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Study guide · Session 1

Economics

6-9% of the exam · session 1 · 8 learning modules

Economics covers how firms set prices under different market structures, how economies move through business and credit cycles, how fiscal and monetary policy work, and how geopolitics, trade and exchange rates connect countries. Level I questions test definitions and cause-and-effect reasoning, with a few calculations on breakeven points, concentration, multipliers, currency changes, cross-rates and forward rates.

A study feature written by ExamDragon, not part of the real exam. Each heading is one of this topic's 8 learning modules in the 2027 curriculum, named in our own words.

At a glance

Session 1
6-9%

of the exam, as CFA Institute weights it for 2027

Weight
6-9%
Modules
8
Key terms
11

What this guide covers, module by module

  1. ECON.1Costs, competition and market power
  2. ECON.2Expansions, recessions and credit cycles
  3. ECON.3Government spending, taxes and deficits
  4. ECON.4Central banks and interest rate policy
  5. ECON.5Geopolitics, globalisation and investment risk
  6. ECON.6Gains from trade and trade barriers
  7. ECON.7Currency markets, regimes and capital flows
  8. ECON.8Cross-rates and forward exchange rates

ECON.1Costs, competition and market power

  • Every firm maximises profit where marginal revenue equals marginal cost; under perfect competition price equals marginal revenue.
  • Breakeven is where price equals average total cost; in the short run a firm keeps operating while price covers average variable cost and shuts down below it.
  • Economies of scale lower long-run average cost as output grows; diseconomies raise it; the minimum efficient scale is the lowest output at which long-run average cost bottoms out.
  • Perfect competition: many firms, identical products, no pricing power. Monopolistic competition: many firms, differentiated products, zero economic profit in the long run. Oligopoly: few interdependent firms. Monopoly: one firm, high barriers.
  • Oligopoly models include the kinked demand curve (rivals match cuts, ignore rises), Cournot, Stackelberg (a leader moves first) and dominant-firm pricing; collusion is unstable because each member gains by cheating.
  • Concentration measures: the N-firm concentration ratio sums the largest shares; the Herfindahl-Hirschman Index sums squared shares. Neither captures barriers to entry or potential competition.
  1. The situationA competitive firm sells at CAD 8 a unit; at its best output, average variable cost is CAD 6 and average total cost is CAD 9.
  2. Step 1Price is below ATC, so the firm loses CAD 1 a unit.
  3. Step 2Price is above AVC, so each unit still covers CAD 2 of fixed costs.
  4. Step 3Closing would lose all fixed costs, so the firm keeps operating in the short run.
  5. Where questions turnThe short-run shutdown point is minimum average variable cost, not minimum average total cost.
  6. The takeawayOperate in the short run while price covers AVC; exit in the long run if price stays below ATC.
Practise ECON.1

ECON.2Expansions, recessions and credit cycles

  • The business cycle runs through recovery, expansion, slowdown and contraction, measured against the economy's potential output.
  • Credit cycles are swings in lending and asset prices; they are usually longer and deeper than business cycles and amplify them.
  • Firms adjust hours and inventories first and headcount later; the inventory-to-sales ratio rises in a contraction and falls early in a recovery.
  • Consumers cut spending on durable goods first in a downturn; housing is sensitive to interest rates and credit; trade follows domestic and foreign growth and the exchange rate.
  • Leading indicators turn before the economy (average weekly hours, new orders, building permits, share prices); coincident indicators move with it (industrial production, real income); lagging indicators turn after it (unemployment duration, unit labour costs).
  1. The situationAn analyst sees new orders and weekly hours rising, industrial production flat, and the unemployment rate still climbing.
  2. Step 1Leading indicators are turning up.
  3. Step 2The coincident indicator has not yet turned and the lagging indicator is still worsening.
  4. Step 3The pattern fits the trough or the start of a recovery.
  5. Where questions turnA still-rising unemployment rate is consistent with a recovery that has already begun, because unemployment lags output.
  6. The takeawayReading the three groups together places the economy in the cycle better than any single series.
Practise ECON.2

ECON.3Government spending, taxes and deficits

  • Fiscal policy uses government spending and taxes; monetary policy uses interest rates and the money supply. Fiscal policy is set by the government, monetary policy by the central bank.
  • Fiscal objectives include stabilising output, redistributing income and providing public goods.
  • Concerns about high debt to GDP include crowding out of private investment, higher future taxes and loss of market confidence; counter-arguments include debt held domestically and borrowing that funds productive investment. Ricardian equivalence holds that people save tax cuts in expectation of later taxes.
  • Tools: transfer payments, current and capital spending, and direct and indirect taxes; indirect taxes can be changed quickly, while capital projects are slow.
  • Automatic stabilisers, such as progressive taxes and unemployment benefits, act without new decisions; discretionary policy faces recognition, action and impact lags.
  • Judge the fiscal stance with the structural (cyclically adjusted) balance; the fiscal multiplier is 1 / [1 - MPC x (1 - t)].
  1. The situationHouseholds spend 90% of extra disposable income, the tax rate is 20%, and the government raises spending by 10 billion.
  2. Step 1Multiplier = 1 / [1 - 0.9 x (1 - 0.2)] = 1 / 0.28 = 3.57.
  3. Step 2Change in output = 10 billion x 3.57 = 35.7 billion.
  4. Where questions turnA deficit that widens in a recession with no change in policy reflects automatic stabilisers, not a discretionary expansion.
  5. The takeawayTaxes leak spending out of each round, so the multiplier of 3.57 is well below the 10 that an MPC of 0.9 alone would give.
Practise ECON.3

ECON.4Central banks and interest rate policy

  • Central banks issue currency, act as bankers to the government and to banks, lend as a last resort, supervise banks and manage reserves; the main objective is usually stable prices.
  • Tools: the policy rate, open market operations and reserve requirements; when rates are near zero, quantitative easing buys assets to lower longer-term yields.
  • Transmission: a policy rate change moves market rates, asset prices, expectations and the exchange rate, which then affect spending, output and inflation.
  • Effective central banks are independent, credible and transparent; inflation targeting is common, while exchange rate targeting gives up control of domestic rates.
  • The neutral nominal rate is roughly the real neutral rate plus expected inflation; a policy rate above it is contractionary, below it expansionary.
  • Limits: banks may not lend and households may not borrow (a liquidity trap), and rates cannot fall far below zero. Combinations: loose fiscal with tight monetary tends to raise interest rates and the government's share of output.
  1. The situationThe real neutral rate is 1.5%, the inflation target is 2.0% and the policy rate is 2.5%.
  2. Step 1Neutral nominal rate = 1.5% + 2.0% = 3.5%.
  3. Step 2The policy rate of 2.5% is below 3.5%.
  4. Where questions turnDefending a weak currency means buying it with reserves, which tightens domestic money, not selling it.
  5. The takeawayPolicy is expansionary even though the rate is positive, because it sits below the neutral rate.
Practise ECON.4

ECON.5Geopolitics, globalisation and investment risk

  • Geopolitics studies how geography, politics and power shape relations between countries; states range from cooperative to non-cooperative.
  • Globalisation is the flow of goods, services, capital, people and ideas across borders; nationalism pulls the other way.
  • Combining the two axes gives broad stances: autarky (non-cooperative, nationalist), hegemony (non-cooperative, global), bilateralism and multilateralism (cooperative).
  • The IMF supports monetary stability and lends to members with balance of payments problems; the World Bank funds development; the WTO sets trade rules and settles disputes.
  • Tools of geopolitics are national security tools (armed force, alliances), economic tools (tariffs, sanctions, cooperation agreements) and financial tools (capital and currency controls, investment screening).
  • Geopolitical risk can be event risk (elections, scheduled changes), exogenous risk (sudden shocks) or thematic risk (lasting trends such as cyber threats); analysts weigh its likelihood, speed and size of impact on markets.
  1. The situationA country announces sanctions on a major exporter of a metal that a portfolio company uses heavily.
  2. Step 1Classify it as an exogenous risk event with fast, possibly large market impact.
  3. Step 2Trace the channel: higher input costs and supply disruption for the company.
  4. Step 3Run scenarios on margins and consider hedging or reducing exposure.
  5. Where questions turnDo not confuse the three institutions: crisis lending is the IMF, development finance the World Bank, trade rules the WTO.
  6. The takeawayGeopolitical analysis turns an event into channels and scenarios that can be priced into a forecast.
Practise ECON.5

ECON.6Gains from trade and trade barriers

  • Countries gain by specialising in goods where they have a comparative advantage, the lower opportunity cost, even if another country is better at producing everything (absolute advantage).
  • Benefits of trade include lower prices, wider choice, economies of scale and the spread of technology; costs fall on workers and firms in industries that face new competition.
  • A tariff raises the domestic price, cuts imports, earns government revenue and creates a deadweight loss; a small country cannot shift the world price.
  • A quota limits quantity; if licences are given free to foreign exporters, the rent the tariff would have raised goes abroad. Export subsidies lower welfare in the subsidising country.
  • Regional integration runs from free trade areas (no internal barriers) to customs unions (a common external tariff), common markets (free movement of labour and capital) and economic and monetary unions (common policies and currency).
  1. The situationIn Country A one unit of cloth costs 2 units of wheat to produce; in Country B it costs 4 units of wheat.
  2. Step 1A's opportunity cost of cloth is lower, so A has the comparative advantage in cloth.
  3. Step 2B's opportunity cost of wheat is 1/4 unit of cloth versus A's 1/2, so B has the comparative advantage in wheat.
  4. Step 3Trading cloth for wheat at any ratio between 2 and 4 benefits both.
  5. Where questions turnOnly a large country can gain from a tariff through better terms of trade; a small country always loses welfare.
  6. The takeawayOpportunity cost, not absolute productivity, decides who should produce what.
Practise ECON.6

ECON.7Currency markets, regimes and capital flows

  • An exchange rate is the price of the base currency in units of the price currency; in USD 1.10 per EUR, the EUR is the base.
  • Market participants include corporations, investors, governments, central banks and retail travellers; spot, forward, futures, swap and option markets serve trade, hedging and speculation.
  • To measure a currency's percentage change, put it in the base: an appreciation of the EUR by 5% is a USD depreciation of 1 / 1.05 - 1 = -4.76%, not -5%.
  • The real exchange rate adjusts the nominal rate for price levels: real (price/base) = nominal x P_base / P_price.
  • Regimes range from no separate legal tender (dollarisation), currency boards and fixed pegs to target zones, crawling pegs, managed floats and independent floats.
  • A weaker currency tends to help exports and hurt imports over time; capital controls aim to steady the exchange rate, protect reserves, keep monetary independence or protect strategic industries.
  1. The situationThe rate moves from USD 1.20 per EUR to USD 1.26 per EUR while US inflation is 3% and eurozone inflation is 1%.
  2. Step 1Nominal change in the EUR = 1.26 / 1.20 - 1 = +5.00%.
  3. Step 2Real change = 1.05 x 1.01 / 1.03 - 1 = +2.96%.
  4. Where questions turnA currency's appreciation and the other currency's depreciation are not mirror images in percentage terms.
  5. The takeawayHigher US inflation offsets part of the EUR's nominal gain, leaving a real appreciation of about 3%.
Practise ECON.7

ECON.8Cross-rates and forward exchange rates

  • A cross-rate links two currencies through a third: (JPY / USD) x (USD / GBP) = JPY / GBP; arrange the quotes so the common currency cancels.
  • Covered interest rate parity: F (price/base) = S x (1 + i_price x t) / (1 + i_base x t); otherwise a riskless arbitrage exists.
  • The currency with the higher interest rate trades at a forward discount; the one with the lower rate at a forward premium.
  • Forward points are the forward minus the spot, quoted in units of the last decimal: 25 points on a four-decimal quote is 0.0025.
  • The forward premium or discount in percentage terms is (F - S) / S, which approximates the interest rate differential over the period.
  1. The situationSpot is JPY 160.00 per EUR, the 1-year JPY rate is 0.5% and the 1-year EUR rate is 2.5%.
  2. Step 1F = 160.00 x 1.005 / 1.025 = 156.88.
  3. Step 2Forward points = 156.88 - 160.00 = -3.12, or -312 points on a two-decimal quote.
  4. Where questions turnPut the price currency's interest rate in the numerator and the base currency's in the denominator, or the forward moves the wrong way.
  5. The takeawayThe EUR, with the higher interest rate, trades at a forward discount of about 2% against the JPY.
Practise ECON.8

Key terms

Shutdown point
Price equal to minimum average variable cost; below it the firm stops producing in the short run.
Herfindahl-Hirschman Index
The sum of squared market shares, a measure of concentration.
Leading indicator
A series that tends to turn before the economy as a whole.
Automatic stabiliser
A tax or spending feature that offsets the cycle without new decisions.
Fiscal multiplier
The change in output per unit change in government spending, 1 / [1 - MPC x (1 - t)].
Neutral interest rate
The policy rate that neither stimulates nor restrains the economy.
Quantitative easing
Large-scale asset purchases by a central bank to lower longer-term rates.
Comparative advantage
The ability to produce a good at a lower opportunity cost than another country.
Real exchange rate
The nominal exchange rate adjusted for relative price levels.
Cross-rate
The exchange rate between two currencies worked out through a third currency.
Covered interest rate parity
The forward rate that makes hedged returns in two currencies equal.

After this guide: You should be able to identify a market structure and its pricing, place an economy in the cycle, judge fiscal and monetary stances, explain trade and geopolitical effects, and calculate currency changes, cross-rates and forward rates.

Practise Economics

Built to the topics and weights CFA Institute publishes for the 2027 Level I curriculum. The module names, explanations, worked examples and traps are ExamDragon's own. Every source this path is built on.