CME Flashcards
Taylor Rule
target interest rate = neutral rate + expected inflation + [0.5(expected GDP - GDP trend) + 0.5(expected inflation - target inflation)]
Neutral Rate
Equilibrium interest rate –> balance between growth and inflation
Comprised of:
1) inflation component
2) real growth component
3) judgment from policymakers
eg inflation target 3%, economy expected growth 2%, neutral rate = 5%
What happens to Rates, capital flows, exchange rates when the CB tries to pursue expansionary or contractionary policy?
If CB attempts to push rates DOWN (expansionary policy):
capital flows out –> downward pressure on FX rate –> forces bank to BUY its own currency –> reverses expansionary Policy
If CB attempts to push rates UP (contractionary policy):
capital flows in –> puts upward pressure on FX rate–> forces bank to sell its own currency –> reverses contractionary policy
Causes for Concern For a Country: Levels of
1) Current account deficit
2) Persistent annual grwoth rate
3) Debt-to-GDP Ratio
4) Foreign debt levels
5) Forex reserves
1) Current account deficit= want it LOWER than 4% (higher = cause for concern)
2) Persistent annual real growth rate = want it HIGHER than 4% (lower = cause for concern)
3) Debt-to-GDP Ratio: 70-80% could be troublesome for EM
4) Foreign debt levels >50% might = overleveraged, or debt levels >200% of current account receipts
5) Forex reserves <100% of ST debt –> more than 200% considered strong
What is the shape of the yield curve when
Fiscal and monetary policy both expansive
Fiscal and monetary policy both restrictive
Monetary = expansive, but fiscal restrictive
Monetary = restrictive, but fiscal = expansive
Fiscal and monetary policy both expansive = sharply UP sloping because ST rates are low and lower taxes, higher spending
Fiscal and monetary policy both restrictive = DOWNward sloping, ST rates are high, higher taxes, less spending –> sign heading towards a downturn
Monetary = expansive, but fiscal restrictive –> MILDLY UPward sloping
Monetary = restrictive, but fiscal = expansive –> FLAT
Forecasting Approaches: Econometric vs. Economic Indicators Vs Checklist Approaches
Econometric Models
Economic Indicators and their advantages / disadvantages + diffusion index
Leading indicators mroe useful
can be used individually or in a composite
Diffusion index = a composite where you look at the number of indicators pointing towards expansion vs contraction –> eg if 9 out of 10 say expansion
Advantages:
- Economic indicators are simple, intuitive, and easy to interpret.
- Data are often readily available from third parties.
- Indicator lists can be tailored to meet specific forecasting needs.
Disadvantages:
- Forecasting results have been inconsistent.
- Economic indicators have given false signals.
- Indicators are revised frequently, which can make them appear to fit past business cycles better than they did when the data were first released.
Grinold-Kroner Model
adds variables to GGM to predict LT equity return bc GGM is not suitable for LT time horizon
Disadvantage: may lead to irrational results –> assumes INFINITE horizon, so doesnt account for investor’s horizon
ER = (dividend yield) + (inflation) + (real earnings growth rate) - (change in stock oustanding) + ( change in PE ratio)
FOR EXAM:
1) note that middle term is change in earnings per share…if change in shares is POSITIVE, keep the MINUS sign, because less shares = higher EPS, all else equal
2) will need to separate into three components:
It is helpful to view the Grinold-Kroner model as the sum of the (1) expected cash flow return, (2) expected nominal earnings growth rate, and (3) expected repricing return. this formula is DIFFERENT from the one in the photo –> just rearranged
E(Re) ≈ (D/P − %ΔS) + %ΔE + %ΔP/E
A) Income component = D/P - %changeS
B) the nominal growth componenet = %changeE
C) the repricing component = %change PE
Output Gap
difference between actual GDP and potential GDP, scaled by potential GDP
if closing / expected to become positive as a proportion of potential GDP –> spare capacity of economy is forecast to decline –> implies higher inflationary pressure
Relative Purchasing Power Parity
the country with the LOWER expected inflation should see its currency STRENGTHEN vs one with higher inflation
Current Account Surplus/Deficit Effect on Currency Strength
in the absence of capital flows, the country with a current account SURPLUS will see its currency STRENGTHEN vs one with a deficit, to address the trade imbalance
the country with the current account DEFICIT will see its currency WEAKEN vs the one that has a surplus
GDP Growth effect on currency strength
higher GDP growth = more investment opportunities = strengthening currency
so if comparing between two countries, the one with the higher GDP growth will have strengthening currency vs the other one
