomes 1431. Introduction 1432. Analysis of Market Structures 1442.1. Economists’ Four Types of Structure 1442.2. Factors That Determine Market Structure 1463. Perfect Competition 1493.1. Demand Analysis in Perfectly Competitive Markets 1493.2. Supply Analysis in Perfectly Competitive Markets 1583.3. Optimal Price and Output in Perfectly Competitive Markets 1593.4. Factors Affecting Long-Run Equilibrium in Perfectly Competitive Markets 1614. Monopolistic Competition 1634.1. Demand Analysis in Monopolistically Competitive Markets 1664.2. Supply Analysis in Monopolistically Competitive Markets 1664.3. Optimal Price and Output in Monopolistically Competitive Markets 1674.4. Factors Affecting Long-Run Equilibrium in Monopolistically Competitive Markets 1685. Oligopoly 1695.1. Demand Analysis and Pricing Strategies in Oligopoly Markets 1695.2. Supply Analysis in Oligopoly Markets 1765.3. Optimal Price and Output in Oligopoly Markets 1785.4. Factors Affecting Long-Run Equilibrium in Oligopoly Markets 1786. Monopoly 1796.1. Demand Analysis in Monopoly Markets 1816.2. Supply Analysis in Monopoly Markets 1826.3. Optimal Price and Output in Monopoly Markets 1846.4. Price Discrimination and Consumer Surplus 1856.5. Factors Affecting Long-Run Equilibrium in Monopoly Markets 1877. Identification of Market Structure 1887.1. Econometric Approaches 1897.2. Simpler Measures 1898. Summary 191Practice Problems 192CHAPTER 5 Aggregate Output, Prices, and Economic Growth 197Learning Outcomes 1971. Introduction 1982. Aggregate Output and Income 1982.1. Gross Domestic Product 2002.2. The Components of GDP 2082.3. GDP, National Income, Personal Income, and Personal Disposable Income 2113. Aggregate Demand, Aggregate Supply, and Equilibrium 2173.1. Aggregate Demand 2173.2. Aggregate Supply 2303.3. Shifts in Aggregate Demand and Supply 2323.4. Equilibrium GDP and Prices 2454. Economic Growth and Sustainability 2564.1. The Production Function and Potential GDP 2574.2. Sources of Economic Growth 2594.3. Measures of Sustainable Growth 2645. Summary 270Practice Problems 273CHAPTER 6 Understanding Business Cycles 279Learning Outcomes 2791. Introduction 2792. Overview of the Business Cycle 2802.1. Phases of the Business Cycle 2802.2. Resource Use through the Business Cycle 2842.3. Housing Sector Behavior 2922.4. External Trade Sector Behavior 2933. Theories of the Business Cycle 2943.1. Neoclassical and Austrian Schools 2953.2. Keynesian and Monetarist Schools 2963.3. The New Classical School 2994. Unemployment and Inflation 3034.1. Unemployment 3044.2. Inflation 3075. Economic Indicators 3195.1. Popular Economic Indicators 3205.2. Other Variables Used as Economic Indicators 3256. Summary 327Practice Problems 328CHAPTER 7 Monetary and Fiscal Policy 333Learning Outcomes 3331. Introduction 3342. Monetary Policy 3352.1. Money 3362.2. Roles of Central Banks 3482.3. Objectives of Monetary Policy 3512.4. Contractionary and Expansionary Monetary Policies and the Neutral Rate 3672.5. Limitations of Monetary Policy 3693. Fiscal Policy 3743.1. Roles and Objectives of Fiscal Policy 3743.2. Fiscal Policy Tools and the Macroeconomy 3823.3. Fiscal Policy Implementation: Active and Discretionary Fiscal Policy 3884. The Relationship between Monetary and Fiscal Policy 3924.1. Factors Influencing the Mix of Fiscal and Monetary Policy 3934.2. Quantitative Easing and Policy Interaction 3944.3. The Importance of Credibility and Commitment 3955. Summary 396Practice Problems 397CHAPTER 8 International Trade and Capital Flows 403Learning Outcomes 4031. Introduction 4032. International Trade 4042.1. Basic Terminology 4042.2. Patterns and Trends in International Trade and Capital Flows 4072.3. Benefits and Costs of International Trade 4112.4. Comparative Advantage and the Gains from Trade 4153. Trade and Capital Flows: Restrictions and Agreements 4243.1. Tariffs 4243.2. Quotas 4273.3. Export Subsidies 4273.4. Trading Blocs, Common Markets, and Economic Unions 4303.5. Capital Restrictions 4354. The Balance of Payments 4364.1. Balance of Payments Accounts 4384.2. Balance of Payments Components 4384.3. Paired Transactions in the Balance of Payments Bookkeeping System 4404.4. National Economic Accounts and the Balance of Payments 4455. Trade Organizations 4515.1. International Monetary Fund 4515.2. World Bank Group 4535.3. World Trade Organization 4546. Summary 457Practice Problems 459CHAPTER 9 Currency Exchange Rates 465Learning Outcomes 4651. Introduction 4652. The Foreign Exchange Market 4672.1. Market Functions 4732.2. Market Participants 4782.3. Market Size and Composition 4823. Currency Exchange Rate Calculations 4843.1. Exchange Rate Quotations 4843.2. Cross-Rate Calculations 4883.3. Forward Calculations 4924. Exchange Rate Regimes 5004.1. The Ideal Currency Regime 5004.2. Historical Perspective on Currency Regimes 5014.3. A Taxonomy of Currency Regimes 5035. Exchange Rates, International Trade, and Capital Flows 5115.1. Exchange Rates and the Trade Balance: The Elasticities Approach 5125.2. Exchange Rates and the Trade Balance: The Absorption Approach 5176. Summary 521Practice Problems 524CHAPTER 10 Currency Exchange Rates: Determination and Forecasting 527Learning Outcomes 5271. Introduction 5282. Foreign Exchange Market Concepts 5302.1. Arbitrage Constraints on Spot Exchange Rate Quotes 5332.2. Forward Markets 5383. A Long-Term Framework for Exchange Rates 5473.1. International Parity Conditions 5493.2. Assessing an Exchange Rate’s Equilibrium Level 5653.3. Tying It Together: A Model That Includes Long-Term Equilibrium 5684. The Carry Trade 5695. The Impact of Balance of Payments Flows 5735.1. Current Account Imbalances and the Determination of Exchange Rates 5745.2. Capital Flows and the Determination of Exchange Rates 5776. Monetary and Fiscal Policies 5856.1. The MundellFleming Model 5856.2. Monetary Models of Exchange Rate Determination 5886.3. The Taylor Rule and the Determination of Exchange Rates 5896.4. Monetary Policy and Exchange Rates—The Historical Evidence 5916.5. Fiscal Policy and the Determination of Exchange Rates 5957. Exchange Rate Management: Intervention and Controls 5978. Currency Crises 6029. Shorter-Term Forecasting Tools 6059.1. Technical Analysis 6069.2. Order Flow, Sentiment, and Positioning 60810. Summary 61111. Appendix: Currency Codes Used in This Chapter 615Practice Problems 615CHAPTER 11 Economic Growth and the Investment Decision 621Learning Outcomes 6211. Introduction 6222. Growth in the Global Economy: Developed versus Developing Countries 6222.1. Savings and Investment 6252.2. Financial Markets and Intermediaries 6262.3. Political Stability, Rule of Law, and Property Rights 6262.4. Education and Health Care Systems 6262.5. Tax and Regulatory Systems 6272.6. Free Trade and Unrestricted Capital Flows 6272.7. Summary of Factors Limiting Growth in Developing Countries 6283. Why Potential Growth Matters to Investors 6314. Determinants of Economic Growth 6354.1. Production Function 6354.2. Capital Deepening versus Technological Progress 6374.3. Growth Accounting 6404.4. Extending the Production Function 6414.5. Natural Resources 6424.6. Labor Supply 6454.7. Labor Quality: Human Capital 6494.8. Capital: ICT and Non-ICT 6504.9. Technology 6534.10. Public Infrastructure 6574.11. Summary 6575. Theories of Growth 6635.1. Classical Model 6645.2. Neoclassical Model 6645.3. Endogenous Growth Theory 6775.4. Convergence Debate 6806. Growth in an Open Economy 6847. Summary 694Practice Problems 696CHAPTER 12 Economics of Regulation 703Learning Outcomes 7031. Introduction 7032. Overview of Regulation 7042.1. Classification of Regulations and Regulators 7042.2. Economic Rationale for Regulation 7072.3. Regulatory Tools 7103. Regulation of Commerce 7154. Regulation of Financial Markets 7195. Cost-Benefit Analysis of Regulation 7206. Analysis of Regulation 7226.1. Effects of Regulations 7247. Summary 728Practice Problems 729Glossary 731References 745About the Editors 751About the CFA Program 753Index 755