Economics

Study Guide

The Firm and Market Structures

Firms operate within specific market structures that determine their pricing power and strategic decisions. The primary goal for firms in all structures is to maximize profit, which occurs at the output level where Marginal Revenue (MR) = Marginal Cost (MC).

Understanding Business Cycles

The business cycle refers to the fluctuation of economic activity around its long-term growth trend. It has four distinct phases:

1. Expansion: Real GDP is increasing.
2. Peak: The highest point of economic activity.
3. Contraction (Recession): Real GDP is decreasing for at least two consecutive quarters.
4. Trough: The lowest point of economic activity.

Economic Indicators:

• Leading Indicators: Change before the economy as a whole (e.g., stock market indices, building permits, initial jobless claims).
• Coincident Indicators: Change at approximately the same time as the economy (e.g., non-farm payrolls, industrial production).
• Lagging Indicators: Change after the economy has changed (e.g., average prime rate, unemployment rate).

Fiscal Policy

Fiscal policy involves the use of government spending and taxation to influence aggregate demand and economic activity.

• Expansionary Fiscal Policy: Used to combat a recession.
  • Action: Increase government spending or decrease taxes.
  • Effect: Increases aggregate demand, aiming to boost output and employment.
• Contractionary Fiscal Policy: Used to combat inflation.
  • Action: Decrease government spending or increase taxes.
  • Effect: Decreases aggregate demand, aiming to control price levels.

Fiscal Multiplier: Measures the change in equilibrium national income resulting from a change in government spending. $\text{Fiscal Multiplier} = \frac{1}{1 - \text{MPC}(1 - t)}$ where MPC is the marginal propensity to consume and t is the tax rate.

Monetary Policy

Monetary policy consists of actions undertaken by a central bank to influence the availability and cost of money and credit.

• Expansionary (Accommodative) Monetary Policy: Used to stimulate a slowing economy.
  • Action: Lower the policy rate, buy government securities (open market operations), lower reserve requirements.
  • Effect: Increases the money supply, lowers interest rates, encourages borrowing and spending.
• Contractionary (Restrictive) Monetary Policy: Used to slow down an overheating economy and control inflation.
  • Action: Raise the policy rate, sell government securities, raise reserve requirements.
  • Effect: Decreases the money supply, raises interest rates, discourages borrowing and spending.

The Quantity Theory of Money: Relates the money supply to the price level and economic output. $M \times V = P \times Y$ where M = Money Supply, V = Velocity of Money, P = Average Price Level, Y = Real Output.

Introduction to Geopolitics

Geopolitics is the analysis of how geography, politics, and economics interact to influence relations between countries. For investors, geopolitical risk is a key consideration as it can create market volatility and impact asset values.

• Key Risks: Trade wars, military conflicts, political instability, resource nationalism, terrorism.
• Impact on Markets: Geopolitical events can disrupt supply chains (e.g., oil), alter capital flows, and change investor sentiment, leading to significant price movements in equities, bonds, commodities, and currencies.

International Trade

International trade allows countries to specialize based on their competitive advantages, leading to greater overall economic efficiency.

• Absolute Advantage: The ability to produce a good using fewer resources than another producer.
• Comparative Advantage: The ability to produce a good at a lower opportunity cost than another producer. This is the fundamental basis for trade.

Trade Restrictions:

• Tariffs: A tax imposed on imported goods. Increases the domestic price, reduces the quantity imported, and generates government revenue.
• Quotas: A quantitative limit on the amount of a good that can be imported.
• Export Subsidies: Government payments to firms that export goods.
• Voluntary Export Restraints (VERs): A self-imposed limit on the quantity of a good that an exporting country is allowed to export to another country.

Capital Flows and the FX Market

The Balance of Payments (BoP) is a summary of all transactions between a country and the rest of the world. It comprises three main accounts:

1. Current Account: Measures the flow of goods, services, investment income, and unilateral transfers. A surplus means a country is a net lender to the rest of the world.
2. Capital Account: Measures capital transfers and the sale/purchase of non-produced, non-financial assets.
3. Financial Account: Measures the flow of investment in real and financial assets.

The basic BoP equation is: Current Account (CA) + Financial Account (FA) + Capital Account (KA) = 0 An imbalance in the current account must be offset by an opposite imbalance in the capital and financial accounts. For example, a current account deficit must be financed by a surplus in the financial/capital accounts (i.e., net borrowing from abroad).

Exchange Rate Calculations

An exchange rate is the price of one currency expressed in terms of another.

• Direct Quote: The domestic currency price of one unit of foreign currency (e.g., 1.10 USD/EUR from a US perspective).
• Indirect Quote: The foreign currency price of one unit of domestic currency (e.g., 0.9091 EUR/USD from a US perspective).

Cross-Rate Calculation: The exchange rate between two currencies implied by their exchange rates with a common third currency. Formula: $\frac{A}{C} = \frac{A}{B} \times \frac{B}{C}$ Example: Given USD/EUR and GBP/USD, the GBP/EUR rate is (GBP/USD) × (USD/EUR).

Forward Premium/Discount: The percentage difference between the forward rate and the spot rate, annualized. $\text{Forward Premium/Discount} = \left( \frac{\text{Forward} - \text{Spot}}{\text{Spot}} \right) \times \frac{360}{\text{Term in days}}$

Interest Rate Parity (IRP): A no-arbitrage condition stating that the forward premium or discount should be equal to the interest rate differential between two countries. $\frac{F_{f/d}}{S_{f/d}} = \frac{1 + i_f}{1 + i_d}$ Where F is the forward rate, S is the spot rate, i is the interest rate, and the subscripts f and d denote the foreign and domestic currencies, respectively.