Economics and Capital Markets
Economics and Capital Markets tests how macro forces set discount rates, inflation, currency values, and business-cycle conditions that flow into financial forecasts. Expect monetary and fiscal policy, GDP accounting, inflation measures, exchange-rate regimes, and market structure. The exam also connects macro variables to earnings estimates and discount rates.
Core rules
- GDP = C + I + G + (X - M). Real GDP strips out price changes; nominal GDP includes them. Forecasts should separate volume growth from inflation.
- Central banks set policy rates to target inflation and stabilize output. Raising the policy rate raises short-term rates, usually flattens or inverts the yield curve, and pressures long-duration asset prices.
- The Fisher equation: nominal rate ≈ real rate + expected inflation. The exact form is (1 + nominal) = (1 + real)(1 + inflation).
- Purchasing power parity links exchange rates to relative inflation; interest rate parity links forward exchange rates to interest differentials. A currency with higher interest rates usually trades at a forward discount.
- Market structures such as perfect competition, monopolistic competition, oligopoly, and monopoly determine pricing power and long-run margins.
Worked example
A country has a nominal policy rate of 6% and expected inflation of 4%. The approximate real rate is 2%. If inflation expectations rise to 5% while the nominal rate stays at 6%, the real rate falls to about 1%, which is accommodative and can weaken the currency. If the central bank raises the nominal rate to 7%, the real rate returns to about 2%, supporting the currency but slowing credit-sensitive demand.
Traps
- Do not confuse currency appreciation with a stronger export position; appreciation makes exports more expensive.
- Headline CPI includes food and energy; core CPI excludes them and is often the better policy signal.
- A yield curve inversion is a signal, not a guarantee, of recession.
- Fiscal stimulus can raise growth and inflation simultaneously, complicating the rate outlook.
- Nominal cash flow forecasts discounted at a real rate overstate value.