Economics — Study Notes
CFA® Level I topic weight 6–9% · micro foundations, macro cycles, and currencies
Microeconomics: elasticity & firm behavior
- Own-price elasticity of demand = %Δ quantity ÷ %Δ price. Demand is elastic when the magnitude exceeds 1 — a price cut then raises total revenue; inelastic demand means a price rise raises revenue. Elasticity is higher with close substitutes, a larger budget share, and longer adjustment time.
- Income elasticity is positive for normal goods and negative for inferior goods. Cross-price elasticity is positive for substitutes and negative for complements — the sign is the exam answer.
- Profit maximization: every firm produces where marginal revenue = marginal cost. In perfect competition MR equals price; a monopolist’s MR lies below its demand curve, so it produces less and charges more.
- Shutdown decisions: in the short run a firm operates as long as price covers average variable cost; below AVC it shuts down. In the long run price must cover full average total cost or the firm exits.
- Market structures: perfect competition (price takers, zero long-run economic profit), monopolistic competition (differentiated products, entry drives long-run profit to zero), oligopoly (few interdependent firms, pricing depends on rivals’ reactions), and monopoly (one seller, price searcher, sustained economic profit possible behind entry barriers).
Macroeconomics: output, cycles & inflation
- GDP accounting: the expenditure approach sums C + I + G + (X − M); the income approach sums payments to factors of production. Real GDP strips out price changes; the GDP deflator = nominal GDP ÷ real GDP × 100.
- Business cycle phases: expansion, peak, contraction, trough. Inventories and interest-sensitive spending (housing, durables) turn first; employment often lags. Indicators are classified as leading (new orders, building permits, stock prices), coincident (payrolls, industrial production) and lagging (unemployment duration, inventories-to-sales).
- Inflation: headline CPI includes food and energy; core excludes them for signal stability. Demand-pull inflation comes from aggregate demand outrunning capacity; cost-push from supply shocks raising input costs. Unexpected inflation redistributes wealth from lenders to borrowers.
- Monetary policy: central banks steer short-term rates via policy-rate targets and open market operations; buying securities injects reserves and eases policy. Policy transmits through market rates, asset prices, expectations and the exchange rate, with long and variable lags.
- Fiscal policy: government spending and taxation. Discretionary changes suffer recognition, implementation and impact lags; automatic stabilizers (progressive taxes, unemployment benefits) respond without new legislation.
Currencies & trade
- Exchange rate quotes: a price/base convention — in USD/EUR = 1.10, the euro is the base currency and costs 1.10 dollars. An increase in the quote means the base currency appreciated. Cross rates chain two quotes through a common currency.
- Real exchange rate adjusts the nominal rate for relative price levels — it measures relative purchasing power, and is what matters for trade competitiveness.
- Forward premium/discount: a currency trades at a forward premium when its forward price exceeds spot. Under covered interest rate parity, the forward rate offsets the interest differential: the higher-rate currency trades at a forward discount, eliminating arbitrage.
- Comparative advantage: countries gain from trade by specializing where their opportunity cost is lowest — even a country worse at producing everything gains by trading. Absolute advantage is neither necessary nor sufficient.
- Trade restrictions: tariffs, quotas and export subsidies all raise domestic prices, protect domestic producers, and create deadweight loss; tariffs generate government revenue while quotas transfer that value to license holders.
Common traps
- Treating elasticity as constant along a linear demand curve — it varies from elastic (upper half) to inelastic (lower half), with revenue maximized at unit elasticity.
- Using average total cost for the short-run shutdown decision — short run compares price with average variable cost; ATC governs long-run exit.
- Misreading which currency is the base in an FX quote — identify base and price currency before deciding which one appreciated.
- Assuming the higher-interest-rate currency trades at a forward premium — covered interest parity puts it at a forward discount.
- Confusing absolute with comparative advantage — gains from trade follow opportunity costs, not productivity levels.
Drill 65 Economics practice questions
Micro, macro and FX questions with worked explanations, plus the topic’s share of a 540-question mock bank.
For exam preparation reference only — original condensed summaries of publicly known Level I curriculum concepts. Independent study aid. CFA Institute does not endorse, promote, or warrant the accuracy or quality of this product. CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute.
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