CHRISTOPHER D. PIROS, PHD, CFA, is the Managing Director of Investment Strategy and Chairman of the Investment Policy Committee at Hawthorn, a member of the PNC Financial Services Group, Inc., which is dedicated to serving the needs of individuals and families with investable assets in excess of [...] million. Prior to joining PNC, Mr. Piros served on the team responsible for the curriculum underlying the Chartered Financial Analyst® designation. He also has served as Director of Investment Strategy & Portfolio Management at Prudential Investments LLC, the wealth management services arm of Prudential Financial. And he was a global fixed-income portfolio manager and head of fixed-income quantitative analysis at MFS Investment Management.

JERALD E. PINTO, PHD, CFA, is Director, Curriculum Projects, in the education division of the CFA Institute. Prior to joining CFA Institute, he consulted with corporations, foundations, and partnerships in investment planning, portfolio analysis, valuation, and quantitative analysis. Pinto also worked in the investment and banking industries in New York, and taught finance at NYU Stern School of Business. He holds an MBA from Baruch College, a PhD in finance from the Stern School, and is a member of CFA Virginia.

CFA INSTITUTE is a global, not-for-profit organization comprising the world's largest association of investment professionals. With over 100,000 members, and regional societies around the world, CFA Institute is dedicated to developing and promoting the highest educational, ethical, and professional standards in the investment industry. CFA Institute offers a range of educational and career resources, including the Chartered Financial Analyst (CFA) and the Certificate in Investment Performance Measurement (CIPM) designations, and is a leading voice on global issues of fairness, market efficiency, and investor protection.

Foreword xiii

Acknowledgments xvii

About the CFA Institute Investment Series xix

CHAPTER 1 Demand and Supply Analysis: Introduction 1

Learning Outcomes 1

1. Introduction 2

2. Types of Markets 3

3. Basic Principles and Concepts 4

3.1. The Demand Function and the Demand Curve 5

3.2. Changes in Demand versus Movements along the Demand Curve 7

3.3. The Supply Function and the Supply Curve 10

3.4. Changes in Supply versus Movements along the Supply Curve 11

3.5. Aggregating the Demand and Supply Functions 13

3.6. Market Equilibrium 17

3.7. The Market Mechanism: Iterating toward Equilibrium-or Not 19

3.8. Auctions as a Way to Find Equilibrium Price 24

3.9. Consumer Surplus-Value minus Expenditure 28

3.10. Producer Surplus-Revenue minus Variable Cost 30

3.11. Total Surplus-Total Value minus Total Variable Cost 32

3.12. Markets Maximize Society's Total Surplus 32

3.13. Market Interference: The Negative Impact on Total Surplus 34

4. Demand Elasticities 40

4.1. Own-Price Elasticity of Demand 41

4.2. Own-Price Elasticity of Demand: Impact on Total Expenditure 46

4.3. Income Elasticity of Demand: Normal and Inferior Goods 47

4.4. Cross-Price Elasticity of Demand: Substitutes and Complements 48

4.5. Calculating Demand Elasticities from Demand Functions 49

5. Summary 51

Practice Problems 53

CHAPTER 2 Demand and Supply Analysis: Consumer Demand 59

Learning Outcomes 59

1. Introduction 59

2. Consumer Theory: From Preferences to Demand Functions 60

3. Utility Theory: Modeling Preferences and Tastes 60

3.1. Axioms of the Theory of Consumer Choice 61

3.2. Representing the Preference of a Consumer: The Utility Function 62

3.3. Indifference Curves: The Graphical Portrayal of the Utility Function 63

3.4. Indifference Curve Maps 66

3.5. Gains from Voluntary Exchange: Creating Wealth through Trade 66

4. The Opportunity Set: Consumption, Production, and Investment Choice 70

4.1. The Budget Constraint 70

4.2. The Production Opportunity Set 72

4.3. The Investment Opportunity Set 74

5. Consumer Equilibrium: Maximizing Utility Subject to the Budget Constraint 75

5.1. Determining the Consumer's Equilibrium Bundle of Goods 75

5.2. Consumer Response to Changes in Income: Normal and Inferior Goods 76

5.3. How the Consumer Responds to Changes in Price 77

6. Revisiting the Consumer's Demand Function 78

6.1. Consumer's Demand Curve from Preferences and Budget Constraints 78

6.2. Substitution and Income Effects for a Normal Good 79

6.3. Income and Substitution Effects for an Inferior Good 82

6.4. Negative Income Effect Larger than Substitution Effect: Giffen Goods 83

6.5. Veblen Goods: Another Possibility for a Positively Sloped Demand Curve 85

7. Summary 86

Practice Problems 87

CHAPTER 3 Demand and Supply Analysis: The Firm 89

Learning Outcomes 89

1. Introduction 89

2. Objectives of the Firm 90

2.1. Types of Profit Measures 91

2.2. Comparison of Profit Measures 95

3. Analysis of Revenue, Costs, and Profits 96

3.1. Profit Maximization 97

3.2. Productivity 127

4. Summary 135

Practice Problems 136

CHAPTER 4 The Firm and Market Structures 143

Learning Outcomes 143

1. Introduction 143

2. Analysis of Market Structures 144

2.1. Economists' Four Types of Structure 144

2.2. Factors That Determine Market Structure 146

3. Perfect Competition 149

3.1. Demand Analysis in Perfectly Competitive Markets 149

3.2. Supply Analysis in Perfectly Competitive Markets 158

3.3. Optimal Price and Output in Perfectly Competitive Markets 159

3.4. Factors Affecting Long-Run Equilibrium in Perfectly Competitive Markets 161

4. Monopolistic Competition 163

4.1. Demand Analysis in Monopolistically Competitive Markets 166

4.2. Supply Analysis in Monopolistically Competitive Markets 166

4.3. Optimal Price and Output in Monopolistically Competitive Markets 167

4.4. Factors Affecting Long-Run Equilibrium in Monopolistically Competitive Markets 168

5. Oligopoly 169

5.1. Demand Analysis and Pricing Strategies in Oligopoly Markets 169

5.2. Supply Analysis in Oligopoly Markets 176

5.3. Optimal Price and Output in Oligopoly Markets 178

5.4. Factors Affecting Long-Run Equilibrium in Oligopoly Markets 178

6. Monopoly 179

6.1. Demand Analysis in Monopoly Markets 181

6.2. Supply Analysis in Monopoly Markets 182

6.3. Optimal Price and Output in Monopoly Markets 184

6.4. Price Discrimination and Consumer Surplus 185

6.5. Factors Affecting Long-Run Equilibrium in Monopoly Markets 187

7. Identification of Market Structure 188

7.1. Econometric Approaches 189

7.2. Simpler Measures 189

8. Summary 191

Practice Problems 192

CHAPTER 5 Aggregate Output, Prices, and Economic Growth 197

Learning Outcomes 197

1. Introduction 198

2. Aggregate Output and Income 198

2.1. Gross Domestic Product 200

2.2. The Components of GDP 208

2.3. GDP, National Income, Personal Income, and Personal Disposable Income 211

3. Aggregate Demand, Aggregate Supply, and Equilibrium 217

3.1. Aggregate Demand 217

3.2. Aggregate Supply 230

3.3. Shifts in Aggregate Demand and Supply 232

3.4. Equilibrium GDP and Prices 245

4. Economic Growth and Sustainability 256

4.1. The Production Function and Potential GDP 257

4.2. Sources of Economic Growth 259

4.3. Measures of Sustainable Growth 264

5. Summary 270

Practice Problems 273

CHAPTER 6 Understanding Business Cycles 279

Learning Outcomes 279

1. Introduction 279

2. Overview of the Business Cycle 280

2.1. Phases of the Business Cycle 280

2.2. Resource Use through the Business Cycle 284

2.3. Housing Sector Behavior 292

2.4. External Trade Sector Behavior 293

3. Theories of the Business Cycle 294

3.1. Neoclassical and Austrian Schools 295

3.2. Keynesian and Monetarist Schools 296

3.3. The New Classical School 299

4. Unemployment and Inflation 303

4.1. Unemployment 304

4.2. Inflation 307

5. Economic Indicators 319

5.1. Popular Economic Indicators 320

5.2. Other Variables Used as Economic Indicators 325

6. Summary 327

Practice Problems 328

CHAPTER 7 Monetary and Fiscal Policy 333

Learning Outcomes 333

1. Introduction 334

2. Monetary Policy 335

2.1. Money 336

2.2. Roles of Central Banks 348

2.3. Objectives of Monetary Policy 351

2.4. Contractionary and Expansionary Monetary Policies and the Neutral Rate 367

2.5. Limitations of Monetary Policy 369

3. Fiscal Policy 374

3.1. Roles and Objectives of Fiscal Policy 374

3.2. Fiscal Policy Tools and the Macroeconomy 382

3.3. Fiscal Policy Implementation: Active and Discretionary Fiscal Policy 388

4. The Relationship between Monetary and Fiscal Policy 392

4.1. Factors Influencing the Mix of Fiscal and Monetary Policy 393

4.2. Quantitative Easing and Policy Interaction 394

4.3. The Importance of Credibility and Commitment 395

5. Summary 396

Practice Problems 397

CHAPTER 8 International Trade and Capital Flows 403

Learning Outcomes 403

1. Introduction 403

2. International Trade 404

2.1. Basic Terminology 404

2.2. Patterns and Trends in International Trade and Capital Flows 407

2.3. Benefits and Costs of International Trade 411

2.4. Comparative Advantage and the Gains from Trade 415

3. Trade and Capital Flows: Restrictions and Agreements 424

3.1. Tariffs 424

3.2. Quotas 427

3.3. Export Subsidies 427

3.4. Trading Blocs, Common Markets, and Economic Unions 430

3.5. Capital Restrictions 435

4. The Balance of Payments 436

4.1. Balance of Payments Accounts 438

4.2. Balance of Payments Components 438

4.3. Paired Transactions in the Balance of Payments Bookkeeping System 440

4.4. National Economic Accounts and the Balance of Payments 445

5. Trade Organizations 451

5.1. International Monetary Fund 451

5.2. World Bank Group 453

5.3. World Trade Organization 454

6. Summary 457

Practice Problems 459

CHAPTER 9 Currency Exchange Rates 465

Learning Outcomes 465

1. Introduction 465

2. The Foreign Exchange Market 467

2.1. Market Functions 473

2.2. Market Participants 478

2.3. Market Size and Composition 482

3. Currency Exchange Rate Calculations 484

3.1. Exchange Rate Quotations 484

3.2. Cross-Rate Calculations 488

3.3. Forward Calculations 492

4. Exchange Rate Regimes 500

4.1. The Ideal Currency Regime 500

4.2. Historical Perspective on Currency Regimes 501

4.3. A Taxonomy of Currency Regimes 503

5. Exchange Rates, International Trade, and Capital Flows 511

5.1. Exchange Rates and the Trade Balance: The Elasticities Approach 512

5.2. Exchange Rates and the Trade Balance: The Absorption Approach 517

6. Summary 521

Practice Problems 524

CHAPTER 10 Currency Exchange Rates: Determination and Forecasting 527

Learning Outcomes 527

1. Introduction 528

2. Foreign Exchange Market Concepts 530

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