CFA L1 Economics Flashcards
1
Q
What variables influence the quantity of demand?
A
- Price
- Incomes in the economy
- Prices of substitues and complements
EC PREREQ1 Topics in demand and supply analysis
2
Q
At what point would a business maximising revenue stop increasing prices?
A
- When there is unit elasticity
- ie elasticity = 1
- ie when a 1% increase in price results in a 1% decrease in demand (no net change in revenue)
EC PREREQ1 Topics in demand and supply analysis
3
Q
What goods have more price elasticity?
A
- When close substitutes are available
- When it constitutes a large % of the household budget
- When looking at long term demand (more sensitive to price over the long run)
- When the goods are optional or discretionary
EC PREREQ1 Topics in demand and supply analysis
4
Q
What goods are less price elastic?
A
- Those for which there are no close substitutes available
- Goods which constitute a small % of the household budget
- Goods for which there is only short term demand (i.e., travel)
- Goods which are a necessity or non-discretionary
EC PREREQ1 Topics in demand and supply analysis
5
Q
Where on the demand curve is price unit elastic?
A
In the middle.
- Top left is elastic
- Bottom right is inelastic
EC PREREQ1 Topics in demand and supply analysis
6
Q
What is income elasticity of demand?
A
- The amount demand for a given good changes when income in the economy increases
EC PREREQ1 Topics in demand and supply analysis
7
Q
What is a normal good?
A
A good for which demand increases when income increases
- Income elasticity of demand is greater than 0
EC PREREQ1 Topics in demand and supply analysis
8
Q
What is an inferior good?
A
A good for which demand DECREASES when income increases
- Income elasticity of demand is less than 9
EC PREREQ1 Topics in demand and supply analysis
9
Q
What is the substitution effect?
A
- As price goes down, quantity goes up as demand gets substituted over
- Tends to always be positive
EC PREREQ1 Topics in demand and supply analysis
10
Q
Is the income effect positive or negative?
A
- It depends on the type of good
- If it is a normal good, the income effect is positive
- If it is an inferior good, the income effect is negative
EC PREREQ1 Topics in demand and supply analysis
11
Q
How do substitution and income effect impact quantity demanded of normal goods versus inferior goods?
A
- For normal goods they reinforce each other
- For inferior goods they offset each other (and quantity demanded increasing is not as much)
EC PREREQ1 Topics in demand and supply analysis
12
Q
What is a Giffen good?
A
- An inferior good for which the negative income effect (due to substituting away) outweights the positive substitution effect when price decreases
- i.e., as the real price drops the quantity demanded drops
EC PREREQ1 Topics in demand and supply analysis
13
Q
What is a Veblen good?
A
As the nominal price rises, quantity demanded rises
EC PREREQ1 Topics in demand and supply analysis
14
Q
What are increasing marginal returns?
A
The productivity of each additional unit of a resource (L,K) increases as each additional unit of that input are employed
- An example might be adding labour, through specialisation and division of labour ie Adam Smith’s production line
EC PREREQ1 Topics in demand and supply analysis
15
Q
What are diminishing marginal returns?
A
- After a certain output, the output to labour ratio begins to decrease
- One example is if K (capital) is being used at 100% capacity. In this case, labour will not increase output
EC PREREQ1 Topics in demand and supply analysis
16
Q
What are the benefits of increased productivity?
A
- lower total costs (which translates into higher productivity measures)
- if increased productivity is passed onto the worker, then increase in worker rewards, which motivates further productivity increases from labour
- Increase in market value of a company’s equity
EC PREREQ1 Topics in demand and supply analysis
17
Q
What is economic profit?
A
Total revenue - economic costs
Where economic costs are accounting costs + an equity charge + the opportunity cost
EC PREREQ1 Topics in demand and supply analysis
18
Q
Under perfect or imperfect competition what does the demand curve look like?
A
- Under perfect competition all firms are small and none have influence over the price (cannot produce enough to do so)
- They are all price takers
- Therefore it is a horizontal line
- Under imperfect competition there is a downward sloping curve, because if we lower our price we will get a different quantity
EC PREREQ1 Topics in demand and supply analysis
19
Q
What is shutdown point?
A
Variable costs equal revenue (so not enough to cover fixed cost)
EC PREREQ1 Topics in demand and supply analysis
20
Q
How can you justify increases in wages using the marginal cost formula?
A
If wages increase then ceteris paribus marginal cost just increases
- If wages increase but the marginal product of labour increases to offset it then marginal cost does not change
- As such increases in wages can be justified where an increase in marginal product of labour equally accompanies it, as the economics of the business for the owners do not change
EC PREREQ1 Topics in demand and supply analysis
21
Q
What does it mean that under perfect competition no firms will make a profit?
A
The profit here is economic profit
- Therefore it includes opportunity cost
- It is not saying that the firms will make no money
- Rather, it is that firms will only make back their cost of capital
- There are no ABNORMAL profits
EC PREREQ1 Topics in demand and supply analysis
22
Q
What determines optimal output?
A
The intersection of marginal revenue and marginal cost
EC PREREQ1 Topics in demand and supply analysis
23
Q
What determines optimal price?
A
The demand curve, which is extended above marginal revenue on the graph
EC PREREQ1 Topics in demand and supply analysis
24
Q
How do you find average total cost from a cost per unit graph?
A
- Find quantity on the X
- Go upwards to see the Y value of average fixed cost
- See the difference between average variable cost and average variable cost at that X value
- Add the two together
EC PREREQ1 Topics in demand and supply analysis
25
What is marginal cost?
- The change in total cost for a change in quantity
## Footnote
EC PREREQ1 Topics in demand and supply analysis
26
What is the diff between short run marginal cost and long run?
- Short run = additional cost of labour input / Q
- Long run = additional cost of all inputs / Q
## Footnote
EC PREREQ1 Topics in demand and supply analysis
27
What is the short run?
- The period of time over which all factors of production are fixed except labour
- In the long run all factors of production are variable
## Footnote
EC PREREQ1 Topics in demand and supply analysis
28
What is average variable cost?
- Total variable costs / Q
- Therefore if wages go up, AVC increases
- If average product of labour goes down, AVC increases
## Footnote
EC PREREQ1 Topics in demand and supply analysis
29
What is r on the cost/unit graph?
- The minimum point of marginal costs
- Beyond this point producing more units begins to get more expensive per unit because of fixed input constraints
## Footnote
EC PREREQ1 Topics in demand and supply analysis
30
What is S on the cost/unit corve?
- The lowest point on the average variable cost curve
- Every point before S average varable cost is downward sloping (decreasing costs per unit)
- Beyond S, marginal cost is greater than average variable cost, and therefore average variable cost is upward sloping
- This means increasing costs per unit
- S is called our shutdown point
## Footnote
EC PREREQ1 Topics in demand and supply analysis
31
What is T on the cost/unit graph?
- The economic breakeven point
- The lowest point on the average total cost curve
## Footnote
EC PREREQ1 Topics in demand and supply analysis
32
What is abnormal economic profit?
- When profits cover the cost of capital and go beyond
- Normal economic profit would be covering the cost of capital
- This is different from a financial profit because financial profit does NOT take into account cost of capital
- Therefore economic profit can be negative when financial profit is positive
33
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What shape is the demand curve under imperfect competition?
- Inverse U shape, because there is some maximum point beyond which producing more quantity does not increase total revenue
- By contrast under perfect competition total revenue and quantity have a upward sloping relationship throughout
## Footnote
EC PREREQ1 Topics in demand and supply analysis
34
What are the characteristics of perfect competition?
1. Many firms, no one less than 10% of the market
2. Products are homogeneous and standardised
3. No power over pricing decisions
4. Very low barriers to entry/exit
5. Competing solely on price
A good example is commodities
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
35
What are the characteristics of monopolistic competition?
1. Many firms but with some with greater than 10% market share
2. Products are differentiated
3. Sellers have some power over pricing decisions
4. Low barriers to entry or exit
5. Advertising and product differentiation create non price competition
A good example is clothing brands
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
36
What is the definition of oligopoly?
- Few firms
- Homogeneous and standardised products
- Some to considerable seller power over pricing
- High barriers to entry or exit
- Advertising and product differentiation create non price competition
A good example is airlines
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
37
What is the definition of monopoly?
1. One firm
2. Unique product
3. Considerable seller power over pricing decisions
4. Very barriers to entry or exit
5. Don't need to worry about non price competition, but otherwise do it through advertising
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
38
What does the demand curve look like for perfect competition?
- Infinitely elastic. Price taker and prices are industry determined
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
39
What does the demand curve look like under monopolistic competition?
- Inverted U shape total revenue curve
- Downward sloping price/quantity curve since prices are firm determined
- The marginal revenue curve has a slope twice that of the demand curve
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
40
What does the supply curve look like for perfect competition?
- Level of output is determined by the marginal cost schedule (where MR = MC)
- Under the shutdown point the firm would not produce anything, since it does not even cover variable cost
- MR = MC is where we either maximise profit or minimise loss
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
41
What does the supply curve look like for monopolistic competition?
- No well defined supply curve because there are multiple prices. We need to plot out P/Q points and connect them
- Level of output determined by where MR = MC
- However price is not determined by MR unlike perfect comptition, price is determined by the demand curve
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
42
What is optimal price/output for perfect competition?
- Depends how high the ATC curve is
- If you can lower your costs then MC meets MR at a point above ATC
- This means there is economic profit greater than zero, attracting new entrants into the industry
- If costs increase such that MR meets MR at a point below AVC, Q jumps to 0 (shutdown)
- Otherwise firms will minimise losses, by just covering VC
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
43
What is optimal price/output for monopolistic competition?
- Where MR meets MC
- revenue = P x Q
- Profit = the area between C and P, x Q
- Optimal output maximises that area
44
Why is equilibrium desirable?
- Demand curve can be interpreted as a marginal value curve
- As price gets lower certain buyers get more and more value
- Consumer surplus is the triangle above P x Q
- Consumer surplus can be calculated as 1/2 b x h and this equation rearranged to work backward from price to consumer surplus if we have an equation linking P and Q
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
45
What is minimum efficient scale?
- The point at which a firm must make products in a certain quantity and with total costs in order to enter the market
- Perfect competition means firms achieve this value
- Minimum efficient scale is not achieved under monopolistic competition because firms must spend on advertising to compete
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
46
What might cause monopoly?
- Patents and copyrights
- Control over critical resources
- Government authorisation (ie if deemed to be a natural monopoly)
- Network effects ie Facebook
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
47
48
What does the supply curve look for monopoly?
- There is no well defined supply function
- Profit maximising level of output is still MR = MC
- More like a supply point
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
49
Where can regulation step in to regulate a monopoly?
- Either on the long run average cost or long run marginal cost curve
- in the first instance govt provides subsidies to bring the price to where it would be without monopoly. Not very popular
- In the second govt sets a price of what it would be without monopoly, i.e., on the LRMC curve. Note this includes returns to account for cost of capital, it does NOT mean the firm makes no profit.
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
50
How is quantity affected by the 3 different strategies of regulating monopoly?
- If govt provides subsidies Q will be higher
- If govt sets price then Q will be lower
- If govt nationalises the company this will ENABLE the existence of a company. If there was perfect competition no one would make a profit and no one would enter the market for very large industries ie infrastructure. Thus national ownership CREATES the possibility of supply
## Footnote
2024 L1 EC PREREQ2 – Introduction to the Firm and Market Organization
51
What is aggregate output?
Value of all goods and services produced in a specific time period
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
52
What is aggregate income?
- Value of all payments earned by the suppliers of the factors of produciton
- Includes wages, rent, interest, profit
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
53
How can we measure GDP?
- Since households are the ultimate owners of productive assets plus the source fo all labour it is standard to attribute all income to the household sector
- Since aggregate output = aggregate income = aggregate expenditure = GDP (denoted as Y), total household income must equal spending must equal GDP
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
54
What does GDP attempt to measure, according to the output definition?
The market value of all FINAL G&S produced within an economy in a given period of time
- This is the output definition
- All goods and services must me produced during the measurement period
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
55
# tempt
What does GDP exclude under the output definition?
- G&S whose value can be determined by being sold in a market
- Only the market value of all FINAL G&S is included (excludes value of intermediate manufacturing steps + cost of imports)
- Production in previous periods, capital gains, and transfer payments from govt to households are excluded
- As such inventory is accounted for when PRODUCED not in the period when sold
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
56
Why is expenditure an easier means to measure GDP?
- Versus income expenditure data is far more easy, more disclosed, and more widely available
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
57
What work is not included in GDP?
- Work which does not have a market value ie where no one is paid
- If you shovel snow on your own driveway it does not count toward GDP
- For this reason it's easier to count the aggregate income or expenditure rather than aggregate production
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
58
What are the two measurement methods to the output approach?
- Value of final output: what is the price from retailer to customer
- Sum of value added: sum of differences between purchase of inputs and sale of outputs across every stage of the production chain
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
59
How do we account for G&S whose market price cannot be determined in GDP?
- We proxy using a market equivalent
- For example we assume that all people who own their houses pay rent "to themselves"
- The advantage of this is that for housing the production is far too cyclical (really high in some periods and really low in others) meaning we wouldn't get a good picture of the whole economy (?)
- Government services are included at cost with no value added
- Barter transactions are not included
- Illegal activites are excluded
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
60
What is the difference between nominal and real GDP?
- Nominal GDP is the value of G&S produced at current prices
- Real GDP removes the effect of changes in the general price level, and per capita real GDP meanures the standard of living in an economy
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
61
How do we calculate real GDP?
- Multiply prices at the base year by quantity in the measurement year
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
62
What is the GDP deflator?
- Nominal GDP / Real GDP x 100
- By rearranging we can find real GDP
- We can also find real GDP growth
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
63
What is deflation?
- Any level of inflation below 1%
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
64
How does money flow around an economy between households, firms, the government, and rest of world via the factor market, goods market, and financial markets?
1. Household consumption > goods market
2. Govt spending > goods market
3. Firm investment > goods market
4. C + I + G + (X-M) from goods market > firms
5. Net exports between goods market and rest of world
6. Factor market income > households
7. Factor market labour, capital, land > firms
8. Financial markets > govt borrowing
9. Financial markets net foreign borrowing/lending > rest of world
10. Firm business financing of debt and equity > financial markets
11. Household net taxes > govt
12. Household savings > financial market
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
65
What is the most volatile component of GDP?
Investment
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
66
What do we have to add to net domestic income to arrive at GDP or national income?
- Consumption of fixed capital (ie depreciation) to replenish capital stock
- Statistical discrepancy
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
67
What is personal income?
- All income received by households
- Wages + net mixed income + net property income
- Net mixed income includes income that may not have been earned
- Net property income is the rent houseowners "pay to themselves" ie to account for property production
- Net property income cancels out in consumption so isn't counted there
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
68
What is disposable income?
- Personal income - net personal taxes
- Net personal taxes = taxes paid - transfers received
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
69
What are personal savings?
- Disposable income - consumption + change in pension entitlements
- pension entitlements are the tax deduction plus the return on the assets as well
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
70
What are domestic savings used to finance?
- Investment
- Fiscal deficit
- Trade surpluses
- This is because S = I + (G-T) + (X-M)
- It holds because AE = AI
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
71
What happens if you add all global exports and imports?
- You reach zero, because net trade is zero sum
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
72
Why do savings finance trade surpluses?
- If we sell more to other countries than we buy from them then the money they send to us has to be going back somehow
- And they must spend less on their domestic economy than they generate in domestic income
- As such other countries have to finance our trade deficit
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
73
Why are inflation and interest rates the first things you look at as a forecaster to determine investment in the future?
- Inflation and interest rates are major determinants of purchasing, saving, and investment decisions by firms and households
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
74
What function is C relative to Y and r (the real interest rate)?
- An increasing function of Yd because consumption increases when disposable income increases
- as most households have a marginal propensity to consume. When they make more they spend more
- A decreasing function of r because we are less likely to purchase durable goods (like cars, large appliance purchases, property and property improvements)
- because durable goods are usually purchased through finance
- high interest rates make these purchases less attractive
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
75
What is the paradox of thrift?
- If r is really high it might cause excessive saving
- this means no one spends in the economy and slows the economy
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
76
What impact does larger MPC have on the relationship between consumption and GDP?
- Larger marginal propensity to consume means GDP changes have a greater impact
- Consumer sector has a larger impact on GDP
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
77
What function of I is relative to r and aggregate expenditure?
- Investment is a decreasing function of r (when financing costs are high people are less likely to build more capacity)
- Investment is an increasing function of aggregate expenditure (stronger demand means more investment spending)
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
78
What is G relative to AE?
- Government spending is an increasing function of aggregate expenditure
- Because taxes are
- Govt expenditure is treated as exogeneous ie simply determined externally
- Therefore fiscal balance will increase as AE decreases and decreases as AE increases (surplus)
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
79
What is the relation of net trade balance to domestic, foreign income and the fx rate?
- Decreasing function of domestic income, because increasing domestic income makes our products more expensive and others relatively cheaper, incentivising imports
- Increasing function of foreign income, because of the opposite effect
- negatively related to the fx rate, because as fx rate goes up it means our currency is strengthening.
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
80
What is aggregate demand?
The Q of G&S that households, businesses government and intl customers want to buy at ANY given level of prices
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
81
Why is the AD curve downward sloping?
1. Wealth effect: a rise in the general price level (P1 to P2)
decreases the quantity of G&S that can be purchased with a fixed Q of nominal wealth
ie consumer are less wealth and therefore demand fewer G&S
2. Interest rate effect: as P changes, D for money changes (increase & increase). Since the money supply is fixed, the price of money increases. The price of money = the interst rate. As P decreases, less demand to hold money, more investment, so bond brices increases and r decrease.When P increases, more demand to hold money, less investment, so bond prices decrease and r increases/ As r increases businesses invest less and consumers buy less durable goods. In total P increasing drives r up, leading to lower AD.
3. Real FX rate: As P increases real FX rate increases. This makes domestic G&S more expensive abroad reducing exports. This also makes foreign goods less expensive raising imports. Therefore the trade balance decreases. Recall that when P increases r increases: so capital inflows increase demand for local currency and thus increase real FX rate.
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
82
What is the impact of higher price level on wealth, r and real fx rate?
- Real wealth declines
- Higher money demand means higher r, therefore fewer profitable investments and fewer large (financed) consumer purchases, plus higher fund inflows from abroad
- Higher real fx rate because of fund inflows from abroad, making ex less competitive and im cheaper
- This causes neg impact on net exports
- Drop in AD
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
83
What is the impact on wealth, r and real fx rate from lower price level?
- Real wealth increases
- Lower money demand leads to lower r, increasing no of profitable investmnets and more financed consumer purchases
- Then reduced fund inflows from abroad weaken the fx rate and have a positive impact on exports
- Real fx rate depreciates making exports competitive and imports expensive
- Rise in AD
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
84
Are costs variable in the short run?
- No, only labour, because in the very SR only working more or less is the response
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
85
Why do prices keep rising over time?
- Prices slowly rise to take into account increasing input costs
- Output falls back to the mean reverting level in the economy but at a permanently higher price level
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
86
How long is the long run?
- As long as it can be before capital becomes variable
- When capital becomes variable this is the "very long run"
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
87
Does demand lead supply or supply lead demand?
- Generally demand leads supply
- However the exception is in supply shock
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
88
What draws out the business cycle?
- Expansions and contractions of the aggregate demand curve (which cause short run fluctuations of real GDP)
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
89
How do we anticipate and measure shifts in AD?
- Household wealth: when investments have performed well people feel wealthier and spend more, shifting AD to right
- Consumer and biz expectations: when confidence increases AD shifts to right
- Capacity utilisation: at greater than 82-85% capacity utilisation investment tends to increase as factories are deemed to be "at capacity), shifting AD to right
- Fiscal policy: if G increases or T decreases, C increases and AD shifts to right
- MP: increases in money supply shift AD to right. Money supply can increase if securities are bought from banks, the required reserve ratio is lowered, or the target r is reduced.
- Exchange rate: fx rate increases pushes AD to right as net exports increase
- Higher global growth shifts AD to right
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
90
How would reducing central bank reserves affect the economy?
- Shift AD to left
- Equities worse as consumers consume less
- Bonds worse as interest rates increase
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
91
What would the impact of capacity utilisation increase to 86.7% from the prev year have on the economy?
- Indicates lack of spare capacity
- Increases capital spending
- Upward pressure on interest rates
- Places inflationary pressure on the economy, MAY be bad for fixed income and good for equities but uncertain
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
92
What economic impact would increased corporate profits have?
- Better equity market
- More investment by firms
- Shifts AD curve to right
- Increased output would have neg impact on fixed income securities
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
93
What economic impact would govt announcing it will start to build renewables to reduce foreign oil reliance have?
- Increase in govt spending would shift AD right
- Increase in output may positively impact equities
- Neutral to negative for bonds
- The imported oil impact is too far out to have effect
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
94
What economic impact would a recession in a foreign country have?
- Reduce demand for your exports so shift AD left
- Negative for equities particularly exporting companies
- Firm to positive for bonds
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
95
What causes the short run aggreage supply curve to shift?
- Changes in cost of production or expected profit margins
- i.e., change in unit labour cost. changes in input proces, changes in expectations about future prices, changes in business taxes and subsidies, changes in fx rate
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
96
What affects long run aggregate supply?
- Supply of labour (pop, participation rate, net immigration)
- Supply of natural resources
- Supply of physical capital (increased capital stock)
- Supply of human capital (higher qual labour increases potential gdp)
- Labour productivity and tech
## Footnote
2024 L1 EC PREREQ3 – Aggregate Output, Prices, and Economic Growth
97
What happens in a recessionary gap?
- Growth of Y is below long term trend
- AD shifts left meaning lower Y and lower
- We can measure the actual size of the gap
## Footnote
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98
How do we identify a recessionary gap?
- Corp profits decline
- Commodity prices decline
- R declines
- Demand for credit declines
- All of these reduce investments in cyclucal companies, commodity oriented companies and speculative equity
- Increased investments in devensive stocks, investment grade bonds or gilts
99
How do we identify an inflationary gap?
- Corp profits increase
- Commodity prices increase
- R increases
- Demand for credit increases
- Inflationary pressure builds
- Increase investments in high beta stocks and high yield securities
- Would want to reduce defensive stocks, govt or IG bonds, plus long term bonds
## Footnote
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100
What happens under stagflation?
- Falling output, increasing prices
- Tf inflation
- Reduce exposure to equities AND fixed income is best
- Increase exposure to commodities and real assets (the things driving stagflation)
## Footnote
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101
What does the production function describe?
- Output is a result of total factor productivity, labour and capital
- Tech (plus organisation and knowledge) makes labour and capital more productive
- We can have constant, diminishing or increasing returns of scale with any of these inputs
## Footnote
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102
What does the capital to labour ratio describe?
- marginal output for an increase in capital will be much higher when the base capital is lower
- Thus adding capital to developing economies leads to higher growth than developed
## Footnote
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103
What does the labour to capital ratio imply for the US?
- A change in labour will have a larger effect on GDP than an increase in capital
## Footnote
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104
What are the sources of economic growth?
1. Labour supply (participation rate, population, hours worked per worker)
2. Human capital (ed, training, expoerience)
3. Physical capital stock
4. Technology (the most important factor as it allows economies to overcome the limits imposed by diminishing marginal returns)
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How do you take into account change in TFP?
- Discount changes in capital and labour, since change in technology/TFP cannot be measured directly
## Footnote
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106
What are the fluctuations in employment over biz cycles?
- Recovery: layoffs slow. Businesses use overtime before hiring. Unemployment remains high
- Expansion: businesses start hiring. Unemployment stabilises and starts falling
- Slowdown: hiring slows. Unemployment falls but at decreasing rate
- Contraction: hours cut and overtime eliminated. Hiring frozen, layoffs. Unemployment rises
## Footnote
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107
What are the fluctuations of sales and production over biz cycles?
Recovery: sales decline slows, then recover. Production upturn but prod lags behind sales growth. Production approaches normal levels as excess inventory cleared.
Expansion: sales increase. Production rises fast to keep up + replenish inventories. This increases demand for intermediate products.
Slowdown: sales slow faster than production. Inventories increase. Econ slowdown means production cutbacks & orders cancelled
Contraction: biz produces at rates below sales volume to dispose of unwanted inventory
## Footnote
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What are the flucations of the inventory/sales ratio over biz cycles?
Recovery: ratio begins to drop as sales recovery outpaces production
Expansion: ratio stable
Slowdown: ratio increases, signalling weakening economy
Contraction: ratio falls back to normal.
## Footnote
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How do biz conditions and expectations fluctuate over biz cycles?
Recovery: Excess capacity, low utilisation, little need for capacity expansion
Expansion: Capacity utilisation increases, biz happy, productive capacity begins to limit ability to respond to demand, increased inv spending thanks to higher cash flows meaning ability to
Slowdown: Peak biz conditions and health cash flow, high interest rates
Contraction: Fall in demand, profits, cash flows
## Footnote
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How does capital spending fluctuate over biz cycles?
Recovery: low but increasing, focuses on efficiency (ie getting rid of workers), first spending is on quickly obsolescent items ie tech
Expansion: capacity expansion. New spending required as demand structure no longer matches company supply structure. Orders lead shipments so orders used as indicator of econ health
Slowdown: New orders intend to increase capacity but this is sign of potential slowdown. Companies continue to place new orders.
Contraction: New orders halted, some cancelled. Initial cutbacks sharp & may exacerbate downturn. Maintenance and heavy equipmt spending scaled back to preserve cash flow (that covers variable costs)
## Footnote
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How do incomes, employment and confidence move over biz cycle?
Recovery: Unemployment above average, layoffs slow, biz relies on overtime before hiring, consumer confidence starts improving
Expansion: hiring restarts, unemployment stabilises then falls. Consumer incomes rise, healthy employment prospects, confidence
Slowdown: biz continues hiring but at slower pace, unemployment continues to fall, incomes still growing, consumers remain confident
Contraction: biz cuts hours of overtime then freezes hiring then layoffs. Employment declines, consumer confidence weakens
## Footnote
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How does spending on consumer durables (cars, motorbikes, appliances, furniture) fluctuate over the biz cycle?
Recovery: spending limited as households postpone spending
Expansion: spending increases
Slowdown: spending above average
Contraction: purchases postponed, spending decreasing
## Footnote
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How does consumer non durable spending fluctuate over the biz cycle?
- It changes little but outperforms in slowdown and contraction
- Not because they perform well just better than other slowing/contracting sectors
## Footnote
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How does services spending (entertainment, eating out, comms, personal services) fluctuate over the biz cycle?
Recovery: Spending below avg
Expansion: Spending increases
Slowdown: Above average
Contraction: Declines
## Footnote
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How can we look at household income?
- Either disposable income pos related to spending on durables
- Or permanent income: this excludes temp income and unsustainable losses and gains
- The latter component correlates well with non discretionary spending
## Footnote
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What signals do household savings send RE biz cycles?
- Higher savings may indicate future caution
- Stock of savings may indicate future consumption potential, WITHOUT a need for rising incomes!
## Footnote
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117
How does the housing sector behave over biz cycles?
- new/existing home sales can indicate demand size
- Building permits can indicate supply side ie construction activity
- Housing Price Index gives clue to position in cycle
- Low rates support prices and construction rises
- Rising incomes cause housing price rise
- Rates rise when income / avg price ratio is LOW, construction drops
- Late buyers buying off momentum and speculation indicate slowdown
## Footnote
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118
How does external trade sector behave over biz cycles?
- Imports peak at top of biz cycle
- Imports drop to min at trough
- Exports drop at peak due to higher relative cost to other countries
- Exports rise during trough and recovery
- These mostly affect primary trading partners
- FX rates can help boost exports. Low rates encourage exports discourage imports
- However short term FX has minimal effects due to hedging, needs to move in one direction for some period of time
- Trade balance data can help measure this
119
What are the terms for un/employment?
- Employed: those with job
- Labour force: those with a job + those looking for one
- Uemployed: those without a job but looking
- Long term uemployed: 3-4 months but still looking
- Frictionally unemployed: natural movement from job to job
- Unemployment rate: unemployed / labour force
120
What is a price wage inflationary spiral?
- Where there are few available workers plus escalators (ie yearly raises built into employment contracts) tied to CPI
- Can only occur under low unemployment
## Footnote
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When can unemployment increase when economic conditions are still good?
- When labour force grows because no of people looking for a job who prev weren't increases
- This can actually indicate economic optimism
## Footnote
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When can job growth seemingly occur even when economy is very bad?
When the participation rate / activity ratio increases because some people stop looking for work
- if people stop looking for work long term unemployed decreases
- Therefore ratio of employed to unemployed increases on the left
## Footnote
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What is underemployment?
When someone has a job below their qualifications, or has a part time job and wants a full-time one
## Footnote
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What is a discouraged worker?
Person who has stopped looking for work. Not counted as unemployed.
## Footnote
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What is voluntary unemployment?
When someone who COULD get a job stops looking for work. They are not counted as unemployed
## Footnote
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How do we assess the unemployment rate?
- Surveys (in the US BLS)
- Claims for unemployment insurance
- total no of people at working age, regardless of their willingness
- However labour force responds to the economic environment so it is a lagging indicator rather than a leading one
- Changes in the participation rate can also produce paradoxical results so we can't trust them 100%
## Footnote
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How can we used productivity data to assess the business cycle?
- At the trough, there is an increase in hours or overtime. Productivity rises. Part time or temp workers are added, then FT workers.
- When output per hour drops it is an indicator of the peak, because output drops faster than hours
- At the peak, productivity drops. Overtime is cut and then normal hours. Temp staff are cut then FT jobs are cut. The total payroll drops.
## Footnote
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128
What is inflation?
- A SUSTAINED rise in the OVERALL level of prices
- Some prices fluctuate independently esp in volatile sectors like food and energy
- The same amount of money purchases fewer goods
- Inflation is a procyclical with a lag of a year or more
- Therefore inflation is a LAGGING indicator
- However inflation expectations are a LEADING indicator
129
How do we calculate inflation rate?
(price index 1 - price index 0) / price index 0
## Footnote
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What is deflation?
- A sustained decrease in the aggregate price level
- Value of money increases
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What is hyperinflation?
- An extremely fast rise in the aggregate price level
- Typically as a result of a rapid increase in the money supply
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What is disinflation?
- A decline in the RATE of increase of inflation
- Ie 4% inflation dropping to 3%
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What is laspeyres index?
Composition of the representative basket of inflation is held constant as of a base year (updated every 5 yrs)
## Footnote
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What are the issues with Laspeyres index?
- Sub effect: if the basket is left unadjusted results in an upward bias as households might move away to other products if original product has sharp price increase
- Quality: if not adjusted for results in an upward bias as product may improve in quality
- New products: results in upward bias as new products NOT included until new update (so might be cheaper new solutions)
- The last two can be accounted for using hedonic pricing
## Footnote
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What is a chained price index?
- Fisher index is the common one
- FI is a geometric mean of two inflation indices, the Paasche Index and Laspeyres Index (multiply together and take sqrt)
- The Laspeyres Index is just original basket based to a base year
- Paasche Index takes price of new/current basket times by price on numerator, but current basket times by original price on the denominator
- This solves issues with slippage between original basket and current consumer spending patterns
## Footnote
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What is the PPI?
Price index for inputs paid by domestic producers. Some price changes passed on to consumers to CPI some not, dep on industry
## Footnote
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What is a price deflator?
The means by which nominal GDP is converted to real
## Footnote
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What is the difference between headline and core inflation?
- Core inflation strips out the most volatile components, ie energy and food
## Footnote
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What is cost push inflation?
- Rising costs ie wages compel businesses to raise prices. Wages are the largest input cost
- NAIRU (Non Accelerating Inflation Rate of Unemployment) is the natural rate of unemploment where wage inflation is at a steady pace not accelerating
- When there is worker shortage there is excess wage inflation pressure
- Indicators of wage inflation must consider productivity ie unit labour cost, total work per hour over output
- Unit labour costs typically rise in tight labour markets
- Unions typically negotiate by asking for wage rises and promising productivity gains
## Footnote
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What is demand pull inflation?
Demand is so high they can keep raising prices and still see demand
- Capacity utilisation being high indicates this
- Actual output vs potential is what capacity utilisation measures
- Monetarists printing too much money causes inflation independent of demand pull or cost push inflation
## Footnote
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141
How do we assess inflationary potential from velocity?
If velocity of money decreases due to supply of money increasing, this pay be inflationary
- If velocity increases due to nominal GDP increasing, this may be disinflationary or deflationary
- Inflationary expectations may become self fulfilling: CB targets make inflation rates more credible
## Footnote
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What do central banks do?
- Use interst rates and money supply to engineer an economy where growht is stable and positive, and inflation is stable and low but positive (like a dog chasing its own tail)
- Government spending and taxation also attempt to do the same
## Footnote
2024 L1 EC PREREQ5 – Monetary and Fiscal Policy
143
What is money?
- A medium of exchange
- A store of value
- A unit of account ie we can compare amounts
- Must be readily acceptable
- Must have a known value
- Be easily divisible
- Have a high value:weight ratio
- Be difficult to counterfeit
## Footnote
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144
What constitutes M1 money?
- Coins/notes in circulation
- Demand deposits
- Chequing account balances
- Travellers checks of non bank issuers (though irrelevant now)
## Footnote
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What is M2 money?
- M1 money plus
- Savings / money market accounts
- Time deposits less than 100k
- Retail money market/mutual fund accts
## Footnote
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146
What is the money multiplier?
1/ reserve requirement
- This tells us how money is actually deposited in the system
- So if there is 1000 in the system and a 20% reserve requirement then the multiplier is 5x and total 5000
## Footnote
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What is the quantity theory of money?
M x V = P x Y
- Where Y is GDP
- P is price level
- M is money supply
- V is how many times it changes hands in the year (an accounting identity)
- Assumptions were made in every part so V is a heavily theoretical identity (theoretical squared even)
- This is why it breaks down a lot
- It says the amount of money used to buy stuff = the monetary value of the output
- Since we assume V is constant then spending (P x Y) is proportional to M
- This is quite obvious!
148
What is money neutrality?
If money supply increases, only P increases (price level)
- Money is neutral in terms of output, it doesn't cause more growht it just causes inflation
- Quantity theory of money is what the entire economy is based off
- Attempts to engineer the economy using quantity theory of money usually fail, MM says
## Footnote
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149
Why is there demand for money?
1. Transactions: to buy things (pro cyclical)
2. Precautionary: to have a rainy day fund
3. Speculative: people want money when other assets aren't yielding much (counter cyclical, however positively related to perceived risk)
## Footnote
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150
What is the supply demand curve for money?
- Demand for speculative money inversely related to yields. So when yield are high demand for speculative money is low
- When there is excess money demand there is more speculative demand and less demand for yielding assets. This drives interest rates higher.
## Footnote
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151
What impact does control of the money supply have on interest rates?
Money supply rising reduces equilibrium interest rate
- Money supply falling increases equilibrium interest rate
## Footnote
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152
What is the Fisher effect?
- The real rate of interest is stable over time
- Therefore changes in nominal rates are the result of changes in expected inflation
- Pi is used for interest rate expecation for inextricable reasons
- However MM says prices reflect collective stupidity of the market rather than intelligence, meaning there is uncertainty in this expectation figure
- Nor does MM believe Fisher's thesis about interest rate stability!
- If Fisher is right nominal R is a required real return plus intflation expectation premium plus risk premium
- MM thinks real interest rate changes but it is the slowst changing of the three. So we could say over the short run it is stable
## Footnote
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What are the expected and predictable costs of high inflation?
- Wages could increase by the expectation
- Nominal r would be set to the expectation
- Prices would reflect the expectation
- Expectations would become reality
## Footnote
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154
What is the cost of unexpected high inflation?
- Lagging incomes (plus give rise to shoe leather costs ie consumer unwillingness to hold cash balances during high inflation causing transaction costs)
- borrowers benefit at expense of lenders (cheaper loans)
- Frequent price changes (menu costs)
- Reduces the information content of prices (harder to understand prices and compare across time)
## Footnote
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155
What is the diff between GDP and GNP?
- Both measure the market value of finals G&S produced by factors of production
- GDP includes that located within a country or economy
- GNI includes that supplied by citizens ofa country either in or out of a country
## Footnote
2024 L1 EC PREREQ6 – International Trade and Capital Flows
156
Why compare GDP and GNP?
- GNP tells us how mmone income is accruing to its own citizens
- Foreign own factory production is counted in GDP but not GNP
- US used to use GNP until 90s then switch to GDP for intl comparability
## Footnote
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157
What is the export price index / import price index
- Set to 100 at some base year
- If greater than 100 means fewer exports needed to pay for same level of imports
- If less than 100 means more exports needed to pay for the same level of imports. Terms of trade worsened
## Footnote
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158
What is a closed economy?
- Autarky, meaning no world trade. Also means autarkic prices
- Contrast to open economy with global trade where you have world prices
## Footnote
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What happens when you introduce inward trade to a closed economy?
- Decreases price level. Consumer wins
- Lower domestic production
- Lower domestic employment
## Footnote
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What happens when you introduce outward trade to a closed economy?
- Trade at a higher price
- Higher P level
- Higher domestic production and employment
## Footnote
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161
What is the theory behind global trade?
- There must be comparative and not absolute advantage otherwise there would be no reason to trade
- Some industries may be depressed by lower prices from abroad, others will gain by exporting at higher prices
- There is a tug of war between production and employment effects
- However overall there should be a net gain
- If the trade affected sector is labour intensive exports have a positive effect and imports have a negative effect
## Footnote
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What are the benefits of trade?
- Countries gain from exchange and specialisation. Exports occur at higher prices, imports occur at lower prices
- Industries experience greater economies of scale (smaller companies have a progressively harder time competing)
- Reduces monopoly power of domestic firms
- Households and firms have greater product variety (more choice)
- Competition increases (improving product qual), improving pace of innovation as incentives increase as well
- Resources allocated more efficiently
- MM believes knowledge spillover lacks a mechanism but is touted as a benefit
## Footnote
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What are the costs of global trade?
- Potential for greater income inequality
- Loss of jobs in developed countries (= structure unemployment, which is the most difficult to fix, usually requires retraining)
-
## Footnote
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What is absolute vs comparative advantage?
- Absolute advantage is where a country can produce all goods more efficiently
- Comparative is when we compare two countries and see that the most efficient trade allocation is for one country to produce the good it is relatively best at and the other to produce the good the other is not relatively best at
- It makes more sense to say comparatively less disadvantaged
- One country can come away with a much larger advantage
- When there is absolute advantage there is not necessarily comparative advantage. The disadvantaged country can also be at a comparative disadvantage
## Footnote
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What is the Ricardian model of trade?
- Picks up where Adam Smith left off
- Trade is based on tech differences result in differences in labour productivity and tf comparative advantage
- Assumes labour is the only variable factor input and that technology varies across countries
- Essentially advantage is about no of hours required to make different products
## Footnote
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What is the Hecksher-Ohlin model of trade?
- trade is based on endowment of factors of production
- Comp adv lines in goods produced with relatively abundant factor
- We may have capital abundant or labour abundant factors
- Assumes identical technologies within industries across countries, and that L and K are variable factor inputs
## Footnote
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What is the balance of payments?
- Accounting double entry. Every debit entry requires a credit entry
- Debits are increases in assets and decreases in liabilities
- Credits are decreases in assets and increases in liabilities
- The assets and liabilities are made up of: exports, imports, financial transactions, and transfer payments
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What are the components of the balance of payments?
1. Current account: measures the flow of goods and services
2. Capital account: measures the transfer of capital
3. Financial account: records investment flows
The BoP identity is current account = capital transfer + investment flows
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What are the subsectors of the current account:
1. Merchandise trade: all commodities and manufactured goods bought, sold, and given away
2. Services: tourism, transportation, engineering, business services, fees on patents and copyrights
3. Income receipts: dividends interest
4. Unilateral transfers: one way transfer of assets including foreign direct aid and income earned from abroad sent back home
The first two are the overwhemling component
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What are the components of the capital account?
1. Capital transfers: debt forgiveness, migrant transfers, gift/inheritance faxes, death duties, transfer of funds linked to sale/purchase of fixed assets
2. Sale and purchase of non produced non financial assets (rights to natural resources, sales/purchases of intangible assets)
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What are the components of the financial account:
1. Financial assets abroad: official reserve assets, govt assets, private assets. Like gold, forex, securities
2. Foreign owned financial assets within the country. Including official assets like bonds stocks, and other foreign assets like direct investments and foreign liabilities.
## Footnote
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What does the current account measure indirectly?
- Since trade is overwhelming proportion of current account it measures the size and direction if international borrowing + lending
- Tf CA = Y - (C + I + G)
- If CA is <0 we must be borrowing from abroad
- If CA >0 we must be lending money abroad
- Therefore if CA<0 level of investment the level of domestic investment can be greater than our savings
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How to read FX pairs?
- First currency (ie EUR, USD, GBP) is the base
- Base is what you buy and sell
- Price is the second currency in the pair
- So if we buy USDJPY we expect USD to appreciate against the Japanese yen
- Whewe put it into a fraction base in the denominator (bottom)
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What is the spot rate?
Amount those two currencies can be exchanged for at that point in time
- a nominal exchange rate
- Traded 24hrs a day during business days
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What are direct and indirect exchange rates?
- Direct is when the foreign currency is the base (on the denominator)
- Indirect is when the domestic currency is the base
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How do we decide which is domestic and which is foreign currency when both in the pair are actually foreign currency?
- Traders gains accrue in the price currency (the second)
- Therefore they will likely trade based on which currency they want to get paid
- So if I am British and I want to trade a dollar peso pair I may choose MXNUSD because I will get paid in the usually lower inflation USD
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How does PPP affect currency theoretically?
- In a world of homogeneous G&S, no market frictions, and no trade barriers (incl capital restrictions)...
- If an iPad cost 500GBP or 750USD we would expect GBPUSD = 1.5000
- However this is rarely satisfied
- This is called a PPP exchange rate
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How can the price increase when buying a good from a foreign country?
1. The foreign currency appreciates relative to yours
2. Price level keeps going up in the foreign country (foreign inflation)
3. If income and inflation decrease in tandem in your country
4. Any combination of these
If we multiply spot rate (A,B) by a CPI ratio (B,A) we get the real exchange rate
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What is a forward exchange rate?
- Delivery at a future date agreed upon today
- These are OTC trades
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What are forex futures?
- Forex trades made to be cashed out in the future
- i.e., in 6 months
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What is an FX swap?
- Rolling an existing but expiring forward fx contract to a future date
- Requires SIMULTANEOUS spot transactions PLUS a new forward agreement
182
What are pips?
100 pips = 1 cent
So 1 pip = 1/10,000th of the currency value in forex
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What are the pros of forex markets?
- Facilitate trade in G&S
- Facilitate capital flows (FDI or indirect investment)
- Hedge forex risk
- Can be used for speculation
## Footnote
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Who are the participants of the forex market?
- Corporations, for hedging & to manage capital flows
- Funds: insurance, mutual, pension, endowments, ETFs
- Leveraged fungs (HF, prop traders, leveraged ETFs)
- Retail traders (who usually lose money on the spot market)
- Government or quasi govt bodies
- Central banks (to manage foreign reserves and to make currency interventions)
- SWFs
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Why do fx rates affect the capital account?
- Trade surplus or deficit (the current account) must be offset by the capital account
- When we say capital account we mean capital account and financial account together
- This is because of the Balance of Payments Identity
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What is the mechanism by which trade surplus affects fx rate?
1. Trade surplus places upward pressure on currency (because country is getting richer)
2. Capital flows enter in the short to intermediate term, driving up currency and financial assets
3. If the currency is expected to increase in value speculative money may arrive to accelerate the process
4. Trade surplus shrinks over the long term, and may even become negative
## Footnote
2024 L1 EC PREREQ7 – Currency Exchange Rates
187
What is the Marshall-Lerner Condition?
- Recall from micro elasticity
- Weight of exports (what amount exports are of total external trade, exports plus imports) times elasticity explort plus weight of imports plus elasticity for domestic imports
- is greater than 0
- then it will have an effect on the trade balance
- As such if the latter is low there will be no effect
- If the former is high there will be an effect
- If they equal there will be no effect
- This assumes exports are billed in the domestic currency
- And imports are billed in the foreign currency
- This is a dubious assumption because contracts are often settled in foreign currencies or USD
- Regardless fx depreciation will help to rebalance the trade situation if imports exceed exports
## Footnote
2024 L1 EC PREREQ7 – Currency Exchange Rates
188
Accounting to Marshall Werner, what conditions will make fx rate changes more effective for trade adjustment?
If exports and imports:
- Have substitutes
- Trade in competitive markets
- Are luxury goods, rather than necessities
- Are goods that represent a large portion of consumer expenditures
## Footnote
2024 L1 EC PREREQ7 – Currency Exchange Rates
189
What is the J curve?
- In the short run, if fx rate decreases but elasticity of demand is <1,
- the deficit worsens before it gets better
- Because consumers need time to change behaviour (digest confirm and act on new forex rates)
-
## Footnote
2024 L1 EC PREREQ7 – Currency Exchange Rates
190
What is the absorption approach?
- MM says it's a true macro argument rather than academically building from micro foundations as Marshall Werner does
- Trade balance = GD - Absorption (A)
- Where absorption is total consumption
- Thereforeto improve the trade balance you must either
- Increase outcomes or output, and/or
- Reduce absorption
- ie increase Y or decrease A
- If the marginal propensity to consume is less than 1, output rises faster than absorption so trade balance improves when GDP increases
-
## Footnote
2024 L1 EC PREREQ7 – Currency Exchange Rates
191
What is the objective of the firm?
To max profit
- Profit (pi) = total revenue - total costs
- total revenue includes interest expense
- total costs includes total implicit opportunity costs ie required RoR on equity
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
192
What give a firm abnormal economic profit?
- Tech
- Efficiency
- Cost advantage
- Govt policy
- Monopoly power
- Barriers to entry
- The first three are firm specific and are just a temporary competitive advantage
- The second three are stuctural/long term, and are sustainable competitive advantage
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
193
What is economic rent?
- The firm suddenly gets a windfall through no action of their own
- Ie supply is fixed in the short run, therefore demand determines price. If demand increases the firm can reap economic rent
- Any commodity resource or good that is fixed or nearly fixed in supply has the ability to generate economic rent. The more inelastic supply is, the higher the potential
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
194
What is the effect on equity value of economic profit?
- > 0 = positive effect
- = 0 = no effect (as ROE = RRoR)
- <0 = negative effect on value of equity
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
195
How many price curves does a firm have?
As many products or services that it has
- Different curve for each one
- Total revenue is the aggregate
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
196
What do price curves look like under perf competition?
- Horizontal demand curves
- All firms are price takers
- Can only sell at market price
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
197
Under imperfect competition what does the price curve look like?
Individual firms can influence price
- Firms face downward sloping demand curves
- Change of total revenue at each successive increment of Q is getting smaller
- Average revenue is greater than marginal at ALL points
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
198
What is minimum efficient scale?
Under perfect or near perfect competition firms must enter a market at market price
- To achieve market price they need to produce at a certain scale
- Minimum efficient scale is that production quantity
- Under imperfect competition there are a range of short run average total cost curves touching a longer run ATC curve. Since the firm has pricing power it can enter at a lower level.
- Under perfect competition there is only one intersection between demand and supply therefore only one point of Q where they can sell at the required low price level
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
199
What contributes to economies of scale?
- Division of labour or management, including better specialisation
- Productivity enhancing equipment or tech
- Efficiency gains through waste and energy reduction
- Superior market insight ie better at predicting
- Getting good volume discounts
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
200
What contributes to diseconomies of scale?
- Poor management control or oversight (bloating)
- Overlap or duplication
- Greater stress on local supply markets (driving input prices up)
- Being a big target: provoking unions, antitrust legislation, or litigation
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
201
What happens when firms start to enter an industry?
- Firms can be incentivised to enter an industry when economic profit is abmornal (positive)
- Demand curve shifts left
- Under monopolistic competition it is impossible to get to minimum cost production because there are costs of being different (ie having a brand)
- Under perfect competition in the long run economic profit moves to zero and firms produce at economic cost
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
202
What happens when there is collusion?
- When there is collusion a cartel forms
- All members divide up the aggregate demand curve and take a piece
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
203
Why is there a kinked demand curve when pricing interdependence occurs?
- Pricing interdependence means the price level you set influences others
- If I raise my price and competitors do not this creates a highly elastic demand curve. Increasing my price after this point a bit affects demand for my product a lot
- This creates the kink
- By contrast prices below this level will be much more inelastic ie reducing prices won't affect demand as much
- However if I lower prices below this point my competitors may do so too, triggering a price war, where nobody wins
- The caveat is that I don't really know where P is until I set it
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
204
What is the Cournot assumption?
- ie non cooperative
- Firms set output simultaneously and let market determine price
- Market price depends on total output
- We assume that each firm chooses its profit maximising output, assuming the output of other firms will not change
- Under Cournot assumption price and Q fall somewhere between perf competition and monopoly. This is because firms in the market have different best responses to the market
205
What is the Nash Equilibrium?
- A situation in which no firm can obtain a higher payoff by choosing a different strategy, if all other firm's strategies are held constant
- Under NE none of the participants have an incentive to switch strategy
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
206
What is the concentration ratio?
Sum of market share of N largest firms
- 0% is perfect com
- 100% is oligopoly/monopoly
- Quantifies size, but not market power
- May be unaffected by M&A within the top N firms
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
207
What is HHI?
Herfindahl-Hirschman Index (HHI)
- Sum of (market share^2) of N largest firms
- 1 = monopoly
- 1/M is where there are M firms with equal market share. This is the minimum of HHI
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
208
What are the flaws of market concentration ratios?
- Do not take possibility of entry into account
- Ie if barriers of entry are low market share metric becomes somewhat redundant
- Also does not consider elasticity of demand
- ie if demand is highly inelastic the market concentration is more significant than if demand is highly elastic
## Footnote
2024 L1 EC LM1 - Firms and Market Structures
209
What is the business cycle?
- The classical cycle measures output to define peaks and troughs
- Peak to trough was typically very short (12-18m), trough to peak typically very long (3,5,10y)
- However this isn't very useful for policy
- Growth cycle measures fluctuations in output around a long-term trend line
- Peaks are earlier troughs are later vs classical view
- More periodic by very nature of fitting around a trend line (this would always be the case)
- A growth rate cycle takes a derivative of the classical cycle. So peak is highest rate of growth, trough is lowest rate
- Where tangent is parallel to long term trend line the growth rate line intersects the centre line
- Biz cycle defined in terms of output gaps (no 2)
## Footnote
2024 L1 EC LM2 - Understanding Business Cycles
210
How does credit vary over business cycle?
- In strong economy high credit availability on favourable terms
- Often leads to asset price and real estate bubbles
- Amplifies business cycles as it's financial leverage
- In a weak economy, tight credit market + higher rates
- Cerdit cycles tend to be longer, deeper and sharper than business cycles
- Growth or contraction in credit determines direction in housing and construction markets, and affects extent of expansions and contractionns
- Credit cycles also foreshadow policy auctions
- Strong peaks in credit cycles closely associated with systemic banking crises
## Footnote
2024 L1 EC LM2 - Understanding Business Cycles
211
What is included in household income?
- Permanent income ie salaries
- Excludes temp income and unsustainable losses + gains ie capital gains
- correlates well with non discretionary spending
## Footnote
2024 L1 EC LM2 - Understanding Business Cycles
212
What is fiscal policy?
- Taxation and spending by the government
- Used to regulate economic activity over time
- By contrast monetary policy is activites related to money supply and credit done by the CB
- They are typically independent
## Footnote
2024 L1 EC LM3 - Fiscal Policy
213
What is the goal of fiscal policy?
- Create an econ evnironment where growth is STABLE and POSITIVE and inflation is LOW and STABLE
- Avoid boom and bust scenarios
## Footnote
2024 L1 EC LM3 - Fiscal Policy
214
Why do we care about the govt?
- They are large employers
- Major component of aggregate demand
- Largest bond (debt) issuer
- Govt policy used to redistribute wealth and income
## Footnote
2024 L1 EC LM3 - Fiscal Policy
215
What is the effect of fiscal policy on AD?
- Tax affects: tax influences disposable income (YD), consumption, via sales tax,and CAPEX, by influencing business investment
- Spending affects: employment, by the govt, and consumption
## Footnote
2024 L1 EC LM3 - Fiscal Policy
216
What do Keynesians believe?
- Fiscal policy can have a significant effect on AD, Y and employment WHEN THERE IS AN OUTPUT GAP
- In a recession, govts can incr spending to raise employment and Y.
- In this period revenue is less than espenses so there is a budget surplus and they should issue debt
- In an expansion, govts should lower spending and raise taxes.
- Revenue is more than expenses so there should be a budget suplus and they should pay down debt
- Surplus is contractionary and deficit is expansionary
## Footnote
2024 L1 EC LM3 - Fiscal Policy
217
What do monetarists believe?
- Fiscal changes have only a temporary effect on AD
- No long lasting effect
## Footnote
2024 L1 EC LM3 - Fiscal Policy
218
What are automatic stabilisers?
- Fiscal policy tools that automatically stabilise the policy by decreasing/increasing amount of spending dep on what is happening on the economy
- Ie unemployment payments
## Footnote
2024 L1 EC LM3 - Fiscal Policy
219
What is government debt?
- The sum total of all unpaid deficits
- Govts pay for it by issuing bonds
- These bonds held by banks, insurance firms, pension funds
## Footnote
2024 L1 EC LM3 - Fiscal Policy
220
What happens if real GDP is less than real interest rate on debt?
- Debt to GDP ratio worse since the debt grows faster
## Footnote
2024 L1 EC LM3 - Fiscal Policy
221
What happens to govt debt when inflation occurs?
- Higher inflation increases nGDP but does not increase debt
- Therefore the debt to GDP ratio gets better
- By contrast the ratio gets worse when deflation occurs
- Hence govts with lots of debt (ie Japan) do not want deflation
## Footnote
2024 L1 EC LM3 - Fiscal Policy
222
Why might we not be concerned with government GDP?
- If debt is owed internally
- if debt was used for CAPEX (it could increase productivity later)
- Reducing debt may require tax changes may correct existing distortions
- There may be no net impact because of Ricardian equivalence: higher spending today means higher taxes tomorrow, so should result in higher savings today (however this probably doesn't work)
- If an output dap exists debt is not competing with more productive use of savings
## Footnote
2024 L1 EC LM3 - Fiscal Policy
223
What are transfer payments?
- Welfare, specific govt pensions, housing benefits, tax credits, child benefits, unemployment
- These are not included in GDP as it is NOT considered spending by G. They show up in the C component instead
- Signified as B in equations
## Footnote
2024 L1 EC LM3 - Fiscal Policy
224
What is Alternative Minimum Tax?
- Companies can use all the deductions they want but they must pay at least a minimum rate of corporate tax on profits
- They can defer credits to later years but can never pay below this number
## Footnote
2024 L1 EC LM3 - Fiscal Policy
225
Why might we be concerned about high government debt?
- Higher debt means higher tax rates which may lead to disincentives in economic activity (ie Laffer curve)
- Could cause loss of confience in govt, meaning CB will have to intervene to print money which is inflationary
- May crowd out private investment. When savings are greater than investment because govt debt servicing is taking up more of savings, there is less private investment
## Footnote
2024 L1 EC LM3 - Fiscal Policy
226
What is the policy tool: govt spending?
- Spending on things like health, education, defense. Justified on both economic and social grounds
## Footnote
2024 L1 EC LM3 - Fiscal Policy
227
What is govt CAPEX?
- Infrastructure like roads, ports and schools
- Affects productive potential
## Footnote
2024 L1 EC LM3 - Fiscal Policy
228
What are govt spending inflows?
1. Direct taxes on income (wages, capital gains, on interest, dividends), wealth (real estate, property), and corporate profits
2. Indirect taxes: excise duties (on fuel, alcohol, tobacco), sales tax, lotteries (some govts have monopoly on lotteries and profit from them so this is a kind of tax)
## Footnote
2024 L1 EC LM3 - Fiscal Policy
229
What justifies taxation?
- Can increase revenue across the economy when good govt spending occurs
- Some argue income or wealth redistribution is a fundamental good
## Footnote
2024 L1 EC LM3 - Fiscal Policy
230
What are desirable attributes of a tax policy?
1. Simple
2. Efficient: taxes should interfere as little AS POSSIBLE in choices. It should discourage work and investment as little as possible (I disagree: work is good but only in the right areas and to the right extent. Taxation should also be used for non economic reasons as part of govt efforts to improve people's lives as well ie alcohol and tobacco taxes).
3. Fair: people in similar situations should pay the same tax (horizontal equity). Those who can earn more should pay more (vertical equity)
4. Revenue sufficiency: may conflict with other attributes.
## Footnote
2024 L1 EC LM3 - Fiscal Policy
231
What are potential issues when evaluating tax policy?
1. May reduce incentives to work/save, including capital flight. Also see the Laffer curve. Very high tax rate
2. Fairness of tax policy is subjective and political
3. Tax reform vs spending reform
## Footnote
2024 L1 EC LM3 - Fiscal Policy
232
What are the pros and cons of using fiscal policy to manage the economy?
+ some policies can be adjusted very quickly
- Some are inflexible in the short run (direct taxes, some spending, entitlements) and therefore are not effective in suppressing the effects of a recession (NB actually you should be adopting Keynesian principles from the beginning ie NOT increasing taxes or decreasing benefits during a recession but using your accumulated surplus)
## Footnote
2024 L1 EC LM3 - Fiscal Policy
233
What is the fiscal multiplier?
- How much output changes for a given change in taxation spending
- G - T + B = Budget deficit, where B is transfer payments
- YD = Y - NT = (1-t) Y, where YD is disposable income, Nt is taxes less transfer payments (net taxes)
## Footnote
2024 L1 EC LM3 - Fiscal Policy
234
How does the fiscal multiplier work?
###
## Footnote
2024 L1 EC LM3 - Fiscal Policy
235
What is the balanced budget multiplier?
- If govt spending increases by a dollar, and tax revenue also increases by a dollar (ie balanced budget), spending increases
- This seems counterintuitive
- Only makes sense if we make a dubious assumption about investment and saving in the economy: that investment does not increase when GDP increases, and taxes are not funded by saving (which MM says does not hold)
- Recall Y = C + I + G + (X-M)
- If we add to GDP consumption goes up at a faster rate than investment
## Footnote
2024 L1 EC LM3 - Fiscal Policy
236
What is a structural deficit/surplus?
- What would exist if the economy if the economy was at full employment (or full potential output)
- Automatic stabilisers affect the deficit/surplus unrelated to fiscal policy. What may then appear to be expansionary or contractionary may only be the result of non-discretionary reactions
- Therefore the level of surplus/deficit may not be a good indicator of fiscal policy stance
## Footnote
2024 L1 EC LM3 - Fiscal Policy
237
What happens when govt spending increases but there is no spare capacity?
- Does not increase AD
- Only increases inflation
- This is the issue with higher govt spending when the labour market is tight
## Footnote
2024 L1 EC LM3 - Fiscal Policy
238
What are the roles of CBs?
- Sole supplier of domestic currency (fiat currency which acts as a medium of exchange AS LONG as it holds it value. Therefore currency confidence is critical
- Banker to the govt
- Banker's bank: the lender of LAST RESORT
- Regulator/supervisor of the payment system
- Banking system supervisor
- Manages the country's foreign currency reserves + gold reserves
- Conducts MP (its main job): influences the quantity of money and credit
## Footnote
2024 L1 EC LM4 - Monetary Policy
239
What are CB objectives?
- Maintain stability of the financial system
- Promote full employment (Fed)
- Promote price stability (Fed + ECB + most banks)
## Footnote
2024 L1 EC LM4 - Monetary Policy
240
What tools does CB use?
- Open Market Operations: purchase/sale of govt bonds from/to commercial banks and designated market makers (for overnight to 2 weeks). Known as repuchase agreements (repo): buy, then sell back next day. Also reverse repo: CB sells bond and buys it back next day.
- Policy rate: (FFR in US), usually has a range ie upper and lower bound. Upper is rate CB is willing to lend at, lower bound is rate willing to borrow at. Hike in policy rate is meant to increase lending rates and CONSTRICT credit growth
- Reserve reqs: used more in developing economies. To increase or decrease the supply of money by varying leverage across the economy.
## Footnote
2024 L1 EC LM4 - Monetary Policy
241
What are the transmission mechanisms for CB tools?
- Set official rate wich influences market rates, asset prices, expectations/confidence, and exchange rate
- These all flow into domestic demand and net external demand, which then combine to create the level of domestic inflationary pressure
- Exchange rate further influences import prices (appreciating currency makes imports cheaper with no price change abroad), which slows or quickens inflation as well
## Footnote
2024 L1 EC LM4 - Monetary Policy
242
What is inflation targeting?
- Began in new zealand which targeted 0-2% in the 90s
- Targets a specific range + discloses this. Like nuclear weapons the whole point is to disclose to become self fulfilling + make banking tools less expensive
- 2% most common target because 0% may lead to defalation which is v bad especially for debt
- Higher targets mean higher inflation volatiltiy whichi s not consistent with price stability
## Footnote
2024 L1 EC LM4 - Monetary Policy
243
What is CB independence?
- from govt
- Can make decisions without govt approval
- Non partisan + non elexted, therefore won't use MP to get reelected and do stupid things
- Operational vs target independence: operational means set level of rates. Target independence meansthey set the inflation target WITHOUT it being voted on as well, PLUS which definition of inflation they use
## Footnote
2024 L1 EC LM4 - Monetary Policy
244
What is CB credibility?
- Markets must believe CB will stick to its targets, and that can be measured by inflation expecations
## Footnote
2024 L1 EC LM4 - Monetary Policy
245
What is CB transparency?
- Minutes of meetings, press conferences, economic forecasts are disclosed
- Should consider a wide range of economic and financial indicators when making decisions
## Footnote
2024 L1 EC LM4 - Monetary Policy
246
Why does BoJ not have a defined inflation target?
- Old and aging pop
- Consumption falls long term
- deflation larger threat
- May not be credible if it announced a target (historical failings)
- US Fed never explicitly says it has a 2% target but rather uses it as an anchor, because of the dual mandate
## Footnote
2024 L1 EC LM4 - Monetary Policy
247
What does MP look like in developing economies?
- More challenging RE price stability
- Iliquid small govt bond markets making OMOs challenging
- Rapidly changing economy makes setting neutral rate difficult
- No clear and sstable definition of money supply
- General lack of stability
- General lack of independence
## Footnote
2024 L1 EC LM4 - Monetary Policy
248
What is exchange rate targeting?
- Fixed level ie peg or a band (managed exchange rate policy) around a major currency
- By tying the domestic currency to that of an economy with a credible CB it imports that credibiity
## Footnote
2024 L1 EC LM4 - Monetary Policy
249
How does FX rate targeting work?
- Sell foreign reserves and buy domestic to reduce domestic money supply and reduce inflationary pressure
- Interest rates would adjust upward
- When MEDCs set rates they set the rate then fx adjusts. In LEDCS their fx rate is set abroad and the interest rates adjust. This leads to more volatile interest rates in LEDCs and more volatile fx rates in developed economies
- Dollarisation is where a country adopts USD as its functional currency
## Footnote
2024 L1 EC LM4 - Monetary Policy
250
What are the limitations of MP?
- When policy rates are high this is contractionary, when low this is expansionary. Somewhere between is the neutral rate with stable growth and stable inflation
- Should target real GDP growth rate that results in stable inflation
- Changes in rates work well for demand shocks but not supply shocks ie rates cannot remedy shortaegs
- transmission probelms: inverted yield curves work against contractionary policy, and long rates high works aaginst expansionary policy
- Liquidity traps: money injected into the system is just held by banks and not lended out. This is common when deflation is expected. results in loan risk increasing and real rates rising rapidly
- Deflation: ZLB. Negative interest is sometimes used to remedy liquidity traps.
## Footnote
2024 L1 EC LM4 - Monetary Policy
251
What is QE?
- Large scale bond buying
- Lowers LT rates
- Floods the economy with money
## Footnote
2024 L1 EC LM4 - Monetary Policy
252
What happens when MP is easy and FP is easy?
- Assuming that spending has a higher impact than taxation, and transfer payments to the poorest are 2x better than transfer payments to all
- Highly expansionary
- AD increases, rates decrease
- Consumption and G increase
- Will encourage inflation
- 2020/21 US is emblematic
## Footnote
2024 L1 EC LM4 - Monetary Policy
253
What is the effect of tight MP and easy FP?
- Taxes down (consumers have more money) or spending increases, so therefore G increases
- Rates are high, therefore consumption down
- G/GDP ratio increases
- 2022/23 US is emblematic
## Footnote
2024 L1 EC LM4 - Monetary Policy
254
What is the effect of tight FP & tight MP?
- rates high
- higher taxes/lower spending
- C down and G down
- AD decrease
- Do this when inflation very high & potentially leading to runaway expecations
- Somewhat 2024 but fiscal policy is not that tight given the IRA
## Footnote
2024 L1 EC LM4 - Monetary Policy
254
What is the effect of tight FP and easy MP?
- Taxes up or savings down, rates low
- Consumption up, G down
- Therefore C/GDP ratio increases
- Less crowding out, so private investment increases. This increases potential real GDP
- 1995 to 2000 under Clinton: the govt was running budget surplus and paying down debt
- MM says this was instrumental in the internet boom & has led to markedly higher productivity today
## Footnote
2024 L1 EC LM4 - Monetary Policy
255
Which action is a CB least likely to take if it wants to encourage biz and households to borrow for investment and consumption purposes?
- Sell long dated govt securities
- Increasing supply decreases price
- This pushes yields up
- Yields up means less borrowing
## Footnote
2024 L1 EC LM4 - Monetary Policy
256
The least likely limitation to the effectiveness of MP is that CBs cannot...
A. accurately determine the neutral rate of interest
B. Regulate the wilingness of FIs to lend
C. Control amounts that economic agents deposit into banks
A, because both B and C are indeed limitations
## Footnote
2024 L1 EC LM4 - Monetary Policy
257
What is geopolitics?
- Study of how geography affects political and IR
## Footnote
2024 L1 EC LM5 - Introduction to Geopolitics
258
What is geopolitical risk?
- Risk associated with tensions or actions between actors that affect the normal and peaceful corurse of IR
- Actors = individuals, organisations, companies, national govts
- The impacts of geopolitical risk can affect growth, rates, access to key resources, currency value, supply channels, access to markerts
- This results in risk premia, asset allocation, and geographical exposure
## Footnote
2024 L1 EC LM5 - Introduction to Geopolitics
259
What is a state actor?
- Nat govts, political organisations, and country leaderes that exert authority over a country's national security and resources
- Non-state actors do NOT directly control national security or country resources eg NGOs, MNCs, charities, influential individuals
## Footnote
2024 L1 EC LM5 - Introduction to Geopolitics
260
What are the features of political cooperation?
- When cooperative countries work tgt for some shared goal or purpose (military, economic, cultural)
- Cooperation = rules standardisation, tariffs harmonisation, free mvmt across bordesr, permitted mvmt of goods, services & capital, reciprocation, tech exchange
## Footnote
2024 L1 EC LM5 - Introduction to Geopolitics
261
What are the characteristics of political non cooperation?
- Inconsistent rules
- Arbitrary ruels
- Restricted mvmt across borders
- Restricted trade
- Capital controls
- Retaliation
- Lack of tech exchange
## Footnote
2024 L1 EC LM5 - Introduction to Geopolitics
262
Why would countries cooperate?
- Military interest & deterrence
- Economic: access to key resources plus ability of domestic firms to operate on global scale (ie WTO)
- Unequal distribution of resources creates need and desire for cooperation. May also create inter and intra country power imbalances
-
## Footnote
2024 L1 EC LM5 - Introduction to Geopolitics
263
What are the methods of political cooperation?
- Satandardistion of process for production, sale, transport, of use of products and services (rules of engagement)
- Regulatory cooperation ie Basel Committee on Banking Supervision
- Process standardisation, ie SWIFT for payments
- Operation synchronisation ie containerisation of shipped goods
## Footnote
2024 L1 EC LM5 - Introduction to Geopolitics
264
What is soft power?
- A means of influence without force or coercion
- Ie student exchange programs, student visas
- Cultural considerations: cultural similarities, immigration patterns can impact or evidence influence
## Footnote
2024 L1 EC LM5 - Introduction to Geopolitics
265
What is the role of institutions within political cooperation?
- Institutions are an established organisation or practice in a society or culture
- Doesn't need to be a building
- Strong institutions contribute to more stable internal and external political force
- ie rule of law, property rights, human rights
- All of these provide more opps to develop durable cooperative relationships
- Globalisation and cooperation tend to be correlated
## Footnote
2024 L1 EC LM5 - Introduction to Geopolitics
266
What is the hierarchy of interest?
- The rank of interests which determine cooperation
- Think Maslow: as lower needs become satiated then different interests may become important
- For example US China: Us cares about dem and human rights but cheap labour more important
- West Russia: wants to spread dem and extend NATO, but needs Russian energy
## Footnote
2024 L1 EC LM5 - Introduction to Geopolitics
267
How are the powers and capabilities of political decisionmakers different between countries?
- In countries with a political party or congress/parliament in power, there are short political cycles and therefore changing priorities
- In countries with an individual ie autocrat/dictator in power, psychology is very important. Possibly more unpredictable
## Footnote
2024 L1 EC LM5 - Introduction to Geopolitics
268
What is nationalism?
- Domestic economic and financial activity dominant to the exclusion of the interest of other nations
- Nationalism is not necessarily bad but has tended to be associated with bad actors in the past
- Comes from all sides of the political spectrum
- Just about spending taxpayer funds to benefit themselves
- Reshoring: moving some of the essential supply chain components home to reduce supply chain volatility
## Footnote
2024 L1 EC LM5 - Introduction to Geopolitics
269
Motivations for globalisation?
1. Increasing profits
- new markets create increased sales and may involve FDI
- Lower costs: cheaper labour, lower tax operating enviroments, supply chain effectiveness (lower transport costs/direct access to commodities)
2. Access to resources and markets: talent or raw materials
3. Intrinsic gain: information exchange, knowledge spilloers (/ induced innovation increasing competitiveness)
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Costs of globalisation?
- Unequal access of economic and financial gains: winners and losers
- Lower ESG standards: will operate to local standards (regulatory arbitrage)
- Political consequences: net job losses, out migration, capital outflows
- Interdependence: overreliance on the resources, or a key resource, from another potentially uncooperative country
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What have induced threats of globalisation rollback?
- Exposed vulnerabilities such ass:
- reshoring essential production
- Country sourcing diversificaiton
- Owning foreign production
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What are the archetypes for global trade?
1. Hegemony: poltiical economic or military domination by regional or global leaders
2. Bilateralism: each trade agreement is only 2 way and no shared universaals
3. Multilateralism: trade among a group, extensive rules harmonisation. Also see regionalism, the same within a particular region ie EU
4. Autarky: Self sufficiency, limited trade. Can result from isolation ie DPRK
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What are the three classes of tools of geopolitics?
1. National security tools ie espionage, armed conflict terrorism. Involve threat and sometimes can involve backlash / moral censure
2.Economic tools: can use common markets, economic and monetary unions, and multilateral trade agreements
3.Finanical tools: free exchange of currencies, allowing FDI
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What are the 3 types of geopolitical risk?
1. Event risk: date specific ie elections, new legislation
2. Exogeneous risk: unanticipated risk that impacts either a country's cooperative stance, ability of non state actors to globalise, or both
3. Thematic risk: evolve and expand over a long period of time, e.g., climate change, imigration patters, populism
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How to assess geopolitical threats?
1. Likelihood: probability that it will occur. Mostly subjective
2. Velocity: pace at which gp risk impacts investor portfolios
3. Impact: high or low, discrete (company/sector specific) or broad (economy/market
- Create a base case and then an optimistic/pessimistic evolution scenario set. use signposts eg levels and indicators to determine when you should make moves ie change which markets or types of investment you're investing in
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What is the IMF?
Oversees the fixed exchange rate agreements between countries
- Helps govts manage their exchange rates
- Provides short term capital to aid balance of payments (prevent the spread of crises)
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What is the world bank?
- Help LEDCs fight poverty and enhance environmentally sound economic growth
- Not for profit
- Pass low rates from good AAA credit ratings directly onto those they lend to
- However they use policy based lending
- Generally tends to require policy that benefits rich countries faster or sooner (even if the overall impact in the long run might be positive for everyone)
- A supranational org
- If the loan was 100% to fight poverty there would not be stringent policy reqs
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What does the WTO do?
- Regulates cross border trade relationships globally
- Implements administers operates individaul agreements
- Settles disputes
- Regional trade agreements can be tailored to needs faster to set up and faster to tackle disputes. WTO is slow! so sometimes regionals are prepared
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What are the benefits of intl trade?
- Countries gain from exchange and specilalisation
- Higher prices for exports
- Lower prices for imports
- Industries experience greater economies of scale
- Households and firms have greater product variety
- Increased competitiveness
- Resources are allocated more efficiently
- Increased exchange of ideas, freer flow of technical exertise
- General consenssu is that trade increases overall welfare in an economy
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What are the potential costs of intl trade?
- Potential for greater income inequality
- Loss of jobs in developed countries
- Greater competition may lead to the decline of some domestic industries
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What are trade restrictions?
- Govt policies that limit trade
- Protect domestic industries or new industries
- Protect domestic employment
- Protect strategic industries (national security reasons)
- Gain rev from tariffs
- Retaliation
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What are tariffs?
- Taxes a govt levies on imported goods
- The IMPORTER pays the tariff
- Main obj is to protect domestic industries OR reduce a trade deficit for an imported good/service
- Reduces demand by raising the price ABOVE the free trade price
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What is a quota?
- Restricts the q of a good that can be imported (generally for a period of time)
- Raises dom price
- Sam effect as tariff, but box C is not govt revenue but rather 'quota rent'. Captured by exporting country
- Also involves DWL
- Raises price by restricting supply
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What is a voluntary export restraint?
- If a country believes their trading partner might impose some punitive measure ie tariffs they may voluntarily adopt a quota for export of a G/S
- This means the C box is captured by them rather than their trading partner
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What are export subsidies?
A payment by the govt to a firm for each unit exported
- Shifts sales from the domestic market to the expoert market
- Raises the price in the domestic market by the amt of the subsidy (small country case)
- Large country case: world price declines
- Countervailing duties: levied by importing country against subsidied exports entering the country
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What are domestic content provisions?
- Demanding some percentage of the value added or components use in production should be of domestic origin
- Typically govt spending requires this to boost employment
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What are capital restrictions?
- Controls placed on a foreigners' ability to own domestic asset or on domestic residents' abiltiy to own foreign assets
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What is the effect of regional integration?
- Less efficient allocation of resources as shifts trade and production from lower cost non members to higher cost members
- Trade creation arises because of more efficent resource allocation plus cheaper imports and higher val exports vs autarky
- However also trade diversion from non members
- If trade creation is greater than trade diversion there is a net positive effect
- Costs and benefits are that it has the same benefits of free trade ie less conflict, more interconnected economic futures, leads to convergence of living standards, consumers gain choice, competitive firms gain in productivity.
- But may hurt low skilled workers in wealthier countries, may cause firm failure due to lack of cost competitiveness
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What is the hierarchy of trading blocs?
1. FTA: all barriers to flow of goods and services among members are elimitaed, each ountry maintains its own policies against non members
2. Customs union: fta + common trade policy against non members
3. Common market: customs union: free movement of factors of production among members ie capital, people
4. Economic union: common market + common economic institutions and coordination of economic policy among members
5. Monetary union: economic union + common currency
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What are the challenges of regional integration?
1. Cultural differences
2. historical considerations ie past wars and conflicts
3. High degree of economic integration will limit ability of individual members to pursue independent economic and social policies. For example mobility of labour may thwart policies aimed at raising low wages
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What does it means when the FX rate goes down?
The price currency has appreciated OR the base currency has DEpreciated. They mean the same thing
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What is the ideal currency regime?
1. Rate between any 2 countries would be credibly fixed (eliminates uncertainty
2. All currencies would be freely convertible (freely exchanged for any purpose in any amount
3. Each country would be able to undertake fully independent MP
You can only have 2 of 3
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What creates ideal efficacy for MP in terms of FX regimes?
- Freely floating currency PLUS tight convertibility (capital restrictions
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What is a currency board?
- A fixed fx rate with the domestic currency fully backed by foreign assets
- Expansion or contraction of the monetary base directly linked to trade and capital flows
- Outflows result in increasing interest rates
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What are crawling pegs?
- you can either have active or passive crawling currency pegs
- under an active one you pre announce fx rate to manipulate inflation expectations
- under passive crawling pegs you actually react to changes in domestic inflation
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What are crawling bands?
- Begin with a currency peg to anchor inflation expecations
- Gradually widen a band over time
- Allow for slow exit from the peg
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What is a managed float?
- use a policy target such as trade balance or price stability to manage fx rate
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What is an independent floating rate?
- market determined
- allows CB to have full control over MP
- Doesn't mean no intervention ie sometimes the CB might intervene
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What are capital restrictions?
- Both inward and outward
- Any policy designed to limit or REDIRECT capital flows
- Meet policy objs eg employment, regional dev, national sec
- inward restrictions might limit how much can be invested, restrict investment in certain industries, or prevent HOT MONEY flows but perhaps not FDI
- Outward restrictions impose limits on repatriation of capital or income (ie dividend withholding tax), restrict outflows of wealth, or prevent capital flight (to incentivise purchase of domestic assets).
- Outward restrictions also facilitate taxation of wealth and income
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How are forward spot rates usually quoted?
- Current spot rate plus points which add the adjustment
- Points can be pos or neg
- Points pos is forward premium
- Points neg is forward discount
- These are also called swap points
- Keep in mind the points have separate bid and ask rates
- If you just have one set of points it is the midpoint of the two
- Swap points are in 10,000ths
- The forward rate is just a function of the interest rate differential between the 2 countries, not an indication of what the market thinks the fx rate will be in the future
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When are forward fx rates at a discount and when at a premium?
- Discount when base currency is the higher yielding one
- Premium when the base currency is the LOWER yielding one
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