Economics Flashcards

Question

Total revenue is maximized

Answer 1

when each marginal unit sold is positive

Answer 2

* 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

Answer 3

- Spreading total fixed over larger amount - Eventually diminishing returns

Answer 4

Price = ATC

Answer 5

price = AVC

Answer 6

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

Answer 7

* 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 8

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

Answer 9

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

Answer 10

* 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

Answer 11

* 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 12

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

Answer 13

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

Answer 14

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

Answer 15

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)

Answer 16

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

Answer 17

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

Answer 18

Value of goods and services measured at current prices

Answer 19

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

Answer 20

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

Answer 21

* 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

Answer 22

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

Answer 23

G + X + I = T + M + S

Answer 24

* 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

Answer 25

* 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

Answer 26

* 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

Answer 27

= Money growth rate - Real GDP growth rate

Answer 28

* 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

Answer 29

* 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)

Answer 30

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

Answer 31

* 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

Answer 32

* 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

Answer 33

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

Answer 34

* GDP growth and no inflation

Answer 35

* Inflation occurs

Answer 36

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

Answer 37

* 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

Answer 38

* 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

Answer 39

* 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

Answer 40

> 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 41

1. Trough – Economy hits its lowest point 2. Expansion – Aggregate economic activity is increasing 3. Peak – Economy hits its highest point. 4. Contraction – Economy starts slowing down (often called a recession but may be called a depression when the contraction is severe).

Answer 42

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

Answer 43

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

Answer 44

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

Answer 45

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

Answer 46

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 47

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

Answer 48

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

Answer 49

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

Answer 50

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

Answer 51

* 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 52

* 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 53

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

Answer 54

* 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 55

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 56

* 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 57

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

Answer 58

Decisions about taxation and government spending

Answer 59

* 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 60

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

Answer 61

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

Answer 62

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

Answer 63

* 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 64

* 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 65

* 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 66

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 67

* 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 68

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 69

—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 70

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 71

* 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 72

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 73

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 74

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 75

1. Commodities and manufactured goods bought, sold, or given away 2. Tourism, transportation and business services, such as management consulting, or legal services 3. Income derived from the ownership of assets 4. Foreign direct aid, or gifts

Answer 76

1. Migrants’ transfers – goods and financial assets belonging to migrants as they leave or enter a country, death duties, inheritance taxes 2. Rights to nature resources, sale and purchase of intangible assets, such as patents, copyrights, trademarks etc.

Answer 77

1. Gold, foreign currencies, government’s reserve position in the IMF 2. Direct investment, securities issued by the reporting country’s government and private sectors

Answer 78

* 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 79

* 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 80

* 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 81

- 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 82

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 83

- 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 84

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 85

when each marginal unit sold is positive

Answer 86

Breakeven = P = ATC Shutdown point = P = AVC

Answer 87

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

Answer 88

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 89

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 90

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 91

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

Answer 92

MC = SR supply above PMin PLR = ATC

Answer 93

* 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 94

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 95

* 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 96

* 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 97

* 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 98

1. 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 2. Cournot assumption - Each firm determines its own profit maximizing level assuming the other firm stays constant 3. Nash equilibrium Nash equilibrium * Both firms will act in their own interest and not necessarily the most optimal option

Answer 99

* 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 100

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 101

1. Estimating elasticity through regression analysis 2. ‘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 3. 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 102

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 103

* 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 104

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 105

* 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 106

Monetary policy Central bank activities influencing the quantity of money and credit in an economy Fiscal policy Decisions about taxation and government spending

Answer 107

* 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 108

* 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 109

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 110

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 111

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 112

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 113

* 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 114

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 115

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 116

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

Answer 117

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

Answer 118

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

Answer 119

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

Answer 120

* 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 121

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 122

* 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 123

* 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 124

* 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 125

* 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 126

* 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 127

* 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 128

* 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 129

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 130

* 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 131

* 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 132

* 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 133

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 134

* 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 135

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 136

* 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 137

* 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 138

* 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 139

* 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 140

* 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 141

* 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 142

* 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 143

* 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 144

* 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 145

* 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 146

* 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 147

* 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 148

* 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 149

* 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 150

* 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 151

* 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 152

* 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 153

* 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 154

* 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 155

* 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 156

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 157

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

Answer 158

* 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 159

* 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 160

* 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 161

* 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 162

* 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 163

* 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 164

* 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 165

* 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 166

* 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 167

* 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 168

* 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 169

* 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 170

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 171

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

Answer 172

Taxes levied by government on imported goods

Answer 173

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

Answer 174

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 175

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

Answer 176

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

Answer 177

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

Answer 178

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

Answer 179

Exporter Increases Decreases Decreases Decreases

Answer 180

Importer Increases Decreases No change (rent to foreigners) Decreases

Answer 181

Increases Decreases Increases Imports decrease

Answer 182

Increases Decreases Increases Imports decrease

Answer 183

Increases Decreases Increases Exports increase

Answer 184

Increases Decreases Increases Imports decrease

Answer 185

* 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 186

* 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 187

* 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 188

Expressed as domestic currency units per foreign currency unit

Answer 189

Expressed as foreign currency units per domestic currency unit

Answer 190

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

Answer 191

one country fixes its rate of currency to another currency

Answer 192

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 193

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

Answer 194

1. 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). 2. 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’. 3. 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. 4. Target zone - Fixed parity regime with a wider band of up to +/- 2% around parity. Allowing greater scope for discretionary policy. 5. 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. 6. Fixed parity with crawling bands - Initial fixing to anchor expectations allowing for flexibility further on using crawling bands. 7. Managed float - Exchange rate based on internal or external policy targets. Typically not explicit. 8. 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 195

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 196

most of the borrowing is owed internally to local citizens

Answer 197

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

Answer 198

income tax, VAT, and social benefit

Answer 199

(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 200

via exchange rate targeting rather than inflation targeting.

Answer 201

= Trend growth + Inflation target