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CFA Level I - Study Session 4
1. A. “Economic Fluctuations, Unemployment, and Inflation”
The candidate should be able to
a) explain the phases of the business cycle;
Business cycle is a description of the fluctuations in the general level of economic activity in an
economy as measured by changes variables such as real GDP, employment, and unemployment.
Business cycles consist of distinct phases:
Business Peak: When most businesses in the economy are operating at capacity, real GDP is growing
rapidly and unemployment has fallen. It is not sustainable over a long period and thus leads to;
Contraction: Aggregate business conditions slow, real GDP growth falls and may even turn negative,
and unemployment begins to rise.
Recessionary trough: Is the point at which the economic slowdown reaches its lowest. From this point
onward aggregate economic activity tends to rise;
Expansion: When aggregate economic activity completely recovers from the previous slowdown.
Real GDP growth rises, firms begin to increase their capacity utilization, and unemployment begins
to fall.
Business Cycle & Economic Sectors
Economic
Slowdown
Slowdown/
Recovery
Economic
Expansion
Expansion/
Peak
Economy Slowing Slow Growing Decelerating
Monetary Policy Neutral Easy Neutral Tight
Interest Rates Falling Falling Rising Rising
Profits Slowing Falling Rising Decelerating
Sector Groups Cons. Staples Consumer Basics Utilities

Cyclical Unemployment: Due to business cycle fluctuations in overall economic activity.
Unemployment rises during recessionary periods and falls during expansionary periods.
d) define and explain full employment and the natural rate of unemployment;
Full Employment: Level of employment that results from the efficient use of the labor force after
making allowance for the normal rate of unemployment consistent with information costs, dynamic
changes and structural characteristics of the economy.
Natural Rate of Unemployment: Long-run average level of unemployment due to frictional and
structural conditions in the economy’s labor markets. This level is not set in stone but rather is
affected by dynamic economic change and public policy over time.
e) define inflation and calculate the inflation rate;
Inflation: The sustained rise in the general level of prices of goods and services in the economy.
Annual inflation rate is calculated as the percent change in a chosen price index (PI).
1
1
Inflation rate 100
t t
t
t
PI PI
PI
-
-
-
= ´
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f) discuss the harmful consequences of inflation.
Anticipated Inflation: An increase in the general level of prices that was expected by most decision-
makers on the economy.
Unanticipated Inflation: An increase in the general level of prices that was not expected by most

equilibrium output in long run.
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d. explain how and why budget deficits and trade deficits tend to be linked.
Nat’l Income identity Y = C + I + G + NX
Rearrange yields: Y- C - G = I + NX or (Y-C-T) + (T-G) = I + NX
Where Y-C-T = Private Saving = S, T-G = Budget Balance
If S and I fixed, then increase in Budget Deficit, {(T-G) more negative}, implies that NX more
negative, i.e. larger Current Account Deficit.
e. identify automatic stabilizers and explain how they work, etc.
Automatic stabilizers are fiscal policies that automatically promote budget deficits during
recessions and surpluses during booms. Examples are unemployment compensation, corporate
profits tax, and progressive income tax. These policies affect AD in ways that offset economic
fluctuations.
f. discuss the supply-side effects of fiscal policy.
Changes in tax rates, particularly marginal tax rates, affect aggregate supply through their
impact on the relative attractiveness of productive activity in comparison top leisure and tax
avoidance. Supply-side tax cuts are a long-term growth-oriented strategy that will eventually
increase both SRAS and LRAS.
g. explain the relationships among budget deficits, inflation, and real interest rates;
In theory, higher gov’t budget deficits should lead to higher real interest rates by loanable
funds market analysis. In practice effect is not as strong as expected.
Higher gov’t budget deficits may lead to higher inflation rates and higher nominal interest
rates if gov’t finances deficit by printing money.
1. C. “Money and the Banking System”
The candidate should be able to:
a. identify and explain the three basic functions of money.
At a theoretical level, money supply consists of assets that act as:
• Medium of Exchange - facilitates transactions (liquidity).
• Unit of Account - used to quote prices.

a central bank can use monetary tools to implement monetary policy.
Open Market Operations:
• Purchase or sale of gov’t bonds by the central bank.
• Open Market purchase of bonds by central bank increases reserves at banks, banks lend
excess reserves, and money supply increases.
Reserve Requirements
• Gov’t regulates banks’ minimum reserve-deposit ratios.
• Increase in reserve requirements, lowers money multiplier, and so decrease money
supply as banks call loans to build up reserves.
Discount Rate
• Interest rate on reserves borrowed from central bank.
• Lower discount rate, cheaper borrowed reserves, more reserves borrowed by banks,
banks increase loans, which increase deposits in banking system, thus increasing
money supply.
f. discuss potential problems in measuring an economy’s money supply.
Growth rate of money supply generally used to gauge monetary policy. Money supply
measures subject to changes due to structural shifts & financial innovations.
i. Use of U.S. $ outside of U.S. – US$ acts as international vehicle currency in
international transactions, illegal activities, dollarisation, etc.
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ii. Shifts from interest-bearing checking accounts to MMDA’s – checking accounts in
M1 but MMDA’s only in M2. Distorts M1 vs. M2 measures.
iii. Increased availability of low-fee stock and bond mutual funds – Not counted in money
measures but increasingly liquid, act as near-money.
iv. Debit cards and electronic money – Reduce reasons to hold currency, may transfer
transaction balances outside banking system.
1. D. “Modern Macroeconomics: Monetary Policy”
The candidate should be able to:
a. discuss the determinants of the demand for and supply of money;

If one assumes that Velocity is constant, or changes slowly, then a change in the money
supply, M, must result in the same proportionate change in Nominal GDP, PY. This is
equivalent to saying that expansionary monetary policy shifts out the aggregate demand curve.
How this increase is split between a price increase and an increase in output depends on the
slope of the Short Run Aggregate Supply curve.
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