CFAI understands that high quality investment advisors and portfolio managers need to have base competency in economic theory in order to value and forecast asset prices.  Economic concepts in Level II focus on: economic growth, the impacts of government regulation on an economy, gross domestic product as a measurement of a country’s economic output, international trade concepts, exchange rate systems, and currency markets.

This series aligns with the latest Level II CFA Program Curriculum ©.  Students can expect to see one item set from this material, however items covered under the currency markets section of this series will appear in other exam sections (as well as Level III), so that must be kept in mind.

<strong>Material:</strong>

We will cover the following broad topics:

I.          Economic Growth

II.        Government Regulation

III.       Gross Domestic Product (or Measuring Economic Activity)

IV.       International Trade

V.        Foreign Exchange Rate Systems and Parity Relationships

<strong> </strong>

CFA Level 2: Economics - Introduction

The total output of an economy can be represented by a national income measure called Gross Domestic Product (GDP). This section looks at the relationship between economic output, laborer productivity and the growth of an economy's GDP. Further discussion of GDP accounting will be presented in section titled 'Gross Domestic Product'.

<strong>Sources of Economic Growth:</strong>
<ol>
	<li>Aggregate Hours - the total amount of work hours performed by laborers</li>
	<li>Labor Productivity - the amount of output per worker hour (also known as Real GDP/labor hour)</li>
</ol>
Labor productivity can increase through advances in:
<ul>
	<li>Physical capital - when firms increase the amount of equipment per laborer</li>
	<li>Human capital - when individual laborers become more educated</li>
	<li>Technology - new developments increase laborer productivity; productivity is measured as output per labor hour</li>
</ul>
<strong>Preconditions of Economic Growth</strong>

The existing scenarios that make it possible for aggregate hours and labor productivity to grow an economy are:
<ul>
	<li><strong>Specialization:</strong> when a laborer focuses on the economic activity that he/she does best; in other words, the activity in which he/she has a comparative advantage</li>
	<li><strong>Trade:</strong> institutions that facilitate trade among economic actors are:
<ol>
	<li>Property rights</li>
	<li>Markets</li>
	<li>Monetary exchange</li>
</ol>
</li>
</ul>

Economic Growth

According to the One Third Rule, the changes in productivity in the US economy can be estimated as follows:

<div class="formula1">
%&Delta; Productivity = 1/3(%&Delta; Physical Capital/labor hour) + %&Delta; Technology

</div>
For example, if productivity increased by a total of 3% and the stock of physical capital increased by 3%, then one could infer that 2% of the productivity was caused by advances in technology: 3% = 1/3(3%) + 2%

Changes in Productivity: The One-Third Rule

<p>The productivity curve places Real GDP/Labor Hour (or productivity) on the y-axis and Capital per Hour of Labor on the x-axis.</p>



<ul><li>When physical capital (factories, equipment, etc.) increases, a country moves upward along the productivity curve.</li><li>Technology advances shifts the productivity curve upward.</li></ul>



<div class="wp-block-image"><figure class="aligncenter"><img src="https://financetrain.com/wp-content/uploads/productivity_curve.gif" alt="" class="wp-image-5158"/></figure></div>

The Productivity Curve

<strong>Classical growth theory</strong>

Classical growth theory connects population growth to the growth of labor productivity.  This is a very basic view of economies, believing that productivity growth can expand a population to a finite point and beyond that point productivity will revert to a subsistence level.  The implication is that physical resources are limited.

<strong>Neoclassical growth theory</strong>

Neoclassical growth theory believes that in the long run, physical capital per laborer and laborer productivity will not grow without increases in technology.  In other words, physical capital can only drive so much growth and beyond a certain point, an economy will need new technology to continue to grow.  The neoclassical theory also believes in convergence of economies: output per worker (or per-capita GDP) will become equal across countries, if all countries have access to the same technology and their financial markets are integrated

<strong>New growth theory</strong>

New growth theory is rooted in the notions that educating laborers (also referred to as investing in human capital) and providing incentives for laborers to discover new technologies are needed to drive continuous economic growth.

Economic Growth Theories

Governments may regulate for economic reasons or social reasons.
<ul>
 	<li><strong>Economic regulation</strong> – Seeks to promote competition, regulate natural monopolies, and/or promote fair prices.&nbsp; Economic regulation may come in the form of: anti-trust laws, cost of service regulation, rate of return regulation, or wage and price controls.</li>
 	<li><strong>Social regulation</strong> – Seeks to facilitate product safety, worker protection, and/or environmental protection.&nbsp; Social regulation may come in the form of product standards, employer safety laws, or pollution taxes/fines.</li>
</ul>
The economic impacts of regulating an industry can be quantified on a supply-demand curve, where price is on the y-axis and quantity of output is on the x-axis.&nbsp; Commonly, economic regulation, such as a tax or output restriction, will exhibit a decrease in output and increase in price on this graph.&nbsp; This inefficiency is called a deadweight economic loss.

<img class="aligncenter size-full wp-image-5166" title="deadweight-loss" src="https://financetrain.com/wp-content/uploads/deadweight-loss.gif" alt="">

<strong>Deregulation</strong>

Governments may deregulate industries because the market structure went from uncompetitive to competitive over time or the current regulation is keeping new firms from entering the market.
<ul>
 	<li><strong>Short-term effects:</strong> Weaker firms go out of business, jobs are lost, less skilled workers struggle to maintain employment, and service quality temporarily weakens as the industry transitions.</li>
 	<li><strong>Long-term effects:</strong> The market becomes more competitive, consumer prices drop,&nbsp; more choices become available, production increases, and the deadweight loss experienced in the regulated period shrinks</li>
</ul>
<strong>Theories on Regulatory Behavior</strong>
<ul>
 	<li><strong>Capture Hypothesis</strong> – theorizes that regulators will eventually become the captives of the industry interests that they regulate.&nbsp; An argument behind this theory is that industry actors are more likely to invest in educating law makers and government bodies than the general population.&nbsp; Therefore the general population, lacking expertise, is at a disadvantage when it comes to making regulatory proposals.</li>
 	<li><strong>Share the Gains, Share the Pains Theory</strong> – asserts that regulators will find a compromise among consumers, law makers, and industry for designing regulations that are agreeable to all three of these groups.</li>
</ul>
&nbsp;

Government Regulation, Deregulation, and Regulatory Behaviour

<ul>
	<li>GDP is the total output of all economic activity in a country over a given period and a country’s GDP will include domestic output by foreign owned firms.</li>
	<li>GDP has a mathematical relationship with the measures of gross national income (GNI) and net national income (NNI)
<ul>
	<li>GNI = the sum of all incomes for residents of a country regardless of the location of the assets of these residents</li>
	<li>NNI = GNI less depreciation of physical capital</li>
</ul>
</li>
</ul>
<div class="formula1">

GDP + interest, dividend, rent and profit abroad = GNI

GNI – physical capital depreciation = NNI

</div>
<ul>
	<li>Expenditure Approach to GDP</li>
</ul>
<div class="formula1">

GDP = Personal Consumption + Investment + Government Consumption + (Exports – Imports)

GDP = C + I + G + (X-M)

</div>
<ul>
	<li>GDP at Factor Cost = Expenditure Approach GDP – Indirect Taxes + Subsidies</li>
	<li>GDP does not include items such as: government transfer payments, gifts, unpaid household activities, trades, second hand transactions (ex. selling used goods on Ebay), and transactions involving illegal goods.</li>
	<li>Nominal GDP = GDP in current prices
<ul>
	<li>A price deflator must be applied to the current GDP in order to compare current GDP to the GDP of a prior year.</li>
</ul>
</li>
</ul>

Gross Domestic Product (Measuring Economic Activity)

As different global economies specialize, nations can gain from trading with one another by creating abundances of those products and services that they do best.  The excess of one nation’s product can then be traded to another nation holding an abundance of its own specialty under mutually acceptable terms of trade.

The output mix of two products for an economy can be represented on a production possibilities frontier (PPF), where the output quantity of one product is represented on the x-axis and the output quantity of the other product is on the y-axis.

<strong>Opportunity Cost</strong> = The amount of production lost for one product in order to increase production of another product.

<strong>Comparative Advantage</strong> – When comparing two countries, the country which can produce a product at the lowest opportunity cost has a comparative advantage in that specific product.

In a scenario where two countries both produce the same two goods and each country has a unique comparative advantage in one of the goods, the gains from trade can be calculated.  This basic application shows how countries can mutually increase their respective consumption levels through trade.

<strong>International Trade Restriction</strong>

[caption id="" align="alignright" width="265" caption="Trade Restrictions"]<img src="https://financetrain.com/wp-content/uploads/trade_restrictions.gif" alt="" width="265" height="177" />[/caption]

For various motivations a country may attempt to limit trade through the following policies:
<ul>
	<li><strong>Tariffs</strong> – taxes on imported products.</li>
	<li><strong>Quotas</strong> – limitations on the amount of a product that can be imported</li>
	<li><strong>Voluntary Export Restraints</strong> – a case where trading partners mutually agree to limit the amount of a product that will be exported.</li>
</ul>
Governments may impose international trade restrictions to generate tariff revenue or because special interest groups of minority groups that could be hurt by free trade influence national leaders to impose restrictive trade policies.

Special interest group arguments to restrict trade:
<ul>
	<li>National security</li>
	<li>Infant industry – whereby a new industry needs temporary government protection from international trade in order to develop.</li>
	<li>Anti-dumping – domestic producers may argue that foreign firms are exporting products below their cost in order to drive competitors to bankruptcy, with the intention of later raising prices.</li>
</ul>
&nbsp;

International Trade & Trade Restrictions

The account statement which summarizes the transactions of a country’s citizens with foreigners is commonly called the balance of payments.

<strong>Balance of Payments Accounting Identity</strong>
<div class="formula1">Current Account Balance + Financial Account Balance + Reserve Balance = 0</div>
<strong>Current Account Balance</strong>

Composed of a country’s net exports for goods and services (is negative when exports &gt; imports), net income from investments, and net current transfers (primarily foreign aid, foreign military support, and charity).

<strong>Financial or (Capital) Account Balance</strong>

Composed of direct investments, financial asset investments, bank assets liabilities, and a statistical discrepancy.

The statistical discrepancy is typically small in amount and serves as a plug value to tie the identity to 0 (zero).

<strong>Reserve Account Balance</strong>

Consists mostly of a government’s foreign currency holdings, but could also include inter-governmental exchange of gold.

If the value on the reserve account balance is positive, then a government has sold official reserve assets to buy back domestic currency.

<strong>Using Monetary Policy</strong>

A country’s central bank may ease monetary policy by increasing the money supply, with the objective of stimulating the economy.  The theoretical sequence of events is:
<ul>
	<li>Monetary stimulus (increasing the supply of money) causes real interest rates to drop;</li>
	<li>Foreign demand for domestic financial assets decreases because returns are now lower;</li>
	<li>The financial account balance declines because the inflow of foreign investment has dropped;</li>
	<li>The domestic currency then depreciates;</li>
	<li>The currency depreciation reduces imports (which have become more expensive) and increases exports (which are now cheaper to the rest of the world);</li>
	<li>The increase in exports reverses the deficit trend in the current account balance, as the growth in exports stimulates the country’s economy.</li>
</ul>
<strong>Using Fiscal Policy</strong>

A government may also use fiscal policy (taxing and spending) to stimulate the economy and this also has implications for interest rates, the balance of payments and the domestic currency valuation.
<ul>
	<li>Fiscal stimulus causes interest rates to rise, as lower tax revenues or higher government spending has increased the demand for borrowing by the government;</li>
	<li>Rising real interest rates attracts foreign capital, which increases the financial account balance;</li>
	<li>The inflow of foreign capital increases the value of the domestic currency;</li>
	<li>The decrease in the current account balance is matched by an increase in the financial account balance, as foreign investors have increased their holdings of the domestic currency.</li>
</ul>
 

Balance of Payments

There are two major categories of exchange rate systems:
<ul>
	<li><strong>Flexible or Floating</strong> – laws of supply and demand determine currency value</li>
	<li><strong>Fixed</strong> – the government pegs the exchange rate value and actively participates in currency markets to maintain the value</li>
</ul>
The market quotes nominal exchange rates whereby a unit of once currency can be exchanged for some amount of another currency.  The real exchange rate reflects the price level differentials of the currencies being exchanged.

<div class="formula1">
Real Exchange Rate Foreign/US =

Nominal Exchange Rate <sub>Foreign/US</sub> x (Price Level <sub>US</sub> / Price Level <sub>Foreign</sub>)
</div>

Foreign Exchange Rate Systems and Parity Relationships

<ul>
	<li>In a floating rate exchange system, a supply and demand relationship exists between the price of currency Y against currency X and the quantity available of currency Y.</li>
	<li>Moving along the currency demand curve (or changes in quantity demanded):
<ul>
	<li><strong>Exports Effect –</strong> citizens of country X do not demand currency Y, rather they demand goods and services from country Y.  If currency Y is valued low, then citizens of country X will buy cheap goods and services from Y.  This will require X to accumulate more Y currency, driving up its price.  This relationship shows how demand for foreign currency is a derived demand.</li>
</ul>
</li>
	<li><strong>Expected Profit Effect –</strong> as the price of currency Y drops relative to currency X, the potential profit from owning currency Y in anticipation of a rebound becomes higher.  This is the basic law of demand, in that currency investors may buy more of currency Y as it becomes cheaper if they expect that prices will later rise.</li>
	<li>Moving along the currency supply curve (or changes in quantity supplied):
<ul>
	<li><strong>Imports Effect –</strong> As currency Y appreciates relative to X, residents of country Y will want to import more goods from country X and to do so they will need to supply increasing quantities of their currency to buy goods from country X.</li>
	<li><strong>Expected Profit Effect –</strong> As currency Y appreciates relative to X, its profit potential diminishes and currency market participants will look to sell; this is the opposing force of the expected profit effect on the demand side.</li>
</ul>
</li>
	<li>Factors that SHIFT the demand curve in a floating rate environment:
<ul>
	<li>Changes to the difference (spread) in interest rates between countries.</li>
	<li>Changes in expectations about the future exchange rate.</li>
</ul>
</li>
	<li>Factors that SHIFT the supply curve in a floating rate environment (same as demand shifts):
<ul>
	<li>Changes to the difference (spread) in interest rates between countries.</li>
	<li>Changes in expectations about the future exchange rate.</li>
</ul>
</li>
	<li>While the factors that shift the supply and demand curve are the same, they work in opposite directions, thus demand may increase, when supply simultaneously decreases and quantity remains unchanged – the same amount of equilibrium quantity at a higher price.</li>
	<li>Changes to exchange rate expectations can be caused by:
<ul>
	<li><strong>Purchasing Power Parity –</strong> this is the idea that the currencies exchanged should have equal purchasing power in their respective countries.  When the inflation rate of country Y is expected to increase relative to country X, then market participants will expect country Y to depreciate in value.</li>
	<li><strong>Interest Rate Parity –</strong> this is the idea that all risk free assets (US Treasury bonds and their foreign equivalents) should earn the same real rate of return, irrespective of currency denomination.  Interest rate spreads across the government bonds of countries reflects a difference in nominal rates of return.  When nominal spread of country Y widens (increase) versus country X, market participants should expect the future price of currency Y to decrease relative to the current exchange rate. Changes in expectation about inflation differential should explain the differences in nominal interest rates across countries, when currency values float.</li>
</ul>
</li>
</ul>
<ul>
	<li>Currencies of countries with high expected inflation rates show a tendency to depreciate over time.</li>
	<li>When a country has a comparatively high real interest rate, it will attract foreign investment, which increases the demand (shifts the demand curve rightward) for that currency and causes it to appreciate in value.</li>
	<li>As a country realizes it’s expected economic growth, it will import more and thus slow the currency appreciation experienced during the early part of the growth phase.</li>
</ul>

Foreign Exchange Floating Rate Systems

Fixed Exchange Rate Systems require active intervention by the government to keep the currency value stable.
<ul>
	<li>A country can create a fixed exchange system by:
<ul>
	<li>Implementing a gold standard (the currency can be converted to gold);</li>
	<li>Using a currency board to manage the money supply and keep the domestic currency value stable in relation to some foreign currency.</li>
	<li>Pegging the currency to value of another currency and allow the central market to conduct monetary policy to maintain the peg.</li>
</ul>
</li>
</ul>
<ul>
	<li>A peg system reduces exchange rate volatility, but the system also forces economic shocks to be absorbed by the economy and not the currency, as real interest rates may spike in response to a sharp change in the amount of funds available for investment.  Also, speculators can attack pegged currencies.</li>
</ul>
<ul>
	<li>Crawling pegs target a path for the exchange rate, as opposed to a fixed rate.</li>
</ul>
&nbsp;

 

Fixed Exchange Rate Systems

<ul>
	<li><strong><a title="Understanding Spot FX Transactions" href="https://financetrain.com/understanding-spot-fx-transactions/">Spot market</a> –</strong> the market where currencies trade for immediate exchange.</li>
</ul>
<ul>
	<li><strong>Forward market –</strong> the market where currencies trade for future delivery.</li>
</ul>
<ul>
	<li>Understanding currency markets requires an understanding of <a title="Forex Trading: Reading FX Quotes" href="https://financetrain.com/forex-trading-reading-fx-quotes/">direct and indirect currency quotation</a>.  The example below illustrates the concept.</li>
</ul>
<ul>
	<li><strong>Example: $1.62/£</strong>
<ul>
	<li>This is a direct quote for the British pound sterling, in terms of US dollars.</li>
	<li>This is an indirect quote for the US dollar in terms of British pound Sterling.</li>
	<li>In a direct quotation, the numerator (USD) is considered the domestic currency and the denominator (the pound) is the foreign currency.</li>
	<li>In this example, the pound is “stronger” than the dollar as it takes more than one dollar to buy a single pound.</li>
	<li>Markets typically display quotes as direct quotes for the USD against another currency, placing the $ in the denominator (which makes the dollar the foreign currency).
<ul>
	<li>Common exceptions to this norm are quotes for the British Pound and Euro, as these two currencies are commonly treated as foreign currency (placed in the denominator) when quoted against the US dollar.</li>
</ul>
</li>
	<li>Direct and indirect quotes are reciprocals of one another:
<ul>
	<li>1/Indirect Quote = Direct Quote</li>
</ul>
</li>
</ul>
</li>
</ul>
<ul>
	<li>Currency dealers make a profit through the bid-ask spread and the public trader is disadvantaged by this spread.
<ul>
	<li>% Spread = ((Ask Price – Bid Price)/Ask Price) * 100</li>
</ul>
</li>
</ul>
<ul>
	<li>Currency spreads become wider (and thus more expensive to trade) when:</li>
<ul>
	<li>The political or economic climate of a country becomes uncertain.</li>
	<li>Trading volume in the currency is low.</li>
	<li>Forward contracts have more distant expirations (nearer term contracts are more heavily traded).</li>
</ul>
</ul>
<ul>
	<li><a title="Cross Rates and Different Base Currencies" href="https://financetrain.com/cross-rates-and-different-base-currencies/">Cross exchange rates</a> can be calculated when an analyst has two spot exchange rates involving three different currencies (this is a good thing to practice).</li>
<ul>
	<li>When performing a cross rate calculation and given a bid-ask dealer spread, always choose the quotes that produce the largest dealer spread.</li>
</ul>
</ul>

Overview of Currency Markets

Forward contracts commonly trade at premiums or discounts to the <a title="Understanding Spot FX Transactions" href="https://financetrain.com/understanding-spot-fx-transactions/">spot rate</a> and the presence of a premium or discount provides an analyst with insights into the market’s expectation for one currency’s appreciation or depreciation against another currency.
<div class="formula1">Annualized Forward Premium =((F X-dom/Y-for – Spot X-dom/Y-for)/Spot X-dom/Y-for))*(12 / # of months to settle) * 100

</div>
When this calculation is positive, the forward contract is trading at a premium and this implies that foreign currency Y is likely to strengthen against domestic currency X over the remaining period of the contract.

Forward Exchange Rates 

Interest Rate Parity attempts to explain the difference between forward and spot rates as explained by differences in nominal interest rates and efficient markets will eliminate covered interest rate arbitrage opportunities.
<div class="formula1">FX/Y = SX/Y ((1+rX)/(1+rY))</div>
<ul>
	<li>The annualized forward premium can be approximated by the difference in the two interest rates.</li>
	<li>When the domestic country (X) has a higher interest rate, it should sell at a forward discount as the currency is expected to depreciate; this indicates weakness.</li>
	<li>When the relationship between the forward and the spot rate in the formula above does not hold, an arbitrage opportunity exists.  This is called covered interest rate arbitrage because the trader’s exchange rate risk is covered by the price secured in the forward contract.</li>
</ul>

Interest Rate Parity

<ul>
	<li>PPP theoretically links the movements in exchange rates between two countries to the changes in their currencies’ respective purchasing power.</li>
	<li><strong>The Law of One Price –</strong> if there are no transportation costs, then an identical good should trade at an identical real price anywhere in the world.</li>
	<li><strong>Absolute PPP –</strong> based on the law of one price, absolute PPP postulates that the spot exchange rate should reflect the price of one good compared to the other.</li>
</ul>
<div class="formula1">S X/Y = PriceX/PriceY</div>
<ul>
	<li>Relative PPP – rooted in inflation rates, relative PPP theorizes that the future period spot rate is a function of the current spot rate (S0) and inflation (I) rates until the future spot (S1).</li>
</ul>
<div class="formula1">S 1 X/Y = S 0 X/Y ((1 + IX period)/(1 + IYperiod))</div>
<ul>
	<li>The PPP applications assume common generalities in order to compare the currencies of vastly different economies and cannot fully explain reality.</li>
</ul>
 

Purchasing Power Parity (PPP)

Economist Irving Fisher is credited with the inflation expectations theory of interest rates, which proposes that the <a title="Nominal Interest Rate and Effective Yield" href="https://financetrain.com/nominal-interest-rate-and-effective-yield/">nominal risk free interest rate</a> (i.e., developed economy government issued debt) consists of a real interest rate plus and an inflation expectation.
<div class="formula1">1 + r f nominal = (1 + r f real)(1 + E(I))</div>
The International Fisher Relation connects the difference in nominal risk free interest rates between countries to their expected inflation rates.
<div class="formula1">(1+ r f X)/( 1+ r f Y) = ((1 + E(IX)/(1 + E(IY))</div>
A flaw in the international Fisher relation is that the model does not take business cycle differences between economies into consideration.

 

International Fisher Relation

Uncovered <a title="Interest Rate Parity" href="https://financetrain.com/interest-rate-parity/">interest rate parity</a> assumes that the nominal risk free rates of two economies determine the expected future <a title="Understanding Spot FX Transactions" href="https://financetrain.com/understanding-spot-fx-transactions/">spot exchange rate</a>, when applied to the current spot exchange rate.
<div class="formula1">E(S <sub>1 X/Y</sub>) = S <sub>0 X/Y</sub> (1+ r <sub>f X</sub>)/( 1+ r <sub>f Y</sub>)</div>
Covered interest rate parity concludes that the market’s <a title="Forward Exchange Rates" href="https://financetrain.com/forward-exchange-rates/">forward exchange rate</a> contract should always be tied to the periodic nominal risk free interest rate difference between the two countries.
<div class="formula1">F<sub> X/Y</sub> = S <sub>X/Y</sub> (1+ r <sub>f X</sub>)/( 1+ r <sub>f Y</sub>)</div>
If the analyst feels the forward rate has significantly deviated from its value predicted by the relationship between risk free rates, then an arbitrage currency trade opportunity may be present.

If the forward contract is overvalued, then the trader will purchase the currency in the spot market and sell short the forward.  If the forward contract is undervalued, then trader will buy the forward contract and sell short the spot currency.

Analysts should not be fooled into believing that a higher nominal interest rate implies a higher real return, as currency exchange rates offset this difference.

Forward contracts can be used to hedge the uncertainty surrounding the future value of a transaction denominated in a foreign currency.  For example, a US company set to receive a £1 million payment in three months could sell short a forward contract for British pounds of equal value to lock in a fixed exchange rate.  In that time, the pound could appreciate or depreciate against the US dollar, but that volatility has been eliminated through the forward contract.

 

Uncovered and Covered Interest Rate Parity Relationship

An analyst can apply the Absolute PPP theory (<a title="Purchasing Power Parity (PPP)" href="https://financetrain.com/purchasing-power-parity-ppp/">Purchasing Power Parity</a>) of exchange rates to measure a currency’s fundamental value, by comparing the real cost of like goods across different countries.

An analyst can apply the Relative PPP theory of exchange rates to forecast currency values, if the analyst has strong insights into inflation expectations for these countries over the period of time in question.

An analyst can look at a country’s <a title="Balance of Payments" href="https://financetrain.com/balance-of-payments/">balance of payments</a> to make inferences about the future strengthening or weakening of a currency.  Theoretically, when the official reserve account shows a negative balance, the country is likely acquiring foreign assets and the currency should be strong.

An analyst can also track a country’s monetary policy to make short and long term inferences about interest rates and inflation.  This is called the asset markets approach.

Forecasting Exchange Rates

<strong>Recommendations</strong>
<ul>
	<li>Spend four hours reading Study Session 4 of the Level II CFA Program Curriculum © taking notes.</li>
	<li>Spend one to two hours creating flash cards from this study sheet and the official material.</li>
	<li>Spend four hours taking practice questions.</li>
</ul>
<strong>Conclusion</strong>

With economics, a test taker can likely expect one item set (six questions).  There could be some basic math calculations from growth, <a title="Government Regulation, Deregulation, and Regulatory Behaviour" href="https://financetrain.com/government-regulation-deregulation-and-regulatory-behaviour/">government regulation</a>, <a title="International Trade &amp; Trade Restrictions" href="https://financetrain.com/international-trade-trade-restrictions/">trade</a>, <a title="Gross Domestic Product (Measuring Economic Activity)" href="https://financetrain.com/gross-domestic-product-measuring-economic-activity/">GDP</a>, and <a title="Balance of Payments" href="https://financetrain.com/balance-of-payments/">balance of payments</a>, but it is important to understand this portion of economics conceptually as well.  The <a title="Overview of Currency Markets" href="https://financetrain.com/overview-of-currency-markets/">currency exchange</a> material is highly likely to be tested.  If not in the econ item set, then the concepts and formulas could appear in other sections.  CFAI considers understanding currency relationships a mandatory skill for investment analysts, so be sure to spend time on these applications.

CFA Level 2 Economics – Recommendations

Economics

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COURSE

Economics

Lessons

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