Economics Flashcards

Question 1

Q

Stagflation describes

Answer

A

an economy suffering rising unemployment and rising price levels. It is caused by a leftward shift in short-run aggregate supply (SRAS). The fall in unemployment may lead to lower input prices and labor costs for producers. They will then be able to increase their short-run aggregate supply, possibly resulting in full employment. However, this process can be too slow, and therefore policymakers might try to use fiscal and monetary policy to remove stagflation, but the possibility is a permanent higher price level.

Question 2

Q

The potential growth rate in output

Answer

A

long-term growth rate of the labor force
+
long-term labor productivity growth rate (output per worker)

Question 3

Q

The goods included in the GDP calculation

Answer

A

must have been produced during the measurement period, and they must have an objective price that is determined by the market. Transfer payments, such as unemployment or welfare benefits, are excluded from the GDP calculation

Question 4

Q

Demand function

Answer

A

What influences the quantity of a good consumers are willing to buy, i.e. demand?
- Price
- Income
- Price of substitutes
- Price of complements

Question 5

Q

if economy is in equilibrium

Answer

A

G + X + I = t + M + S

Question 6

Q

Factors that influence price elasticity of demand

Answer

A

Closeness of substitutes
Products that can be more readily substituted with other products
will have a higher elasticity
Percentage of income spent on the good
The greater the percentage of budget spent, the greater elasticity
Time elapsed since price change
The greater the time since the price change, the greater the elasticity
The extent to which the good is seen as necessary
The less the good is seen as necessary the greater the elasticity

Question 7

Q

Perfectly elastic

Answer

A

> Infinity
The smallest possible increase in price
causes an infinitely large decrease in the
quantity demanded

Question 8

Q

Elastic

Answer

A

> Less than infinity but greater than 1
The percentage decrease in the quantity
demanded exceeds the percentage
increase in price

Question 9

Q

Unit elastic

Answer

A

> 1
The percentage decrease in the quantity
demanded equals the percentage
increase in price

Question 10

Q

Inelastic

Answer

A

> Greater than zero but less than 1
The percentage decrease in the quantity
demanded is less than the percentage
increase in price

Question 11

Q

Perfectly inelastic

Answer

A

> Zero
The quantity demanded is the same at
all prices

Question 12

Q

Close substitutes

Answer

A

> Large
The smallest possible increase in price
of one good causes an infinitely large
increase in the quantity demanded of the
other goods

Question 13

Q

Substitutes

Answer

A

Positive
If the price of one good increases, the
quantity demanded of the other good
also increases

Question 14

Q

Unrelated goods

Answer

A

> Zero
If the price of one good increases, the
quantity demanded of the other good
remains the same

Question 15

Q

Complements

Answer

A

> Negative
If the price of one good increases, the
quantity demanded of the other good
decreases

Question 16

Q

Income elastic (normal good)

Answer

A

> Greater than 1
The percentage increase in the quantity
demanded is greater than the
percentage increase in income

Question 17

Q

Income elastic
(normal good) necessity

Answer

A

> Less than 1 but greater than zero
The percentage increase in the quantity
demanded is less than the percentage
increase in income

Question 18

Q

Negative income
elastic (inferior good)

Answer

A

> Less than zero
When income increases, quantity demanded decreases

Question 19

Q

Substitution and income effects

Answer

A

Substitution effect:
If the price of a good declines, then it becomes more of a bargain relative to other goods. Therefore, other goods are substituted for this particular good.

Income effect:
As the price declines, the consumers’ real income increases as they have to spend less on the same amount of goods. For normal goods, as income increases, more of this good is purchased.

Question 20

Q

Normal and inferior goods
Effects of a price decrease on demand

Answer

A

Substitution Effect: Normal
Increase
Income Effect: Normal
Increase
Substitution Effect: Inferior
Increase
Income Effect: Inferior
Decrease

Generally the income effect has less of an impact than the substitution effect.
Therefore the consumer still ends up buying more at the lower price

Question 21

Q

Exceptions to the law of demand – Giffen good

Answer

A

Effects of a price decrease on demand
Decrease in demand:
Subs effect: Incr
Income effect : decr
BUT
Income effect > Substitution effect

If the income effect has a greater impact than the substitution effect for an inferior
good, then a decrease in price would result in a decrease in quantity demanded
and hence a positively sloped demand curve
All Giffen goods are inferior, but not all inferior goods are Giffen

Question 22

Q

Exceptions to the law of demand – Veblen goods

Answer

A

Veblen goods are goods that increase in desirability as price increases, such as a
high status good
E.g. luxury cars
This creates a positively sloped demand curve

Question 23

Q

Marginal product

Answer

A

Increase in total product that results from a one-unit increase in the quantity of labour
employed, with all other inputs remaining the same

Question 24

Q

Law of diminishing marginal returns

Answer

A

Where a firm uses more of a variable input with a given quantity of fixed inputs the
marginal product of the variable input eventually diminishes

Question 25

Q

Total revenue is maximized

Answer

A

when each marginal unit sold is positive

Question 26

Q

Marginal cost

Answer

A

Increase in TC that results from a one-unit increase in output
MC = Δ TC/Δ quantity produced, where TC = TFC + TVC
Decreases at low outputs because of increasing factor returns
Eventually increases due to the law of diminishing returns
MC always cuts ATC and AVC at their minimum points

Question 27

Q

ATC is U-shaped

Answer

A

Spreading total fixed over larger amount
Eventually diminishing returns

Question 28

Q

Breakeven point

Answer

A

Price = ATC

Question 29

Q

Shutdown point

Answer

A

price = AVC

Question 30

Q

Profit maximization

Answer

A

occurs when MR = MC, this is where
the difference between total revenue
and total cost is the greatest

Question 31

Q

Characteristics of perfect competition

Answer

A

Many firms sell identical products (homogeneity) to many buyers
Few and easily surmountable barriers to entry/exit
Established firms have no advantage over new firms
Sellers and buyers are well informed about prices
Non-price competition is absent
Price takers
Firms that take market price as given when selling their product
Each is small relative to the market and cannot affect price
Price = Marginal revenue
Price remains constant when quantity sold changes
Profit maximization
Goal is to maximize economic profit
Marginal revenue (MR) = Marginal cost (MC)

Question 32

Q

Perfect competition of firm

Answer

A

P = D = MR = AR
short-run
Economic profit : P > ATC where P= MC = MR
Economic loss: P < ATC
Breakeven : P = ATC
LONG-RUN
no profitability
MC =SR
pmin = AVC
qLR = ATC

Question 33

Q

Industry supply curve

Answer

A

Sum of the individual firm’s supply curves across a range of prices (where the
quantities supplied by the firms remains constant)

Question 34

Q

Key characteristics of monopoly

Answer

A

Single seller
No close substitutes
High barriers to entry
Strong pricing power
Barriers to entry can take the form of:
Legal barriers
Patents, copyrights or ‘public franchises’ that is government license
Natural barriers
Economies of scale in, for example, electricity generation and water supply
One firm can supply the whole market at a lower cost than two
or more firms

Question 35

Q

Monopoly price-setting strategies:

Answer

A

Single-price monopolies
All output sold at same price to all customers
Price discriminating monopolies
Able to charge classes of customer the highest possible price per
class and can prevent low price customers selling to high price customers

Question 36

Q

A single-price monopoly

Answer

A

produces the quantity Qm at which marginal revenue equals marginal cost and sells that
quantity for price Pm
=> pROFITS

Question 37

Q

Price discrimination arises where the monopoly can:

Answer

A

Identify and separate buyer types
Sell a product that cannot be resold
Supply = MC
Demand = MB
> monopolist aims to extract the entire consumer surplus

Question 38

Q

First-degree price discrimination

Answer

A

A monopolist is able to
charge each customer
the highest price the
customer is willing to
pay

Question 39

Q

Second-degree price
discrimination

Answer

A

A monopolist uses the
quantity purchased to
determine what to
charge the customer
* If the customer is
buying a large
quantity, they value
the product more, and
will therefore pay
more (and vice versa)

Question 40

Q

Third-degree price
discrimination

Answer

A

Customers are
segregated by
demographic or other
traits and each group
is charged a different
price

Question 41

Q

Gross Domestic
Product (GDP)

Answer

A

Income approach
Total amount earned by
households and companies
in the economy
=
Expenditure approach
Total amount spent on goods
and services within the
economy during a period
of time

Question 42

Q

Nominal GDP

Answer

A

Value of goods and services measured at current prices

Question 43

Q

Real GDP

Answer

A

Value of goods and services if prices were
unchanged (no inflation)

Question 44

Q

Per capita real GDP

Answer

A

= Real GDP / Population size
- Used as a measure of the average standard of living in a country

Question 45

Q

The GDP Deflator

Answer

A

The GDP price deflator is a measure that accounts for inflation by converting
output measured at current prices into real GDP
It is also known as the GDP implicit price deflator
GDP deflator = (Value of current year output at current year prices / Value of
current year output at base year prices) x 100
GDP deflator = (Nominal GDP / Real GDP) x 100

Question 46

Q

GDP =

Answer

A

C + I + G + (X - M) + SD = (C + GC) + (I + GI) + (X - M) +SD
Where:
C = Consumer spending
I = Business investment in capital goods and inventory
G = Government spending (= GC + GI = Current spending and investment in capital goods)
X = Exports
M = Imports
SD = Statistical discrepancy

Question 47

Q

If the economy is in equilibrium

Answer

A

G + X + I = T + M + S

Question 48

Q

Changes in aggregate demand (shift in the aggregate demand curve)

Answer

A

Wealth
Increase in household wealth increases current consumption
Expectations
Increases in expected future income increases current consumption
Increases in expected future inflation increases current consumption
Increases in expected future profits increases firms current investment
Fiscal and monetary policy
Government expenditure is a component of aggregate demand
Increase or decrease in interest can be used to produce a change in aggregate demand
World economy
Increasing foreign income increases domestic exports
Appreciating currencies encourage imports as they become less
expensive and discourage exports, causing demand to decrease

Question 49

Q

The Macroeconomic Long-Run and Short-Run
Short-run

Answer

A

Period during which some money prices are sticky
Real GDP might be below, above, or at potential GDP
Unemployment rate might be above, below, or at the natural unemployment rate

Question 50

Q

The Macroeconomic Long-Run and Short-Run
Long-run

Answer

A

Time frame which is long enough for the real wage rate to have adjusted to
achieve full employment
Real GDP equals potential GDP
Unemployment is at the natural rate
Price level is proportional to the quantity of money

Question 51

Q

Inflation rate

Answer

A

= Money growth rate - Real GDP growth rate

Question 52

Q

Aggregate Supply
Short-run aggregate supply

Answer

A

Relationship between quantity of real GDP supplied and the price level when the
money wage rate, prices of other resources, and potential GDP remain constant
Changing price levels might alter short-run aggregate supply if product prices rise
and input costs (particularly wages) do not

Question 53

Q

Aggregate Supply
Long-run aggregate supply

Answer

A

Relationship between quantity of real GDP supplied and the price level in the long-run when real GDP equals potential GDP
The quantity of real GDP supplied (Y) is a function of:
Quantity of labor (L)
Quantity of capital (K)
State of technology (T)

Question 54

Q

Aggregate Supply
Movements along the LAS and SAS curves

Answer

A

LAS : Price level rises and money wage
rate rises by the same percentage

SAS: Price level rises and money wage rate is unchanged

Changing price levels might alter short-run aggregate supply if product prices rise
and input costs (particularly wages) do not
* Changing price levels ALONE does not induce a change in long-run aggregate
supply

Question 55

Q

Shifts in Short-Run Aggregate Supply
The following factors would cause a shift in the SRAS

Answer

A

Changes in nominal wages
Higher wages cause a decrease in aggregate
supply, a leftward shift
Changes in input prices, i.e. prices for
raw materials
Higher prices for raw materials cause a
decrease in aggregate supply, a leftward shift
Expectations about future output prices
and price levels
If companies expect prices to rise, they may
increase production in anticipation of increased profit margins
Business taxes and subsidies
− Higher taxes cause a leftward shift, where as subsidies cause a rightward shift
Exchange rate
− A stronger currency will lower the cost of imports, which may make up some of the raw
materials

Question 56

Q

Aggregate Supply
Changes in long-run aggregate supply

Answer

A

Full-employment quantity of labour increases
Population growth increases long-run supply
Quantity of capital increases
Increasing physical and human capital increases long-run supply
Labour productivity and technology advances

Question 57

Q

Long-run and short-run macroeconomic equilibrium

Answer

A

Short-run definition
Aggregate demand = Aggregate supply
Long-run definition
Real GDP = Potential GDP

Question 58

Q

If aggregate demand grows at the same rate as aggregate supply

Answer

A

GDP growth and no inflation

Question 59

Q

If aggregate demand grows by more than aggregate supply

Answer

A

Inflation occurs

Question 60

Q

Aggregate demand and short-run aggregate supply fluctuate

Answer

A

> Below full-employment equilibrium
Recessionary gap
Long-run equilibrium
Full employment
Above full-employment equilibrium
Inflationary gap

Question 61

Q

Stagflation

Answer

A

Stagflation occurs when there is both high inflation and high unemployment
Decreases in aggregate supply (leftward shifts) may create stagflation
> Higher input costs will cause SRAS to shift leftward

Question 62

Q

Economic Growth and Sustainability

Answer

A

Economic growth is the annual percentage change in real GDP or the annual
change in real per capita GDP
Growth in real GDP measures the pace at which a given economy is expanding, whereas per capita GDP determines the standard of living in each country and
average individual purchasing power
Rapid growth is not always a good thing for an economy, as it may lead to higher
inflation
Sources of economic growth: all shift the LRAS curve outwards
Raw materials
Supply of labor
Supply of physical capital
Supply of human capital
Technological knowledge
The sustainable growth rate is the rate of increase in the economy’s potential
GDP

Question 63

Q

The Production Function

Answer

A

The production function expresses the relationship between the quantity of
productive factors (labor and capital) and level of output for the economy
Output (Y) can be described in terms of a production function as follows:
Y = Aƒ(L,K)
L: Quantity of labor
K: Capital
A: Technological knowledge/total factor productivity
Labor and capital have diminishing marginal productivity. For a given level of labor, each additional unit of capital contributes less to output
Due to diminishing returns to capital and labor, the way to sustain growth in
potential GDP is through technological change

Question 64

Q

Measures of Sustainable Growth
Growth in potential GDP =
Labour productivity =
Potential GDP =
Potential growth rate =

Answer

A

> Growth in potential GDP = Growth in technology + (Labour share of
national income) x Growth in labour + (Capital share of national income) x
Growth in capital
Labour productivity = Real GDP/Aggregate hours
Potential GDP = Aggregate hours x Labour productivity
Potential growth rate = Long-term growth rate of labour force + Long-term labour productivity growth rate

Answer 65

A

Trough – Economy hits its lowest point
Expansion – Aggregate economic activity is increasing
Peak – Economy hits its highest point.
Contraction – Economy starts slowing down (often called a recession but may
be called a depression when the contraction is severe).

Answer 66

A

GDP increase
Layoffs slow, unemployment remains high
Increase spending in housing, durable consumer items
Moderate, may even fall

Answer 67

A

Accelerating rate of growth
Unemployment rate falls
Broader increase including heavy equipment,
construction
modest increase

Answer 68

A

Decelerating rate of growth
Unemployment rate continues to falls, slower hiring
Capital spending expands rapidly
Acceleration

Answer 69

A

GDP decline
Unemployment rate rises
Cutbacks increase
Deceleration (with a lag)

Answer 70

A

The following may result from the start of a contraction:
* Slow down production
* Physical capacity used less than full capacity
* No new investment in physical capital
* Stop ordering new inventory
* Unemployment

Answer 71

A

> Cuts in light equipment and technology immediate.
Sudden rise in inventory-sales ratio. Cut in production to sell off inventory.

Answer 72

A

> Capital orders begin to pick up.
Particularly technology.
Inventory sales ratio begins fall to
normal levels. Production
increases.

Answer 73

A

> Focus on capacity expansion and heavy and complex
equipment
Inventory sales ratio falls. Requires
a surge in production.

Answer 74

A

Extent to which people who want jobs
cannot find them
Number of people unemployed / Lafor force *100
> * Increases in recessions
> * Decreases in expansions

Answer 75

A

Indicator of willingness of people of
working age to take jobs
Labor force / Working - Age population
Discouraged workers leave
labour force during a recession and reenter during an expansion

Answer 76

A

Frictionally unemployed
In between jobs, but unemployed at the time of the statistical survey
Long-term unemployed
People who have been out of work for a long time but are still looking
Discouraged worker
Person who has stopped looking for a job, and therefore is not part of the labor force
Voluntarily unemployed
Person voluntarily outside the labour force

Answer 77

A

> The number of people employed expands and declines in response to the
economic environment
* In a recession, discouraged workers stop looking for work

Answer 78

A

New products bias
A 2012 computer is more expensive than a 1990 typewriter
A fixed basket of goods and services will not include new products
Quality bias
A 2012 car is better than a 2000 car
Part of the increase in the cost is a payment for improved quality, which is not accounted
for in the measured rate
Substitution bias
Changes in relative prices lead consumers to change items they buy
Ignores the substitution of expensive to cheaper items

Answer 79

A

Consumer price index (CPI) is a measure of average of prices paid by urban
consumer for a fixed basket of consumer goods and services.
- The CPI is a Laspeyres index
* The personal consumption expenditures (PCE) index covers all personal
consumption in the U.S. using business surveys.
* The producer price index (PPI) reflects the price changes experienced by
domestic producers in a country.
* In some countries the PPI is called the wholesale price index (WPI).

Answer 80

A

Inflation is an ongoing process whereby price levels are rising and money is
losing value (as opposed to changes in price levels which are one-time
adjustments in price)
Demand-pull inflation
Inflation arising from an initial increase in aggregate demand
Caused by anything that increases aggregate demand
Cost-push inflation
Inflation arising from an initial increase in costs
Two main sources of cost-push inflation
Increase in money wage rates
Increases in the prices of raw materials
Monetarists argue a surplus of money causes inflation

Answer 81

A

Central bank activities influencing the quantity
of money and credit in an economy

Answer 82

A

Decisions about taxation and government
spending

Answer 83

A

Medium of exchange
Any object that is generally accepted in exchange for goods and services
Facilitates transactions (liquidity) and overcomes the need for double coincidence of
wants required in barter transactions
Measure of value
Used to quote prices and compare value
Store of wealth
Transfer purchasing power to the future

Answer 84

A

The practice of lending customers’ money on the assumption that depositors will not withdraw all of
their money at once.

Answer 85

A

The amount of depositor money that is retained by
the bank. The remainder can be lent out.

Answer 86

A

The amount of money created through fractional
reserve banking
1/ Reserve requirement

Answer 87

A

M1 is the sum of:
Notes and coins and traveler’s checks
Deposits at commercial banks
M2 is the sum of:
M1
Savings deposits
Time deposits accounts of less than $100,000
Money market mutual funds and other deposits

Answer 88

A

M1 is the sum of:
Notes and coins in circulation
All overnight deposits
M2 is the sum of:
M1
Deposits with a maturity of up to two years
M3 is the sum of:
M2
Repurchase agreements
Money market funds and debt securities up to two years in maturity

Answer 89

A

The quantity of money is proportional to the total spending
Definitions
M = Quantity of money
V = Velocity of circulation = Average number of times a dollar of money is used
annually to buy the goods and services that make up GDP
P = Price level
Y = Real GDP
GDP = PY
From the definition of the velocity of circulation, the quantity equation of exchange
tells us how M, V, P and Y are connected:
MV = PY
If money neutrality holds then an increase in money supply will increase the price
level (in the long-run), leaving real GDP and velocity of money unchanged

Answer 90

A

The demand for money is the amount of wealth that people choose to hold in the
form of money as opposed to bonds or equities
There are three motives for holding money:
1. Transactions related
- As GDP grows, transaction balances will grow
2. Precautionary
- Money kept to provide a buffer against unforeseen events
- Also increases with GDP and the volume and value of transactions
3. Speculative
- Demand generated when the risks of other financial instruments are high, and may be
expected to decline in value
- Directly related to perceived risk of other financial assets, and inversely related to
expected return on other financial assets

Answer 91

A

Money supply at any point in time is fixed
Interest rates must adjust until the quantity of money supplied = quantity demanded
Excess supply of money: People buy
bonds and the interest rate falls
Excess demand of money: People sell bonds and the interest rate rises

Answer 92

A

Nominal interest rate = Equilibrium real interest rate + Expected inflation
* So the only variable left to adjust in the long-run is the price level
* The price level adjusts to make the quantity of real money supplied equal to the quantity
demanded
* If the central bank changes the nominal quantity of money, the price level changes in the long-run by the same percentage as the percentage change in the quantity of nominal
money

Answer 93

A

—are the primary determinant of exchange rate movements in the short to
intermediate term.

Trade flows become increasingly important in the long term as
expenditure and saving decisions as well as the prices of goods and services adjust.

Answer 94

A

International trade presents many benefits:
* Gains from exchange
* Gains from specialization
* Gains from economies of scale as firms add new markets for products/services
* Greater variety of products/services to firms and households
* Increased competition
* Efficient allocation of resources
International trade also present costs:
* Potential for greater income inequality and loss of jobs in developed countries as
a result of import competition

Answer 95

A

A country has an absolute advantage in the production of a good/service relative
to another country if it can produce the good/service at a lower absolute cost or
with a higher productivity (by using fewer resources in its production)
A country has a comparative advantage in the production of a good/service if it
can produce that good/service at a lower opportunity cost relative to another
country
A country can gain from international trade by producing (and exporting) the
goods/services in which it has a comparative advantage and by importing
goods/services in which it has a comparative disadvantage – relative to its trading
partners

Answer 96

A

The Ricardian Model of Comparative Advantage
* The Ricardian model supports the idea that comparative advantage and the
pattern of trade are determined by differences in technology between countries
* In a Ricardian model, countries specialize in producing what they produce best
(i.e. their comparative advantage)
* The Ricardian model makes the following assumptions:
- Labor is the only variable factor of production
- Differences in labor productivity, reflected by differing levels of technology, are the main
driver in creating a comparative advantage
- A country with a lower opportunity cost (comparative advantage) in the production of a
good will specialize in its production.
- In a two-country model with differing country sizes, we may find the smaller country is
completely specialized, but unable to meet the total demand of the product
- This may result in the larger country being incompletely specialized by having to produce
the good of which it has a comparative disadvantage

Answer 97

A

The Heckscher-Ohlin Model of Comparative
Advantage
* The Heckscher-Ohlin model was produced as an alternative to the Ricardian
model
* It argues that the pattern of international trade is determined by differences in
factor endowments
- Both capital and labor are variable factors of production
- Differences in the relative endowment of these factors are the source of a country’s
comparative advantage
- Technology in an industry is the same across countries, but varies between industries
- A country that is relatively (capital-to-labor ratio) capital abundant is more likely to
specialize in capital-intensive goods
- A country that is relatively labor abundant is likely to concentrate in labor-intensive goods

Answer 98

A

The main components of the balance of payments are:
* A bookkeeping system that summarizes a country’s economic transactions with
the rest of the world for a particular period of time.
* The BOP reflects payments for exports and imports as well as financial
transactions and financial transfers
* The BOP is a double-entry system in which every transaction involves a debit and
credit, therefore in principle the net balance of all entries should be zero
* Some basic entries in a BOP context are summarized below:

Debits : Increase in assets, decrease in liabilities
Value of imported goods and services
Purchase of foreign financial assets
Payment of debt owed to foreigners
Credits : Decrease in assets, increase in
liabilities
Payments for imports of goods and
services
Payment for foreign financial asset
Increase in debt owed to foreigners

Answer 99

A

Commodities and manufactured
goods bought, sold, or given away
Tourism, transportation and business
services, such as management consulting, or legal services
Income derived from the ownership of assets
Foreign direct aid, or gifts

Answer 100

A

Migrants’ transfers – goods and financial
assets belonging to migrants as they leave or enter a country, death duties, inheritance
taxes
Rights to nature resources, sale and
purchase of intangible assets, such
as patents, copyrights, trademarks
etc.

Answer 101

A

Gold, foreign currencies, government’s
reserve position in the IMF
Direct investment, securities issued by the reporting country’s government
and private sectors

Answer 102

A

The national income identity for an open economy is denoted by the following
formula:
Y = C + I + G + (X -M)
Where:
Y = Gross domestic product
C = Private consumption
I = Investment
G = Government purchases
X = Exports
M = Imports
Net exports (X - M) is equivalent to the current account:
X > M = Current account surplus
X < M = Current account deficit
In order for the BOP to balance, a deficit or surplus in the current account must be
offset by an opposite balance in the sum of the capital account and financial
account.
The macroeconomic sources of a current account imbalance can be highlighted
using the following equation:
CA = Sp + Sg - l
Where:
Sp = Private sector saving
Sg = Government saving
I = Investment in domestic capital
If Sg > 0, there is a budget surplus
If Sg < 0, there is a budget deficit
Decisions made by the government, firms and consumers will affect the balance
of payments. For example:
A low level of private savings, high levels of private investments and a government
deficit, or a combination of all three tend to produce current account deficits that must be financed by net capital imports
This current account deficit may reflect a strong domestic economy (higher consumer, government and investment spending), usually accompanied by a higher interest rate. A widening interest rate differential in relation to others countries can lead to growing capital imports and produce an appreciating currency
A persistent current account deficit in the long run will lead to a more permanent increase in claims held by other countries against the deficit country. As a result an increase in the risk premium for such claims of the deficit country may occur, this may lead to a depreciating currency

Answer 103

A

Allows investors to trade currencies on the spot rates and requires delivery to be
made within the appropriate settlement period (for most currencies this is T+2)

Answer 104

A

Investors can enter into contracts with counterparties whereby the two parties
agree to trade two currencies at a specific rate on a specific future date – typically
set to be 30, 60 or 90 days into the future from the date the contract was entered
into by both parties
The forward rate is the rate at which the two parties agree to trade currencies

Answer 105

A

If a currency depreciates, imports become more expensive and exports become cheaper
Total revenue on exports will increase if export prices are elastic and total expenditure
on imports will decrease if import prices are elastic
Marshall-Lerner condition: the combinations of export and import demand elasticities
such that depreciation/devaluation of the domestic currency will alter the trade balance
towards surplus and vice-versa
Exchange rate changes will be a more effective mechanism for trade balance adjustment
if the country imports and exports the following:
Luxury goods
Goods trading in a competitive market
Goods with a large number of substitutes
Goods representing a large proportion
of consumer expenditure

Answer 106

A

Market Functions
The functions of the foreign exchange (FX) market include:
* Facilitate international trade in goods and services
* Speculate – market participants have opinions on future FX movements and may
undertake speculative FX positions
* Hedging – market participants may be exposed to the risk of an exchange rate
moving against them and they may therefore use FX instruments to reduce this
risk
The market participants of the FX market include:
* Sell-side – consists of large FX trading banks
* Buy-side – consists of clients who use these banks to undertake FX transactions:
- Corporate accounts
- Real money accounts
- Leveraged accounts
- Retail accounts
- Governments
- Central banks
- Sovereign wealth funds (SWFs)

Answer 107

A

Focuses on the impact of exchange rates on aggregate expenditure/savings decisions
X - M = (S - I) + (T - G)
X - M = GDP (income) – domestic expenditure
To align a trade balance towards surplus, a change in the exchange rate must increase
income relative to domestic expenditure (absorption). Equivalently, it must increase
domestic savings relative to domestic investment.
If there is excess capacity in an economy, by switching demand to domestically produced goods and services, depreciation of the currency can increase output/income. Some of the additional income will be saved and income will rise relative to expenditure.
If the economy is at full employment, the trade balance cannot improve unless domestic expenditure reduces. The depreciation would put upward pressure on domestic prices to a point where the stimulative effect of the exchange rate change is negated by inflation and the trade
balance reverts.

Answer 108

A

Economic profit
* Difference between firm’s total revenue and total economic costs
Accounting profit
* Difference between firm’s total revenue and total accounting cost

Economic cost
* Opportunity Cost – benefit foregone by not choosing the next best alternative
* E.g. Labor expense – both an economic and accounting cost
* Economic depreciation – change in market value of capital (i.e. plant or machinery)
Accounting cost
* Payments by a firm to purchase productive resources e.g. raw materials

Normal profit is the level of accounting profit required to cover the implicit costs
that were ignored in the accounting costs

Answer 109

A

when each marginal unit sold is positive

Answer 110

A

Breakeven = P = ATC
Shutdown point = P = AVC

Answer 111

A

Profit maximization occurs when MR = MC, this is where the difference between total revenue and total cost is the greatest

Answer 112

A

To study the relationship between a firm’s output decision and its costs, we need to consider the time frame

Short-run
Time frame in which the quantity of at least one factor of
production is fixed
Factors of production are labour, capital, land and materials
Decisions are easily reversed
Long-run
Time frame in which the quantities of all factors of production
can be varied
Period in which the firm can change its plant
Decisions are not easily reversed

Answer 113

A

Economies of scale
Constant returns of scale ( Minimum efficient scale point)
Diseconomies of scale:

Diseconomies of scale:
* Decreasing returns to scale
* Too large to be properly managed
* Overlap and duplication of business
* Higher resource prices because of supply
constraints when buying large quantities

Answer 114

A

Characteristics of perfect competition
* Many firms sell identical products (homogeneity) to many buyers
* Few and easily surmountable barriers to entry/exit
* Established firms have no advantage over new firms
* Sellers and buyers are well informed about prices
* Non-price competition is absent
Price takers
* Firms that take market price as given when selling their product
* Each is small relative to the market and cannot affect price
* Price = Marginal revenue
- Price remains constant when quantity sold changes
Profit maximization
* Goal is to maximize economic profit

Marginal revenue (MR) = Marginal cost (MC)

Answer 115

A

P > ATC
demand curve flat
* Economic loss
P < ATC
Breakeven
P = ATC

Answer 116

A

MC = SR supply above PMin
PLR = ATC

Answer 117

A

A large number of firms
Limited power to influence the price of its product
Each firm is producing a slightly differentiated product from their competitors
Products are close, but not perfect, substitutes
Firms competing on the basis of product quality, price and marketing
Firms face a downward-sloping demand curve
Marketing comprises advertising and packaging
Possible entry into the market with fairly low costs

Answer 118

A

Each firm has set of cost curves
* Each firm has demand curve for its own product and marginal revenue
* Each firm sets output so that MR = MC to maximize profit
* In the short-run, firms may have positive or negative profits

Demand > MR
Economic profit

Answer 119

A

In short-run, firm has positive profits
New firms enter the industry
Lowers each firm’s demand and marginal revenue curves
In long-run, zero economic profits at profit maximizing MR = MC
Firm has excess capacity because it produces below its efficient scale
Price > Marginal cost
Represents the firm’s mark-up

DemandSR > DemandLR
MR SR > MR LR
P SR > P LR

Answer 120

A

More spent on product development, advertising, and branding than in perfect
competition or monopoly

Advantages
* Product variety is desirable
* Advertising and branding expenditure
requires the ‘promoter’ to ensure quality is maintained
Disadvantages
* Activities do generate costs
* Benefits may not outweigh the costs

Answer 121

A

Products offered are close substitutes to those offered by other firms
Products are differentiated through marketing, features and non-price strategies
High barriers to entry
Small number of rival firms
Large share of the market
Firms typically have substantial pricing power, although this is interdependent on other firms

Answer 122

A

Kinked demand-curve model
- Each firm believes that if it raises prices others will not follow
- If it cuts prices, other firms will also cut theirs
- The kinked demand curve is unable to determine the prevailing price from the outset
Cournot assumption
- Each firm determines its own profit maximizing level assuming the other firm stays constant
Nash equilibrium

Nash equilibrium
* Both firms will act in their own interest and not necessarily the most optimal option

Answer 123

A

Single seller
No close substitutes
High barriers to entry
Strong pricing power
Barriers to entry can take the form of:
Legal barriers
Patents, copyrights or ‘public franchises’ that is government license
Natural barriers
Economies of scale in, for example, electricity generation and water supply
One firm can supply the whole market at a lower cost than two or more firms

Monopoly price-setting strategies:
* Single-price monopolies
- All output sold at same price to all customers
* Price discriminating monopolies
- Able to charge classes of customer the highest possible price per
class and can prevent low price customers selling to high price customers

Answer 124

A

A single-price monopoly produces the
quantity Qm at which marginal revenue
equals marginal cost and sells that quantity for price Pm

Demand > MR => pROFITS

Answer 125

A

Estimating elasticity through regression analysis
‘N’ firm concentration ratio
- Market share of ‘N’ largest firms, e.g. sum of market share of four largest firms
- Sum of value of sales for N firms/total sales for the industry
- The number will be between 0 (perfect competition) and 100% (monopoly)
- The measure fails to take account of mergers between the top market players
- Does not take into account ease of entry for new firms (low barriers to entry)
- Does not take into account elasticity of demand
Herfindahl-Hirschmann Index (HHI)
- Sum of the squared market shares of the largest N firms
- If an industry is made up of four firms with a 25% market share each the
HHI for the top 4 firms is:
* 0.25² + 0.25²+ 0.25² + 0.25² = 0.25
- Monopoly
* 1² = 1
- Produces a better result for decision making than the N firm concentration ratio
- Does not take into account ease of entry for new firms (low barriers to entry)
- Does not take into account elasticity of demand

Answer 126

A

Credit cycles describe the changing availability and price of credit
* Availability of credit is essential for business investments and house purchases
* As such they are closely linked to real economic activity captured by business
cycles that describe fluctuations in real GDP
* With a strong or improving economy lenders are more willing to extend credit on
favourable terms and vice versa
* When credit is more costly property prices often fall, defaults rise and there is
further economic weakness
Applications of credit cycles
* It is now recognised that business cycles can be amplified, with deeper
recessions and more extensive expansions, because of changes in access to
external financing
* Recessions accompanied by financial disruption episodes (notably house and
equity price busts) tend to be longer and deeper and recoveries combined with
rapid growth in credit, risk-taking and house prices tend to be stronger
* Credit cycles tend to be longer and deeper than business cycles

Consequences for policy
* Investors pay attention to the credit cycle because it helps them:
- Understand developments in the housing and construction markets
- Assess the extent of business cycle expansions as well as contractions,
particularly the severity of a recession if it coincides with the contraction phase of the credit cycle
- Better anticipate policy makers’ actions
* Typically monetary and fiscal policy concentrates on reducing the volatility of
business cycles
* Similarly, macro-prudential policies that aim to dampen financial booms have
gained in importance
- This is further stressed by findings that strong peaks in credit cycles are closely
associated with systemic banking crises

Answer 127

A

Consumer price index (CPI) is a measure of average of prices paid by urban
consumer for a fixed basket of consumer goods and services.
The CPI is a Laspeyres index
The personal consumption expenditures (PCE) index covers all personal
consumption in the U.S. using business surveys.
The producer price index (PPI) reflects the price changes experienced by
domestic producers in a country.
In some countries the PPI is called the wholesale price index (WPI).

Answer 128

A

Explaining Inflation
Inflation
* Inflation is an ongoing process whereby price levels are rising and money is
losing value (as opposed to changes in price levels which are one-time
adjustments in price)
* Demand-pull inflation
- Inflation arising from an initial increase in aggregate demand
* Caused by anything that increases aggregate demand
* Cost-push inflation
- Inflation arising from an initial increase in costs
- Two main sources of cost-push inflation
* Increase in money wage rates
* Increases in the prices of raw materials
* Monetarists argue a surplus of money causes inflation.

Answer 129

A

Economic indicators are variables that provide information on the state of the
economy as a whole. They are classified according to whether they lag, lead or
coincide with changes in an economy’s growth.
Leading economic indicators change in advance of changes in the economy, giving a preview of what is going to happen before the change actually occurs.
e.g. vendor performance, S&P 500 Stock Index, money supply, real M2.
Coincident economic indicators change about the same time as the overall
economy.
e.g. Non agricultural payrolls, Industrial Production Index.
Lagging economic indicators change after the overall economy but are of minimal use as predictive tools.
e.g. inventory-sales ratio, average bank prime lending rate, average duration of
unemployment.

Answer 130

A

Monetary policy
Central bank activities influencing the quantity of money and credit in an economy

Fiscal policy
Decisions about taxation and government
spending

Answer 131

A

Medium of exchange
Any object that is generally accepted in exchange for goods and services
Facilitates transactions (liquidity) and overcomes the need for double coincidence of wants required in barter transactions
Measure of value
Used to quote prices and compare value
Store of wealth
Transfer purchasing power to the future

Answer 132

A

Fiscal policy aims to use government spending and taxes to influence economic
activity
Fiscal policy could increase aggregate demand in the following forms:
Cut in personal income tax
Cut in sales tax
Cut in corporation tax
Increase public spending
Balanced budget
Budget balance = Tax revenues - Expenditures
Budget surplus
Tax revenues > Expenditures
Budget deficit
Tax revenues < Expenditures

Answer 133

A

Expansionary fiscal policy
* Designed to stimulate an economy
* It consists of:
- Decreasing taxes
- Increasing aggregate expenditure and
aggregate demand through an
increase in government spending
* An expansionary fiscal policy leads to a larger government budget deficit or a smaller budget surplus

Contractionary fiscal policy
* The opposite of an expansionary fiscal policy
* It consists of:
- Increasing taxes
- Decreasing government purchases
* The objective of a contractionary fiscal policy is to restrain the economy, close an inflationary gap, and decrease the inflation rate
* A contractionary fiscal policy is often
supported by a contractionary monetary policy

Answer 134

A

Automatic fiscal policy
* Automatic stabilisers are triggered automatically by the state
of the economy
* Transfer payments (benefits such as social security) and taxation
Discretionary fiscal policy
* Triggered by a deliberate change in policy
* Government changing taxation policies or government spending

Answer 135

A

Government spending
* Transfer payments, e.g. unemployment benefits
* Current government spending, e.g. education, health
* Capital expenditure, e.g. infrastructure, roads

Government revenues
* Direct taxes, e.g. income tax
* Indirect taxes, e.g. sales tax (VAT), duties on tobacco
Advantages
* Indirect taxes can be almost immediately adjusted, and influence
behavior
* Social policies, e.g. discouraging alcohol, can be adjusted immediately
Disadvantages
* Direct taxes and benefits need considerable notice to change
* Capital spending takes time to plan

Answer 136

A

Fiscal Policy
Fiscal multiplier
* Government expenditure makes up part of aggregate expenditure
* If government expenditure changes, aggregate demand changes
* Ratio of the change in equilibrium output to the change in spending that caused
this change
Balanced budget multiplier
* Both government spending and tax are increased by the same amount
* The lower (negative) tax multiplier effect should result in a positive effect on GDP,
while retaining a balanced budget

Answer 137

A

Recognition lag
The time it takes to work out that fiscal policy actions are required
Action lag
The time it takes for a government to pass the laws needed to change taxes or spending
Impact lag
The time it takes from passing a tax or spending change to its effects on real GDP being felt

Answer 138

A

The crowding out effect on investment
* If the government borrows to try to effect a government purchases multiplier, a
rise in real interest rates will follow.

The Ricardian equivalence questions the efficiency of fiscal policy
* If a government decides to reduce taxation by $15bn in one year and replaces
that revenue with borrowing of $15bn, will there be real impact on the economy?
* Ricardian equivalence suggests the reduction in taxes will not have an impact on spending because individuals will save more in anticipation of higher future taxes
to repay the debt borrowed.

Answer 139

A

Arguments in favour of being concerned:
> High levels of debt to GDP may lead to
higher tax rate → disincentives to
economic activity
> If markets lose confidence in a
government, the central bank may have
to print money to finance a deficit
→ high inflation.
> Government borrowing may divert
private sector investment → crowding
out → higher interest rates → lower
private sector investing.

Arguments against being concerned:
> Large fiscal deficits require tax changes which may reduce distortions caused by
existing tax structures.
> A proportion of the money borrowed
may have been used for capital projects
or human capital enhancement.
> Private sector may act to offset fiscal
deficits by increasing saving in
anticipation of future increased taxes
(Ricardian equivalence).

Answer 140

A

Reduce taxes and increase government
spending. Decrease interest rates.
Highly expansionary. Leads to growing private and public sectors.

Answer 141

A

Raise taxes and decrease government spending. Decrease interest rates.
Private sector will be a larger share of GDP than public sector.

Answer 142

A

Reduce taxes and increase government
spending. Raise interest rates
Government spending will become a larger proportion of national income.

Answer 143

A

Raise taxes and decrease government spending. Raise interest rates.
Drop in aggregate demand from both public and private sector.

Answer 144

A

Monopoly supplier of the currency
Banker to the government and the bankers’ bank
Lender of last resort
Regulator and supervisor of the payments system
Conductor of monetary policy
Supervisor of the banking system

Answer 145

A

Stable prices
* Keeping inflation rate low
* Unexpected inflation is most costly
Maximum employment
* Real GDP close to potential GDP
- The rate of unemployment is close to the natural rate of unemployment
Moderate long-term interest rates
* Keeping long-term nominal interest rates close to long-term
real interest rates

Answer 146

A

Purchase or sale of government bonds by the central bank
Open market purchase of bonds by central bank increases reserves at banks, banks lend excess reserves, and money supply increases

Answer 147

A

Regulates banks’ minimum reserve-deposit ratios
(required reserve ratio)
Increase in reserve requirements decreases money
supply as banks call loans to build up reserves

Answer 148

A

Interest rate on reserves borrowed from central bank
Lower discount rate, cheaper borrowed reserves, more reserves borrowed by banks, banks increase loans, which increases deposits in banking system,
thus increasing money supply

Answer 149

A

Maintain price stability by targeting a certain level of inflation – usually around 2%
A 0% target could easily result in deflation, if the target is not met

Answer 150

A

Many developing countries operate monetary policy by targeting exchange rate rather than an inflation measure
To protect this target, a developing country with a high inflation might sell foreign reserves and buy their own currency
Process helps decrease money supply and reduce inflation

Answer 151

A

Increase in the money supply and a reduction in interest rates
Purchasing treasury securities through open market operations, decreasing the discount rate, and decreasing reserve requirements
It is often supported by an
expansionary fiscal policy

Answer 152

A

Decrease in the money supply and an increase in interest rates
Selling treasury securities through open market operations, increasing the discount rate, and increasing reserve requirements
It is often supported by a contractionary fiscal policy

Answer 153

A

Limitations of Monetary Policy
Problems in the monetary transmission mechanism
* A central bank might increase interest rates, but market expectations might cause
long term rates to decrease – making it cheaper to borrow long term
* A central bank might lower interest rates, but banks may not lend to customers

Interest rate adjustment in a deflationary environment
* If interest rates are close to 0%, it cannot be cut any further
* Quantitative easing may follow

Answer 154

A

The study of how geography affects politics and international relations
Analysts study actors and how they interact with each other
Actors include individuals, organizations, companies and national governments that carry
out political, economic and financial activities
These relations matter for investments since they affect drivers of investment
performance including economic growth, business performance, market volatility and
transaction costs

Answer 155

A

The risk associated with tensions or actions between actors that affect the normal
course of international relations
Geopolitical risk rises when geographical and political factors that underpin country
relations shift
Shifts are caused by a change in policy, a natural disaster, a terrorist act, war
Investors study geopolitical risk because it impacts on investment outcomes

Answer 156

A

There are two types of actors to consider:
State actors – typically national governments, political organizations or country leaders
that exert authority over a country’s national security and resources
Examples include Sultan of Brunei, Britain’s prime minister, Malaysia’s parliament
Non-state actors – participate in global political, economic or financial affairs but do not
directly control a country’s national security or resources
Here, examples include NGOs, multinational companies, influential individuals
Actors are influenced by their relationships with one another but also by factors
that impact on their allies and their allies’ adversaries

Answer 157

A

Cooperation
* Rules standardization
* Harmonization of tariffs
* Free movement across
borders
* Permitted movement of
goods, services and capital
* Reciprocation
* Technology exchange

Non-cooperation
* Inconsistent rules
* Arbitrary rules
* Restricted movement across
borders
* Restricted trade; capital
controls
* Retaliation
* Lack of technology exchange

Answer 158

A

Cooperation with neighbors or other actors is typically driven by a country’s
national interests whether they be military, economic or cultural
National security or military interest involves protecting a country from external
threats
Geographic factors play an important role:
Switzerland is landlocked and, as such, relies on its neighbors for access to vital resources
Panama as a conduit for trade might use its geographical location as a lever of power
Economic interest – over time the concept of national security has expanded to
include economic factors such as access to energy, food or water
Growing national wealth and limiting income inequality can contribute to stability
Internationally, the ability of national firms to operate on a global scale is important
In this context, countries are trying to:
Secure essential resources through trade, or
Level the global playing field through standardization

Answer 159

A

Geophysical resource endowment includes factors such as livable geography and
climate as well as access to food and water
* Geophysical resource endowment is unequal among countries
- USA, Russia, China and Australia are relatively self-sufficient
- Western Europe and Japan are reliant on others for fossil fuels
- Saudi Arabia have fossil fuels but rely on others for many basic needs
* Having plentiful supplies of resources can be a double-edged sword
- Might have political leverage when dealing with another country that needs the resource
- Might make the country vulnerable if the use or sale of the resource benefits certain
groups more than others, thereby contributing to political instability

Answer 160

A

Standardization is the process of creating protocols for the production, sale,
transport, or use of a product or service

Challenge: Financial transactions across borders faced higher costs and longer wait times, increasing the burden for cross-border activity

Solution: Society for Worldwide Interbank Financial
Telecommunication (SWIFT)

Process: SWIFT was established in 1973 to provide a global financial infrastructure

Benefit: Facilitates global payments in more than 200 countries and territories, servicing more than 11,000 institutions worldwide

Answer 161

A

Countries may have cultural reasons for cooperating with each other
Historical in nature, long-standing political ties, cultural similarities
Alternatively, countries may engage in ‘soft power’ which means influencing
another country’s decision without force or coercion
Soft power might be built over time though cultural programs, university exchange

Answer 162

A

An institution is an established organization or practice in a society or culture
Can be formal, e.g. a university, process backed by law, an organization
Can be informal, e.g. customs or behavioral patterns important to a society
Can, but need not be, formed by national governments
They are important because strong institutions contribute to more stable internal and external political forces
This enhances the ability of a country to form durable, cooperative relationships
It also allows such countries to act with more authority and independence in the international arena particularly when organizations and structures promote government accountability, rule of law and property rights

Answer 163

A

The national interest of a country is its set of goals and ambitions
This might present in geospatial terms
Need for self-determination, survival as a nation state, need for clear borders, or
expansion of the nation state itself
Alternatively, it might incorporate a wide array of interrelated factors such as
economic and social considerations
Countries have a hierarchy of needs
Those essential for survival are at the top and those that are not are lower down
The hierarchy guides behavior
They cooperate when it benefits the nation state but prioritize when two needs result in conflicting
cooperation tactics

Answer 164

A

Securing access to food and water might take precedence over other hierarchical
needs but once this is achieved the hierarchy can become more subjective
One government might have a different focus than its predecessor
The length of a country’s political cycle has an important impact on prioritization of
needs
Short political cycles, e.g. a few years, might lead to a disinclination to focus on longterm issues such as climate change
Essentially, decision makers have their own set of influences and needs
As such, the needs of decision makers can impact a country’s cooperative and
non-cooperative choices
This introduces non-predictability into choices along the hierarchy of a nation’s
needs that shape geopolitical relationships

Answer 165

A

For some countries it is in their interests to be highly politically cooperative but for
others it is less essential
However, over time most countries are cooperative on some rules standardization
on the international scale
At the same time there are some countries whose political self-determination is
more important than cooperating
Assessing a state actor’s hierarchy of needs and how it may change may help us
to understand its motivations and priorities

Answer 166

A

Globalization is the result of economic and financial cooperation and is carried out
mostly by non-state actors, such as companies, organizations and individuals
Actors participating in globalization reach beyond their own borders for access to
new markets, talent or learning
Anti-globalization or nationalism is marked by limited economic and financial
cooperation
Globalization and cooperation tend to be correlated
Globalization can be accelerated or facilitated by political cooperation

Answer 167

A

Increasing profits due to higher sales and/or lower costs
Access to resources and markets
Intrinsic gain
E.g. the personal growth or education that individuals may receive from expanding their
horizons or increased productivity from learning new methods

Answer 168

A

Unequal accrual of economic and financial gains
If a company moves a factory to another country it creates jobs in that country at the expense of fewer jobs at home
Lower environmental, social and governance standards
If a company produces in a country with lower standards than its own country and adopts those standards then it may make more profit but possibly at a cost to the environment
Political consequences
The two costs identified above may lead to political consequences of global expansion
Globalization can lead to income and wealth inequality as well as differences in opportunities within and between countries
This might lead to reduced political and economic cooperation as well as a rollback in political cooperation
Interdependence – companies might become dependent on other countries’ resources for their supply chain and, as a consequence, a nation itself becomes dependent on other nations for resources
Disruption in the supply chain due to events such as political non-cooperation can have a dramatic effect

Answer 169

A

Facilitates the growth of international trade and promotes employment, economic growth and poverty reduction.
Lends foreign exchange to members when needed to help them address balance of payment problems.
Provides a forum for cooperation on international monetary problems.
Supports exchange rate stability and an open system of international payments.
Since the global financial crisis of 2007-2009, the IMF has redefined its operations as follows:
Analysis of capital market developments
Assessment of financial sector vulnerabilities
Enhancement of lending facilities
Help resolve global economic imbalances
Improvement of the monitoring of economies

Answer 170

A

The World Bank is an international financial institution that provides loans to developing countries for capital programs
The requirements for developing countries to grow and attract business are:
Strengthening governments
Educating government officials
Implementing legal and judicial systems encouraging business
Protecting individual and property rights
Honouring contracts
Developing robust financial systems
Combating corruption
The World Bank has two affiliated entities: The International Bank for Reconstruction and Development (IBRD) and the International Development Association (IDA) - both provide low-interest loans to countries
The World Trade Organization’s (WTO) mission is to foster free trade by providing a major institutional and regulatory framework of global trade rules

Answer 171

A

Countries seeking political self-sufficiency with little or no external trade or finance
State-owned enterprises control strategic domestic industries
They are usually politically strong and exercise control over technology, goods and
services, as well as media and political messaging
Periods of autarky can provide a country with swifter economic and political
development
China was autarkic for much of the twentieth century but its stance enabled it to
substantially alleviate poverty before a move towards more economic and political
cooperation
However, this is not always the result of an autarky as witnessed by North Korea’s
gradual loss of economic and political development

Answer 172

A

Countries that tend to be regional or possibly global leaders
They use their political or economic influence of others to control resources
State-owned enterprises tend to control key export markets
Such systems provide economic benefits to the country itself as well as the international system
Countries aligning with the hegemon’s rules and standards may enjoy the rewards provided by the leader such as stabilization
As hegemons gain or lose influence they may become more competitive which increases the likelihood of geopolitical risk
Examples include the US and Russia

Answer 173

A

Countries that participate in mutually beneficial trade relationships and extensive
rules harmonization
Private firms are fully integrated into the supply chain with multiple trade partners
Examples include Germany and Singapore
Singapore:
Has limited resources and, as such, is very dependent on its trade partners
Is located at the intersection of many important trade routes
Has a highly skilled workforce
Is ranked as the most open economy in the world by the World Economic Forum
The factors outlined above mean that Singapore is capable of and highly
dependent on international cooperation for its economic growth
However, the same cooperation may expose Singapore to geopolitical risk

Answer 174

A

The conduct of political, economic, financial, or cultural cooperation between two
countries
A country might have relationships with more than one country but they are ‘oneat-a-time’ agreements without multiple partners
Countries normally operate on a spectrum between multilateralism and bilateralism
In between the two is regionalism
Both bilateralism and regionalism can be conducted at the exclusion of other groups
Very few countries perfectly fit the bilateralism mold
Moving towards stronger political cooperation tends to lead organically to
globalization
The internet has made it even easier for firms to globalize

Answer 175

A

The tools an actor uses are the source of geopolitical risk as it impacts investors
The tools of geopolitics are separated into three types
National security tools
Economic tools, and
Financial tools

Answer 176

A

Tools that are used to influence or coerce a state actor through direct or indirect impact on the country’s resources, people or borders
The tools might be ‘active’ or ‘threatened’
The most extreme example is armed conflict which has two major impacts
Destruction of physical infrastructure which can inflict long-term damage on a country’s capital stock and ability to rebuild that stock
Migration away from areas of armed conflict, which can reshape international flows of goods, services, capital, and labor.
Not all tools are used in so direct a nature as armed conflict.
For example, espionage, or the practice of using spies to obtain political or military information, is an indirect national security tool.
Military alliances are often used to aid in direct conflict and also to deter conflict from arising in the first place, e.g. NATO

Answer 177

A

Economic tools are the actions used to reinforce cooperative or non-cooperative
stances via economic means
Such tools can include the global harmonization of tariff rules, as facilitated by the
World Trade Organization (WTO)
Highly cooperative economic tools may also include common markets, like the
European Union, or a common currency, like the euro.
Non-cooperative tools include nationalization, i.e. transferring an activity or industry
from private to state control
Countries can engage in voluntary export restraints, meaning they refuse to trade
as much of their goods and services as would meet demand

Answer 178

A

Financial tools are the actions used to reinforce cooperative or non-cooperative stances via financial means
Cooperative tools include the free exchange of currencies across borders and allowing foreign investment
Non-cooperative financial tools include limiting access to local currency markets
and restricting foreign investment
Cooperative financial tools may reduce geopolitical risk if they encourage cooperation in security, economic, or financial arenas
However, the same tools may also create vulnerabilities in the international system
The dominance of the US dollar is one such example
The free exchange of currency helps facilitate financial activity and cooperation more broadly.
However, the US dollar’s importance to exchange also makes other countries vulnerable to changes in US monetary policy.

Answer 179

A

Cabotage is the right to transport passengers or goods within a country by a foreign firm
Many countries, including those with multilateral trade agreements, impose restrictions on cabotage across transportation subsectors—meaning that shippers,
airlines, and truck drivers are not allowed to transport goods and services within another country’s borders
Allowing cabotage requires coordination on areas like physical security and economic coordination
International organizations may also make use of multiple tools of geopolitics
For example, the European Union includes substantial economic, financial and national security components
As actors incorporate more tools of collaboration, they are less likely to initiate conflict or use a non-cooperative tool against fellow actors

Answer 180

A

Geopolitical Risk and Comparative Advantage
* Geopolitical risk and the tools of geopolitics can shape actors’ core priorities
* Countries are endowed with certain resources, or factors, and technological capabilities
* Not every country will be endowed with the same factors and capabilities and thus may benefit from cooperating via trade
* Each country specializes in areas defined by its resources and capabilities and then exchanges with the other in a way that benefits both parties
* Through specialization and exchange, industries within each country experience greater economies of scale
* Geopolitical risk and the tools of geopolitics can tilt comparative advantage in one
direction or another
- For example, countries or regions with limited geopolitical risk exposure may attract more labor and capital and vice versa
- Similarly, a consistent threat of conflict may drive more regular volatility in asset prices, prompting investors to require higher compensation for risk taken

Answer 181

A

There are three types of geopolitical risk
Event risk
Exogenous risk
Thematic risk

Answer 182

A

Event risk arises from set dates, such as elections, new legislation or even
holidays that are known in advance
The UK’s referendum on European Union membership is a good example
It took place in 2016 but was planned for well in advance
The result took many by surprise and investor expectations related to the United
Kingdom’s cooperative stance were drastically changed
The predictability of an event does not necessarily change its likelihood, its speed
of impact, or the size of impact on investors
However, it does give investors more time to prepare a response.

Answer 183

A

Exogenous risk is a sudden or unanticipated risk that impacts either a country’s cooperative stance, the ability of non-state actors to globalize, or both
Examples include sudden uprisings, invasions, or the aftermath of natural disasters

Answer 184

A

Thematic risks are known and evolve or expand over time
Climate change
Pattern migration
Rise of populist forces
Ongoing threat of terrorism
Cyber threats

Answer 185

A

Investors need to ask whether a particular geopolitical risk is relevant for their portfolio management decisions
To make this assessment, an investor should consider geopolitical risk in terms
of the following three areas:
Likelihood it will occur
Velocity of its impact, and
Size and nature of that impact

Answer 186

A

The likelihood of a risk is the probability that it will occur but measuring the likelihood is challenging
Highly collaborative and globalized countries are, on balance, less likely to experience geopolitical risk because the political, economic, and financial costs of partners inflicting those risks are higher
However, collaboration and globalization may also make multilateral countries more vulnerable to certain risks
Their operation in and cooperation with other countries means a risk posed to any of those countries may also impact itself
There are many factors that may increase the likelihood that a risk may occur
e.g. internal political stability, the motivations of governmental actors
Likelihood should only be considered in conjunction with the velocity and impact of the risk.

Answer 187

A

The velocity of geopolitical risk is the speed at which it impacts an investor’s portfolio
In the short-term, we might see market volatility impact certain industries or the entire market
Black swan risk is an event that can cause market volatility and investor ‘flight to quality’
Investors might make tactical changes to their portfolios but long term changes are unlikely
Medium-term risk impacts may impair companies’ processes, costs and investment opportunities
This might lead to the value of the company falling
They tend to impact some companies more than others
Long-term risks may have ESG and other impacts
This might impact an investor’s asset allocation for a long-term horizon
The immediate impact on a portfolio is more limited

Answer 188

A

A high-impact risk will probably lead to an extensive study of its drivers but a lowimpact risk might not
An impact might be broad or discrete
Broad affects the whole market, possibly the global market
Discrete affects a single company or sector
If a cyberattack occurs only investors exposed to that company will be affected but it might lead to a broader impact of more monitoring, due diligence and
security costs for many companies

Answer 189

A

Scenario analysis is the process of evaluating portfolio outcomes across potential circumstances or states of the world
Scenarios can take the form of qualitative analysis, quantitative measurement, or both
Qualitative analysis might start by asking:
What is the most impactful outcome of the risk?
How likely is that risk/outcome to occur in the first place?
Investors can then consider upside and downside scenarios
Ask questions such as – is it a persistent tail risk or is it short-term?
Quantitative scenarios vary widely
You might ask how sensitive a portfolio is to one key factor such as interest rates, asset
prices or exchange rates
For scenario analysis to be useful in portfolio management, teams must work
hard to build creative processes, identify scenarios, track them and assess the
need for action on a regular basis

Answer 190

A

Asset managers create plans for addressing priority risks as they occur so as to reduce the events’ impact on investment outcomes
It is important to identify signposts (an indicator, market level, or event that signals that a risk is becoming more or less likely)
Thought of as a traffic light system, green means nothing to be concerned about, amber means that you might want to think about being prepared to take action
whilst red means some action is needed now
Combinations of economic and financial market circumstances can indicate potential problems
As an example, high inflation and increasing unemployment might signal political
unrest
What affect might this have on your portfolio?

Answer 191

A

Geopolitical risk takes on many forms and its impact on investments is also multi-faceted
High-velocity risks will likely manifest in market volatility via rapid changes in asset prices
Commonly impacted asset prices are commodities, FX, equities and bond prices
Economic shutdowns during COVID caused high volatility; equity markets fell dramatically but bond prices rose
This volatility wasn’t permanent but created risk as well as opportunities
Low-velocity risks can have a more prolonged effect on investments
Continuing disruption can impact on revenues, costs and ultimately the bottom line
This can then serve to lower a company’s valuation
During COVID, disruptions to mobility and consumption had long-term impacts on
company revenues and supply chains
For countries, regions or sectors that are regarded as being more exposed to
geopolitical risk, e.g. emerging markets, investors are likely to require higher
returns

Answer 192

A

The GPR was built in 2019 based on a list of news articles that covered geopolitical tensions and their impact on economic events
The key important observations are;
High levels of geopolitical risk reduce US investment, employment and stock market price levels
Individual firm’s investment falls more in industries exposed to geopolitical risk and that
firms reduce investment in the wake of unique geopolitical risk events
The threat of adverse geopolitical events had a larger impact over time

Answer 193

A

If a risk does occur, what can we do about it?
The final step in incorporating geopolitical risk into the portfolio management process requires the analysis to be translated into investment action as appropriate to investor goals, risk tolerance and time horizon
Portfolio managers may consider geopolitical risk in their asset allocation strategy
The likelihood, velocity and impact of risks may affect capital market assumptions
This may then drive the manager’s exposure to certain countries or regions
Countries with a history of adopting a multilateral approach may be thought of as being more reliable and lower risk leading to increased investor flows
Countries experiencing consistent military threat will likely have lower economic and investment growth
When making a buy or sell recommendation, an analyst may consider relative geopolitical risk exposure as a factor in their analysis
The importance of geopolitical risk to the investment process depends on investor objectives, risk tolerance and time horizon
Low risk tolerance will likely lead to less exposure to geopolitical risk
By choosing low-volatility investments or through hedging
For an investor with a longer time horizon, a geopolitical risk event such as an exogenous shock could represent an investment opportunity
If near retirement, however, an exogenous shock could have a massive effect on the final portfolio value
Changes in style and momentum of international cooperation can have an important impact on capital markets
This is a particular issue for global investors

Answer 194

A

International trade presents many benefits:
* Gains from exchange
* Gains from specialization
* Gains from economies of scale as firms add new markets for products/services
* Greater variety of products/services to firms and households
* Increased competition
* Efficient allocation of resources

International trade also present costs:
* Potential for greater income inequality and loss of jobs in developed countries as
a result of import competition

Answer 195

A

Government policies that restrict the quantity of a good that
can be important into a country – generally for a specified
time period

Answer 196

A

Taxes levied by government on imported goods

Answer 197

A

An amount paid by a government to a firm when it exports a unit of a good that is being subsidized

Answer 198

A

A trade barrier under which, the exporting country agrees to
limit its exports of the good to its trading partners to a
specific number of units

Answer 199

A

Stipulates that some percentage of the value added (or
components) used in production should be of domestic
origin

Answer 200

A

Controls placed on foreigners’ ability to own domestic
assets and/or domestic residents’ ability to own foreign
assets

Answer 201

A

Importer
Increases
Decreases
Increases
Decreases in small country, possibly increase in large country

Answer 202

A

Importer
Increases
Decreases
Mixed
Decreases in small country, possibly increase in large country

Answer 203

A

Exporter
Increases
Decreases
Decreases
Decreases

Answer 204

A

Importer
Increases
Decreases
No change (rent to foreigners)
Decreases

Answer 205

A

Increases
Decreases
Increases
Imports decrease

Answer 206

A

Increases
Decreases
Increases
Imports decrease

Answer 207

A

Increases
Decreases
Increases
Exports increase

Answer 208

A

Increases
Decreases
Increases
Imports decrease

Answer 209

A

Free trade areas (FTA) are a form of regional integration in which all barriers to the flow of goods/services among members (trading partners) have been
removed (Example: North American Free Trade Agreement (NAFTA) for the U.S. Canada and Mexico).
Customs unions extend the free trade area by allowing free movement of goods/services among members and by creating a common trade policy against
non-members (Example: Benelux – Customs union for Belgium, the Netherlands and Luxemburg).
Common markets are a level of economic integration that incorporates all aspects of the customs union and extends it by allowing free movement of factors of production amongst member countries (Example: MERCOSUR – The
southern cone common market for Argentina, Brazil, Uruguay and Paraguay).
Economic union incorporates all aspects of a common market and in addition requires common economic institutions and coordination of economic policies
amongst member countries (Example: The EU – European Union).
A monetary union is a form of economic union in which member countries adopt a common currency (Example: The adoption of the Euro in 1999 by 11 EU
member countries)

Answer 210

A

Established on currency financial markets – forex markets.
Usually established in continuous quotation.
Central banks may also fix the nominal exchange rate in order to reduce the volatility of the price of its currency. It can increase demand for its currency by acting as a buyer or increase supply by selling its currency
tend to deviate from purchasing power parity

Answer 211

A

Correspond to nominal rate minus inflation. For instance, if country A (foreign currency) has an inflation rate of 5%, country B (domestic currency) has an inflation rate of 3%, and no changes in the nominal exchange rate took place,
then country A (foreign currency) now has a currency whose real value is approximately 2% higher than before.

Answer 212

A

Expressed as domestic currency units per foreign currency unit

Answer 213

A

Expressed as foreign currency units per domestic currency unit

Answer 214

A

Ff/d= Sf/d*((1+i_f * act/360) / (1+i_d * act/360))

Answer 215

A

one country fixes its rate of currency to another
currency

Answer 216

A

prices are determined through the demand and supply of currencies. Currencies appreciate if their demand increases
and depreciate if demand decreases (or supply increases)

Answer 217

A

the monetary policy of one country is committed
to keeping the exchange rate between the domestic and foreign currency between
a narrow range

Answer 218

A

Arrangements with no separate tender
- The IMF identifies two types of arrangements in which a country does not have its own legal tender:
* Dollarization – the country uses the currency of another nation as a medium of exchange and unit of account, e.g. East Timor, Ecuador
* Or, a country participates in a monetary union whose members share the same legal tender, e.g. European Economic and Monetary Union (EMU)
* imposes fiscal discipline by eliminating the possibility that the central bank will be induced to monetize government debt (i.e., to persistently purchase government debt with newly created local currency).
Currency Board System
- Similar to a central bank, acting as country’s monetary authority that issues coins and notes. However, a currency board is not the ‘lender of last resort’.
Fixed parity
- Exchange rate is pegged to a single currency, e.g. U.S Dollar. The monetary authority is prepared to buy/sell foreign currency reserves to maintain parity.
Target zone
- Fixed parity regime with a wider band of up to +/- 2% around parity. Allowing greater scope for discretionary policy.
Active and passive crawling pegs
- Crawling pegs for the exchange rate usually against a single currency such as the dollar.
The peg is adjusted frequently (weekly or daily) to keep pace with inflation. This is
a passive crawl.
- In an active crawl the exchange rate is pre-announced with changes taking place in the weeks following the announcement. Aim is to manipulate expectations of inflation.
Fixed parity with crawling bands
- Initial fixing to anchor expectations allowing for flexibility further on using crawling bands.
Managed float
- Exchange rate based on internal or external policy targets. Typically not explicit.
Independently floating rates
- Exchange rate is left to market determination and the monetary authority is able to exercise independent monetary policy aimed at achieving objectives such as price stability and full employment
- Central bank has latitude to act as ‘lender of last resort’ to troubled institutions

Answer 219

A

decreases and expected inflation remains the same.

Neutral rate = Trend growth + Inflation target.

monetary policy : contractionary
when policy rate > neutral rate, and expansionary
policy rate < neutral rate

Answer 220

A

most of the borrowing is owed internally to local citizens

Answer 221

A

deflation

Answer 222

A

because in perfect competition, the firm’s supply schedule is represented by the marginal cost schedule

Answer 223

A

income tax, VAT, and social benefit

Answer 224

A

(1 + ΔSd/f/Sd/f) × (1 + ΔPf/Pf) / (1 + ΔPd/Pd) − 1

ΔSd/f/Sd/f is the change of the nominal exchange rate,
ΔPf/Pf is the foreign inflation rate, and
ΔPd/Pd is the domestic inflation rate

Answer 225

A

via exchange rate targeting rather than inflation targeting.

Answer 226

A

= Trend growth + Inflation target

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