Regardless whether you’ve a background in finance or economics, Economics is a central topic across all 3 levels of the CFA exams that requires some focus to master, especially the exchange rate section!
Building a strong foundation in CFA Level 1 Economics is essential in increasing your chances of passing CFA Level 2 and 3, as it permeates throughout other topics as well. That’s why we decided to create our Cheat Sheet series of articles, which focuses on one specific topic area for one specific CFA Level.
More Cheat Sheets will be published in the coming weeks, sign up to our member’s list to be notified first.
By referring to the CFA curriculum’s Learning Outcome Statements (LOS), we prioritize and highlight the absolute key concepts and formula you need to know for each topic. With some tips at the end too!
Use the Cheat Sheets during your practice sessions to refresh your memory on important concepts.
Let’s dive in – this is a long article. Do breakdown your reading in chunks and come back to it often! 🙂
CFA Level 1 Economics: An Overview
Economics is a central topic in finance, with a similar topic weight across all 3 levels of the CFA exams.
However, the importance of Economics is not just restricted to the CFA exams. The topics covered, such as demand and supply analyses, FX, global trade and international economic policy, will underpin your comprehension of how the economic world works.
CFA Level 1 Economics’ topic weighting is 8-12%, which means 14-22 questions of the 180 questions of CFA Level 1 exam is centered around this topic.
It is covered in Study Sessions 4-5, which includes Reading 12-18.
The Economics topic area can be approximately split into two sub-types:
- Microeconomics: economics on a smaller scale, such as focusing at one firm or one industry at a time. Useful for understanding how market forces will influence a particular business or industry
- Macroeconomics: economics on a country-wide or global scale. Useful to see how government policies, decisions or world events influence the economy
CFA Level 1 Economics covers a lot of concepts that you may have repeatedly heard of, but may not fully understand yet, especially if you’re new to any kind of financial education.
Here’s a summary of the CFA Level 1 Economics chapter readings:
|12||Topics in Demand and Supply Analysis||This reading focuses on microeconomics and covers how the demand and supply changes for a product or service influence each other.|
|13||The Firm and Market Structures||How companies interact and compete with each other in different market conditions: perfect competition, monopolistic competition, oligopoly, and pure monopoly.|
|14||Aggregate Output, Prices and Economic Growth||An introduction to macroeconomics concepts like gross domestic product (GDP), aggregate demand, aggregate supply and sources to economic growth.|
|15||Understanding Business Cycles||Walks through the theory of business cycles, unemployment and discusses the differences between inflation, deflation, hyperinflation and disinflation.|
|16||Monetary and Fiscal Policy||Explains the various tools governments and central banks use, in an attempt to guide, control and optimize their own country’s economy through economic policy.|
|17||International Trade and Capital Flows||An introduction to international trade and capital flows, pros and cons of international trade and balance of payments.|
|18||Currency Exchange Rates||Focuses on the details of how exchange rates are quoted and calculated. Also walks through the effect of exchange rates on international trade and capital flows.|
If biology is the study of how living things work, and physics is the study of how the physical world works, then economics is the study of how the world of business, goods and services work.
Understanding basic economics is key to a successful career in any field, business ventures and even your personal life given how it permeates through our everyday life.
Reading 12: Topics in Demand and Supply Analysis
Own-price elasticity of demand
Note that own price elasticity of demand (PED) is usually negative:
- If PED<1, demand is inelastic;
- If PED=1, demand is unit elastic;
- If PED>1, demand is elastic.
- If PED=0, demand is perfectly inelastic, i.e. vertical demand curve.
- If PED=∞, demand is perfectly elastic, i.e. horizontal demand curve.
Income elasticity of demand
Note that income elasticity of demand is positive for normal good, negative for inferior good.
Cross-price elasticity of demand
Note that cross-price elasticity of demand is positive for substitutes, negative for complements.
Income and substitution effects
When price of good X decreases:
|Substitution effect||Income effect||Consumption of good X||Good X is a|
|Positive||Negative (but smaller than substitution effect)||Increases||Inferior good|
|Positive||Negative (and larger than substitution effect)||Decreases||Giffen good|
Veblen good on the other hand is a ‘status’ good, where demand increases when price increases. Both Veblen good and Giffen good have upward sloping demand curves, but for different reasons.
Breakeven and shutdown analysis in production
Profit maximization occurs when the difference betweeen Total Revenue (TR) and Total Cost (TC) is the greatest. The level of output where this occurs is when:
- Marginal Cost (MC) = Marginal Revenue (MR), and
- MC is rising
Breakeven occurs when:
- TR=TC, and
- price (average revenue) = average total cost (ATC)
At this breakeven level, economic profit is zero, although it may still earn a positive accounting profit (normal profit).
Production shutdown analysis in the short run & long run (TVC = total variable cost):
|Revenue/cost relationship||Short run decision||Long run decision|
|TR = TC||Continue operating||Continue operating|
|TC > TR > TVC||Continue operating||Exit market|
|TR < TVC||Exit market||Exit market|
Reading 13: The Firm and Market Structures
|Characteristics||Perfect competition||Monopolistic market||Oligopoly||Monopoly|
|Number of sellers||Many firms||Many firms||Few firms||Few firms|
|Entry and exit barriers||Very low||Low||High||Very high|
|Product differentiation||Identical products||Substitutes but differentiated (via advertising)||Close substitutes or differentiated via features, quality, advertising||Unique products, no close substitutes|
|Pricing power||None. Price-taker||Some||Some to considerable||Considerable (price discrimination)|
|Other features||Each firm faces a perfectly elastic demand curve (horizontal). All firms make normal profits in the long run.||Each firm faces a downward sloping demand curve. All firms make normal profits in the long run.||Each firm faces a downward sloping demand curve. |
Price collusion is possible: kinked demand curve, Cournot assumptions, Nash equilibrium, Stackelberg model
|Firm faces downward sloping industry demand curve. Can make economic profits in the long run if unregulated.|
Reading 14: Aggregate Output, Prices and Economic Growth
Gross domestic product (GDP)
GDP = C + I + G + (X – M)
GDP = Net domestic income + Consumption of fixed capital + Statistical discrepancy
Expenditure and income equality
(G – T) = (S – I) – (X – M)
where (G – T) = fiscal balance, (S – I) = savings less domestic investments, (X – M) = trade balance.
To finance a fiscal deficit (G – T > 0), the private sector must save more than it invests (S > I) and/or imports (M) should exceed exports (X), i.e. M – X > 0
Factors causing a shift in aggregate demand (AD)
To assess the change in AD, use the equation C + I + G + (X – M)
|An increase in||Shifts the AD curve||Rationale|
|Stock prices||Right||Leads to higher consumption (C)|
|House price||Right||Leads to higher consumption (C)|
|Consumer confidence||Right||Leads to higher consumption (C)|
|Business confidence||Right||Leads to higher investment (I)|
|Capacity utilization||Right||If companies are operating at near or full capacity, this leads to higher investment (I)|
|Government spending (G)||Right||Government spending is a component of AD|
|Taxes (T)||Left||Lowers consumption (C) and investment (I)|
|Bank reserves||Right||Increased money supply leads to lower interest rate, hence higher investment (I) and potentially consumer spending (C)|
|Exchange rates (foreign currency per domestic currency)||Left||Domestic currency appreciation leads to less exports (X), more imports (I), i.e. a decrease in net exports, a component of AD.|
|Global economic growth||Right||Higher exports (X)|
Factors causing a shift in aggregate supply (AS)
|An increase in||Shifts short run AS||Shifts long run AS||Rationale|
|Supply of labor||Right||Right||Increase in resources|
|Supply of natural resources||Right||Right||Increase in resources|
|Supply of human capital||Right||Right||Increase in resources|
|Supply of physical capital||Right||Right||Increase in resources|
|Productivity and technology||Right||Right||Improves input efficiency|
|Nominal wages||Left||No impact||Increases cost of production|
|Input prices (e.g. energy)||Left||No impact||Increases cost of production|
|Expectation of future prices||Right||No impact||Anticipation of higher profitability in the future|
|Business taxes||Left||No impact||Increases cost of production|
|Subsidy||Right||No impact||Reduces cost of production|
|Exchange rate (foreign currency per unit of domestic currency)||Right||No impact||Reduces cost of production|
Impact of (combined) changes in AD and AS
|Change in AS||Change in AD||Effect on real GDP||Effect on aggregate price level|
|–||Increase||Increase. Decreases unemployment||Increase|
|–||Decrease||Decrease. Increases unemployment||Decrease|
|Increase||–||Increase. Decreases unemployment||Decrease|
|Decrease||–||Decrease. Increases unemployment||Increase|
Reading 15: Understanding Business Cycles
4 phases of business cycles
- Trough: lowest point
- Expansion: comes after trough
- Peak: highest point
- Contraction (recession): comes after peak
Summary of business cycle theories
|Theories||Brief description||Recommended policies|
|Neo-classical||Free market, the ‘invisible hand’.||Do nothing, let it be.|
|Austrian||Similar to neo-classical. It is government intervention that is causing fluctuations.||Do nothing, let it be.|
|Keynesian||Advocates government intervention during a recession, as the economy doesn’t automatically correct itself in the short run. Focus on AD curve.||Use fiscal and monetary policy as necessary to increase AD.|
|Monetarist||Monetary policy||Maintain steady money supply growth.|
|New classical||Applies microeconomic analysis to macroeconomics. Business cycles have real causes, no government intervention needed.||Do nothing, let it be.|
Types of unemployment
- Frictional: temporary transitions, e.g. people who are between jobs.
- Structural: caused by long run changes in the economy, e.g. demand for certain skills reduced whilst employers look for a different set of skillsets.
- Cyclical: depends on the stage of business cycle which affects economic activity and hence employment.
- Inflation = a sustained rise in overall prices in the economy
- Deflation = a sustained decrease in aggregate price level, i.e. negative inflation rate or prices are falling.
- Disinflation = declining inflation rate. Note that prices are still rising in disinflation, but at a slower rate than before.
- Hyperinflation = an extremely high inflation rate. If over a 3 year period the aggregate price level doubles, this is a hyperinflation.
- Cost-push inflation = inflation caused by a decrease in aggregate supply (AS)
- Demand-pull inflation = inflation caused by an increase in aggregate demand (AD)
- Laspeyres index: uses base consumption basket to measure inflation
- Paasche index: uses current consumption basket to measure inflation
- Fischer index: is the geometric mean of Laspeyres and Paasche index.
Reading 16: Monetary and Fiscal Policy
Quantity theory of money
MV = PY, where M = quantity of money, V = velocity of money circulation, P = price level, Y = real output.
Rnom = Rreal + πe
where Rnom= nominal interest rate, Rreal= real interest rate, πe= expected inflation rate
Tools to implement monetary policy:
- Open market operations (OMO): Buy/sell government bonds, which leads to increase/decrease in commercial banks’ reserves, to increase/decrease money supply
- Central bank’s policy rate: If policy rate is high, amount of lending will decrease and quantity of money will also decrease. Vice versa.
- Reserve requirements: If reserve requirement is low, the money multiplier (reciprocal of reserve requirement) goes up and money supply decreases. And vice versa.
Contractionary vs. expansionary monetary policy:
- Contractionary monetary policy (reducing money supply and/or increasing interest rates) helps cool off an ‘overheating’ economy with high inflation due to high economic growth.
- Expansionary monetary policy (increasing money supply and/or reducing interest rates) helps boost a slowing economy.
Limitations of monetary policy:
- Central banks cannot control how much households save.
- Central banks cannot control banks’ willingness to lend and hence expand credit.
Contractionary vs. expansionary fiscal policy:
- Contractionary fiscal policy (reducing government spending and/or increasing taxes) helps control inflation in a high growth economy.
- Expansionary fiscal policy (increasing government spending and/or reducing taxes) helps boost aggregate demand in a slowing economy.
Fiscal policy spending vs revenue tools:
|Fiscal spending tools||Fiscal revenue tools|
|Transfer payments: redistribution of wealth, e.g. via welfare payments, unemployment benefits etc.||Direct taxes: Taxes on income (e.g. wealth, income, property, inheritance, capital gains, corporation profits etc)|
|Current government spending: spending on goods and services e.g. education, defence, healthcare etc.||Indirect taxes: Taxes on goods and services (e.g. sales tax, excise duties)|
|Capital expenditure: Infrastructure spending e.g. roads, hospitals, schools etc.|
Limitations to fiscal policy: recognition lag, action lag and impact lag.
where MPC = marginal propensity to consume, t = taxes
Reading 17: International Trade and Capital Flows
Comparative advantage vs. absolute advantage
- Absolute advantage: occurs when a country can product a good with less resources or lower cost.
- Comparative advantage: occurs when a country can product a good with lower opportunity cost than its trading partners.
Ricardian vs. Heckscher-Ohlin models of comparative advantage
|Ricardian model||Heckscher-Ohlin (HO) model|
|Countries without absolute advantages can still benefit from trade from comparative advantages.||Countries’ comparative advantages are based on relative scarcity of resources.|
|Labor is the only variable factor of production.||Capital and labor are the variable factors of production.|
|Differences in technology is the key source of comparative advantage.||HO model assumes the technology in each industry is the same for each country.|
Differences in factor endowments is the key source of comparative advantage.
Regional trading blocs
|Free trade area (FTA)||No barriers to flow of goods and services amongst members|
|Customs union (CU)||FTA + common trade policy amongst non-members|
|Common market (CM)||CU + free movement of factors of production amongst members|
|Economic union (EU)||CM + common economic institution and coordination of economic policies|
|Monetary union (MU)||EU + common currency|
Balance of payments (BOP) components
- Current account (CA): measures the flow of goods and services, e.g. merchandise trade, services, income receipts, unilateral transfers.
- Capital account (KA): measures transfer of capital, e.g. capital transfers, non-financial asset sales/purchases.
- Financial account (FA): records investment flows, e.g. government-owned assets abroad, foreign-owned assets in the country
Current Account (CA) = X – M = Y – (C + I + G)
Reading 18: Currency Exchange Rates
Exchange rate convention in CFA curriculum
It’s important to know that the exchange rate notation in CFA curriculum is different, and opposite to the real world – don’t ask me why!
In the real world, EUR/GBP of 1.15 means EUR 1 = GBP 1.15.
However, in the CFA curriculum, EUR/GBP of 1.15 means EUR 1.15 per GBP 1. This is the opposite notation in the real world, so be mindful if you see real world exchange rate example questions.
It’s a key source of mistake for CFA candidates, and there are lots of foreign exchange questions throughout all 3 levels. Do make sure you get it right!
P.S. – For the purposes of the CFA curriculum, you should also be familiar with the convention of EUR:GBP = 1.15, which means GBP 1.15 = EUR 1, i.e. equals GBP/EUR = 1.15.
Exchange rate calculations
- Nominal exchange rate is the quoted currency exchange rate at any point in time.
- Real exchange rate adjusts the nominal exchange rate for inflation in each country compared to a base period.
where d = domestic currency, f = foreign currency, CPI = consumer price index
- Relationship between forward rates, spot rates and interest rates:
where rd = risk-free rate of domestic currency, rf = risk-free rate of foreign currency
Exchange rate regimes
|Types of exchange rate regimes||Description|
|Formal dollarization||Don’t have own currency. Adopts another country’s currency.|
|Monetary union||Several countries adopt the same currency, e.g. European Union.|
|Currency board system||Commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate.|
|Fixed parity / |
|A country pegs its own currency with a foreign currency (or a basket of currencies) within a +/- 1% margin.|
|Target zone||Similar to fixed parity, but with a wider margin (+/- 2%).|
|Crawling peg||Exchange rate is pegged but adjusted periodically.|
|Crawling bands||Gradually increasing the margins of the fixed peg bands to transition from fixed peg to floating rate.|
|Managed float||Monetary authority intervenes to manage exchange rate without any specific target level.|
|Independently floating||Market-driven exchange rate.|
CFA Level 1 Economics Tips
Economics students: don’t get cocky
To those of you who have taken economics courses in school, you may feel like you’ve done all this before.
Don’t be tempted to simply skip the whole thing. You may be surprised by how much you’ve forgotten, or concepts you’ve not previously fully understood that the CFA exam covers in more detail.
Get good guidance, and/or use examples
You may hear this a lot, but understanding (not memorizing) the core concepts behind this topic area is really important.
Economics is voluminous partly because there are numerous concepts to be explained, rather than, say, mathematical formulae to be memorized.
As it is very text-heavy, when studying Economics, you may find your mind ‘blanking out’, where you’re reading but not really comprehending. You need to break that cycle to quickly move on.
There are 3 good ways to speed up your comprehension:
- A good instructor. Economics is one area where you can really benefit from having proper instruction. An hour of study and discussion with an instructor can advance your comprehension far better than days of self-studying. If Economics is really giving you trouble, do consider live classes, or a review seminar. You can see the latest CFA review courses here.
- Lecture videos. If live classes are outside of your budget, you could also consider lecture videos. Although lacking interactivity with the instructor, videos can guide you through concepts step-by-step, peppered with informal examples and explanations that help seal your comprehension. Again, the latest options can be found in our Offers section.
- Focus on examples. Learning Economics concepts can be a little bit like learning a new board game. Explaining a board game on paper can only get you so far – at some point it’s easier and more engaging to get going. Similarly, with Economics, it can be helpful to focus on the examples given and run through a few step-by-step. If you need more examples than the ones given in the study text, move to a few practice exams or get our Free L1 Practice Test.
Consider covering more ‘effort-efficient’ topics first
Economics has a lot of content for a topic area that’s 8-12% of the exam.
If you find that Economics is slowing your pace down, it might be more effort-efficient to focus on topic areas such as FRA, Fixed Income and Equity Investments. Check out our recommended CFA Level 1 best topic study order here.
Discuss, discuss, discuss
Discussions with your colleagues, friends and mentors (or in our Forum) can greatly help your understanding of Economics.
Whenever you have an opportunity, discuss relevant current events and the underlying economics, clarifying and asking questions where you can. Explain that you’re a CFA candidate if you have to!
Learned about exchange rates? Discuss how Brexit impacted the British Pound, and how that drop would influence the UK economy in various sectors. Speculate on options that the government can take to steady the economy.
In the process of this discussion, you’ll solidify your comprehension of your Economics material, and also increase your knowledge on current events. Win win!
More Cheat Sheet articles will be published over the coming weeks. Get ahead of other CFA candidates by signing up to our member’s list to get notified.
Meanwhile, here are other related articles that may be of interest:
- CFA Level 1 Cheat Sheets series: Quant Methods | Corporate Finance | FRA | Fixed Income | Equity Investments
- CFA Level 1: How to Prepare and Pass CFA in 18 Months
- CFA Level 1 Tips: Top 10 Advice from Previous Candidates
- 18 Actionable Ways to Improve Your Study Memory
- How to Study Effectively: Proven Methods that Work for CFA, FRM and CAIA
- The Ultimate Guide to CFA Practice Questions