CFA Level 1 Economics: Our Cheat Sheet

Note: this cheat sheet is updated for the latest 2023’s curriculum.

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 and continuously updated, 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.

2023 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 Topic 2 with 8 Learning Modules (LMs).

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:

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.

LM1: Topics in Demand and Supply Analysis

Own-price elasticity of demand

\small E_{P_x}^d=\frac{\%\triangle Q_x^d}{\%\triangle P_x}
\\
\\  
\small where \space Q_x^d \space is \space quantity \space demanded \space of \space good \space X, \\P_x \space is \space price \space per \space unit \space of \space good\space X

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

E_i^d=\frac{\%\triangle Q_x^d}{\%\triangle I}, where \space I \space is \space income

Note that income elasticity of demand is positive for normal good, negative for inferior good.

Cross-price elasticity of demand

E_{P_y}^d=\frac{\%\triangle Q_x^d}{\%\triangle P_y}, where \space P_y \space is \space price \space per \space unit \space of \space another \space good \space Y

Note that cross-price elasticity of demand is positive for substitutes, negative for complements.

Income and substitution effects

When price of good X decreases:

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):

LM2: The Firm and Market Structures

LM3: Aggregate Output, Prices and Economic Growth

Gross domestic product (GDP)

Expenditure approach:

GDP = C + I + G + (X – M)

Income approach:

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)

Factors causing a shift in aggregate supply (AS)

Impact of (combined) changes in AD and AS

LM4: Understanding Business Cycles

4 phases of business cycles

1. Trough: lowest point
2. Expansion: comes after trough
3. Peak: highest point
4. Contraction (recession): comes after peak

Summary of business cycle theories

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

• 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.

LM5: 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.

Fischer effect

R_nom = R_real + π^e

where R_nom= nominal interest rate, R_real= real interest rate, π^e= expected inflation rate

Monetary policy

Tools to implement monetary policy:

1. Open market operations (OMO): Buy/sell government bonds, which leads to increase/decrease in commercial banks’ reserves, to increase/decrease money supply
2. Central bank’s policy rate: If policy rate is high, amount of lending will decrease and quantity of money will also decrease. Vice versa.
3. Reserve requirements: If reserve requirement is low, the money multiplier (reciprocal of reserve requirement) goes up and money supply increases. And vice versa.

Required \space reserves \space ratio = \frac{Required \space reserves}{Total \space deposits}

Money \space multiplier=\frac{1}{Reserves \space requirement}

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.

Fiscal policy

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:

Limitations to fiscal policy: recognition lag, action lag and impact lag.

Fiscal multiplier

Fiscal \space multiplier=\frac{1}{1-MPC(1-t)}

where MPC = marginal propensity to consume, t = taxes

LM6: Introduction to Geopolitics

Assessing geopolitical actors and risk

There are generally 4 types of country behavior:

Tools of geopolitics:

• National security tools: espionage, military
• Economic tools: currency union, nationalization
• Financial tools: currency markets, sanctions, capital controls

Incorporating geopolitical risk into the investment process

Types of geopolitical risk:

• event risk
• exogenous risk
• thematic risk

Assessing geopolitical threats

To assess geopolitical risk, an investor should consider:

• Likelihood of occurence
• Speed of impact
• Size and nature of impact

LM7: 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

Regional trading blocs

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)

LM8: 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.

Real \space exchange \space rate_{d/f}=Nominal \space exchange \space rate_{d/f} \times \frac{CPI_f}{CPI_d}

where d = domestic currency, f = foreign currency, CPI = consumer price index

• Relationship between forward rates, spot rates and interest rates:

Forward \space exchange \space rate_{f/d}= Spot \space exchange \space rate_{f/d} \times \frac{1+r_f}{1+r_d}

where r_d = risk-free rate of domestic currency, r_f = risk-free rate of foreign currency

Exchange rate regimes

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 and continuously updated. 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:

• 2023 CFA Level 1 Cheat Sheets series: Quant Methods | FRA | Corporate Issuers | Derivatives | Fixed Income | Equity Investments | Ethics | Alt Investments | Portfolio Management
• 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