Economics Flashcards
1
Q
2.1 Currency Exchange Rates: Understanding Equilibrium Value
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– calculate and interpret the bid–offer spread on a spot or forward currency quotation and describe the factors that affect the bid–offer spread
– identify a triangular arbitrage opportunity and calculate its profit, given the bid–offer quotations for three currencies
– explain spot and forward rates and calculate the forward premium/discount for a given currency
– calculate the mark-to-market value of a forward contract
– explain international parity conditions (covered and uncovered interest rate parity, forward rate parity, purchasing power parity, and the international Fisher effect)
– describe relations among the international parity conditions
– evaluate the use of the current spot rate, the forward rate, purchasing power parity, and uncovered interest parity to forecast future spot exchange rates
– explain approaches to assessing the long-run fair value of an exchange rate
– describe the carry trade and its relation to uncovered interest rate parity and calculate the profit from a carry trade
– explain how flows in the balance of payment accounts affect currency exchange rates
– explain the potential effects of monetary and fiscal policy on exchange rates
– describe objectives of central bank or government intervention and capital controls and describe the effectiveness of intervention and capital controls
– describe warning signs of a currency crisis
2
Q
Notation Conventions: In the CFA curriculum, foreign exchange rates are quoted in price/base terms. These quotes indicate the number of units of the price currency that must be exchanged for one unit of the base currency.
For example, in a USD/EUR quote, USD is the price currency and EUR is the base currency. A quote of USD/EUR 1.25 should be interpreted as “One euro buys 1.25 US dollars.”
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3
Q
In the FX spot market, trades typically settle in two days, known as T+2 settlement. Participants are provided with both bid and offer prices:
1- Bid rate: The rate at which the counterparty (e.g., a dealer or market maker) is willing to buy the base currency. This is the rate you, as a trader, can sell the base currency to the counterparty.
2- Offer (or ask) rate: The rate at which the counterparty is willing to sell the base currency. This is the rate you, as a trader, can buy the base currency from the counterparty.
The offer price is always higher than the bid price, providing compensation to the counterparty offering the quote. The party requesting the quote has the flexibility to transact at either the bid or the offer price provided by the dealer.
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4
Q
FX quotes are typically expressed to four decimal places, with the fourth decimal place referred to as a “pip.” For example, if the USD/EUR rate increases from 1.2000 to 1.2005, we can say that it has gone up by 5 pips.
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5
Q
Bid-offer spreads are usually smaller in the interbank market.
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6
Q
The size of the bid-offer spread for a currency pair is influenced by several factors:
1- Interbank Market Spread:
– Highly liquid pairs like USD/EUR have lower spreads due to high liquidity, while less commonly traded pairs have higher spreads due to lower liquidity.
2- Time of Day:
– Liquidity is highest when the London and New York markets overlap.
– Liquidity is lowest in the late afternoon (New York time) after London closes and before Tokyo opens.
3- Market Volatility:
– Events such as geopolitical tensions or market crashes increase spreads due to heightened risk.
4- Size of the Transaction:
– Larger transactions often face wider spreads because they are harder for dealers to offset.
5- Dealer-Client Relationship:
– Dealers may lower spreads for clients to secure additional business.
– Clients with poor credit may face wider spreads due to increased risk.
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7
Q
Two arbitrage constraints influence the bid-offer quotes provided by dealers in the interbank FX market:
1- Direct Bid-Offer Constraint:
– Dealer bid ≤ Interbank offer
– Dealer offer ≥ Interbank bid
If this condition is not met, dealers could exploit the opportunity by buying from the cheaper source (interbank) and selling to the more expensive source (clients).
2- Cross-Rate Constraint:
– Dealer cross-rate bid < Interbank implied cross-rate offer
– Dealer cross-rate offer > Interbank implied cross-rate bid
This ensures that cross-rate arbitrage opportunities are eliminated by aligning dealer and interbank implied rates.
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8
Q
JPY/EURoffer
Explanation and Triangular Arbitrage:
1. Compute the rate to sell JPY and buy EUR:
The objective is to calculate the JPY/EUR offer rate using the interbank quotes provided:
EUR/USD: 0.7325 / 0.7327 (bid/offer)
JPY/USD: 76.64 / 76.66 (bid/offer)
The JPY/EUR offer rate is calculated as:
(JPY/USDoffer) × (USD/EURoffer )
JPY/EURoffer=(JPY/USDoffer)×(USD/EURoffer)
Since the USD/EUR offer is the inverse of the EUR/USD bid, calculate:
USD/EURoffer
= 1 / EUR/USDbid = 1 / 0.7325 = 1.3654
USD/EURoffer=1/EUR/USDbid=1/0.7325=1.3654
Substitute the values:
JPY/EURoffer
= 76.66 × 1.3654 = 104.65
JPY/EURoffer=76.66×1.3654=104.65
This is the interbank offer rate to sell JPY and buy EUR.
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- Dealer Quote and Arbitrage Opportunity:
The dealer quotes a JPY/EUR bid-offer rate of 104.67 / 104.69.
– The interbank JPY/EUR offer rate is calculated as 104.65 (from Step 1).
– The dealer’s bid rate is 104.67, which is higher than the interbank offer rate, creating an arbitrage opportunity.
To execute the arbitrage:
1- Buy EUR in the interbank market at 104.65 JPY/EUR (interbank offer rate).
2- Sell EUR to the dealer at 104.67 JPY/EUR (dealer bid rate).
Profit per unit of EUR:
Profit = Dealerbid − InterbankofferProfit
= 104.67 − 104.65 = 0.02 JPYperEUR.
Conclusion:
By purchasing EUR for 104.65 JPY in the interbank market and selling it to the dealer for 104.67 JPY, a triangular arbitrage generates a profit of 0.02 JPY per EUR traded.
9
Q
1- Bid rate: The rate at which the counterparty (e.g., a dealer or market maker) is willing to buy the base currency. This is the rate you, as a trader, can sell the base currency to the counterparty.
2- Offer (or ask) rate: The rate at which the counterparty is willing to sell the base currency. This is the rate you, as a trader, can buy the base currency from the counterparty.
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Example with JPY/EUR (104.67 / 104.69):
Bid (104.67): You can sell EUR and receive JPY at this rate.
Offer (104.69): You can buy EUR and pay JPY at this rate.
Therefore, buying it for less than the dealer is willing to pay for.
10
Q
Forward exchange rates are typically quoted in points, which represent the difference between the forward exchange rate and the spot exchange rate.
1- Points Calculation:
– Points are scaled based on the number of decimal places in the spot quote.
– Example:
— If a rate is quoted to four decimal places, 51 forward points is equal to 51 / 10 000 = 0.0051.
— If a rate is quoted to two decimal places, 7 forward points is equal to 7 / 100 = 0.07.
2- Customized Contracts in the FX Market:
– The FX market operates over-the-counter (OTC), allowing participants to customize contracts.
– Non-standard maturities may require dealers to use linear interpolation to determine rates.
– Example: A rate for a 3.5-month contract can be calculated as the midpoint between the 3-month and 4-month rates.
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Ex:
Spot (USD/EUR): 1.0766 / 1.0768
Three months: -15.3 / -14.7
Buy EUR forward against the USD in three months, what would be the rate? :
1.0768 + (-14.7 / 10 000) = 1.07533
11
Q
[Quiz - Valuation of Forward Contract Using Mark-to-Market Offset]
1- Overview of the Scenario
– Schofield entered a 9-month forward contract to sell 16.5 million PED at 8.2550 PED/USD.
– Three months have passed, so the position is now marked to market using a 6-month forward rate.
– To offset the position, Schofield considers entering a 6-month forward contract to buy 16.5 million PED.
– The current forward bid-offer range is -250 to -300 points (or -0.0250 to -0.0300 when divided by 10,000).
2- Identifying Applicable Forward Rates
– As Schofield wants to buy PED (i.e., sell USD), the offer rate must be used.
– Spot rate = 8.3050 (offer side).
– Forward points = -0.0250.
– 6-month forward rate = 8.3050 - 0.0250 = 8.2800.
3- Proceeds from Original Forward Contract
– Schofield is contractually set to receive USD in exchange for selling PED at 8.2550.
– Proceeds in USD:
— USD_received = 16,500,000 ÷ 8.2550 = 1,998,789.
4- Cost of Offsetting Forward Contract
– To offset the position, Schofield must enter a 6-month forward to buy PED at the forward rate of 8.2800.
– USD paid under new forward:
— USD_paid = 16,500,000 ÷ 8.2800 = 1,992,754.
5- Net Cash Flow from Offset
– Net cash flow = USD received - USD paid = 1,998,789 - 1,992,754 = 6,035.
6- Present Value of the Arbitrage Profit
– Time = 6 months = 180 ÷ 360.
– Discount rate = 3.00% (USD 6-month rate).
– PV = 6,035 ÷ [1 + 0.03 × (180 ÷ 360)] = 6,035 ÷ 1.015 = 5,946.
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Key Takeaways
– Schofield can lock in a present value gain of USD 5,946 by offsetting the original forward contract.
– Proper selection of bid-offer sides and forward points is essential for mark-to-market valuation.
– The 6-month USD rate is used to discount future cash flows to present value.
12
Q
The value of a forward contract is zero at inception but can be positive or negative at later dates. A forward contract is closed by entering into an offsetting forward contract. When calculating the mark-to-market value, discounting is required to the settlement date.
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13
Q
Notation Conventions: In the CFA curriculum, foreign exchange rates are quoted in price/base terms. These quotes indicate the number of units of the price currency that must be exchanged for one unit of the base currency.
For example, in a USD/EUR quote, USD is the price currency and EUR is the base currency. A quote of USD/EUR 1.25 should be interpreted as “One euro buys 1.25 US dollars.”
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14
Q
Forward Premium : F f/d > S f/d
Forward Discount : F f/d < S f/d
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15
Q
Exchange rate movements are influenced by several factors:
1- Long Run versus Short Run:
– Long-term equilibrium values act as anchors for exchange rates, but they are generally poor predictors of short-term fluctuations.
2- Expected versus Unexpected Changes:
– In efficient markets, prices and rates reflect current consensus expectations.
– Exchange rates are most influenced by unexpected new information; expected changes have minimal impact.
3- Relative Movements:
– Exchange rates are driven by relative movements among countries rather than absolute changes in isolation.
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! We must accept that no single model can accurately forecast exchange rates in all circumstances. A model that works well for a given currency pair over one period may not be a reliable predictor for other pairs
16
Q
International Parity Conditions
Explain relationships between economic variables across countries in an ideal world. Key parity conditions include:
1- Covered Interest Rate Parity
2- Uncovered Interest Rate Parity
3- Forward Rate Parity
4- Purchasing Power Parity
5- International Fisher Effect
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These conditions provide expectations for:
– Expected inflation differentials
– Interest rate differentials
– Forward exchange rates
– Current spot exchange rates
– Expected future spot exchange rates
However, real-world factors like transaction costs and imperfect information ensure that these conditions do not always hold.
17
Q
[Interest Rate and Price Parity Conditions in International Finance
1- Covered Interest Rate Parity (CIP)
– States that the forward exchange rate should offset interest rate differentials between two countries to eliminate arbitrage opportunities.
– Assumes capital mobility and the use of forward contracts to fully hedge currency risk.
– If CIP holds, no arbitrage profit can be made from discrepancies in interest rates and forward exchange rates.
– Formula: “F ÷ S = (1 + if) ÷ (1 + id)”
2- Uncovered Interest Rate Parity (UIP)
– Suggests that the expected change in the spot exchange rate offsets the interest rate differential between two countries.
– Unlike CIP, it does not use forward contracts, so it includes currency risk.
– UIP implies that higher interest rates in a country are offset by expected depreciation of its currency.
– Formula: “if - id ≈ %ΔS”
3- Forward Rate Parity (FRP)
– States that the forward premium or discount is approximately equal to the expected change in the spot exchange rate.
– If FRP holds, forward rates serve as unbiased predictors of future spot rates under risk neutrality.
– Formula: “(F - S) ÷ S ≈ %ΔS”
4- Purchasing Power Parity (PPP)
– PPP relates exchange rate movements to differences in price levels or inflation between countries.
– Two forms are commonly used: Absolute PPP and Relative (Ex-Ante) PPP.
– 1- Absolute PPP:
— Proposes that identical goods should cost the same across countries when converted into a common currency.
— Formula: “S = Pf ÷ Pd”
– 2- Relative (Ex-Ante) PPP:
— States that the expected change in exchange rate is approximately equal to the inflation rate differential.
— Formula: “%ΔS ≈ πf - πd”
5- International Fisher Effect (IFE)
– Combines the Fisher Effect and Relative PPP.
– Suggests that the nominal interest rate differential between two countries equals the expected inflation differential.
– Assumes real interest rate parity holds.
– Formula: “if - id ≈ πf - πd”
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List of Variables
– S: Spot exchange rate (domestic currency per unit of foreign currency)
– F: Forward exchange rate (domestic currency per unit of foreign currency)
– if: Foreign nominal interest rate
– id: Domestic nominal interest rate
– rf: Foreign real interest rate
– rd: Domestic real interest rate
– πf: Foreign expected inflation rate
– πd: Domestic expected inflation rate
– %ΔS: Expected percentage change in spot exchange rate (foreign relative to domestic)]
18
Q
Covered Interest Rate Parity : Ensures that two risk-free investment options for an investor with one unit of domestic currency provide the same returns, preventing arbitrage opportunities.
The two options are:
1- Invest domestically at the domestic risk-free rate.
2- Invest abroad:
– Convert the domestic currency to the foreign currency.
– Invest at the foreign risk-free rate.
– Use a forward contract to lock in the exchange rate for converting the proceeds back into domestic currency.
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In practice, covered interest rate parity generally holds, as arbitrageurs quickly eliminate price discrepancies in efficient markets.
Assumptions:
– CIRP holds under the following conditions:
No transaction costs in the market.
Domestic and foreign money market instruments are equivalent in terms of:
– Liquidity.
– Maturity.
– Default risk.
19
Q
Uncovered Interest Rate Parity (UIP) suggests that the following two options should provide the same expected return:
1- Invest at the domestic risk-free rate.
2- Convert to the foreign currency, invest at the foreign risk-free rate, and later convert back to the domestic currency at the prevailing spot rate.
Unlike covered interest rate parity, no forward contract is used to lock in a conversion rate in Option 2, making it an unhedged investment. A risk-neutral investor would be indifferent between the two options if UIP holds.
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Key Implication of UIP:
– Any difference between the foreign and domestic risk-free rates should be offset by expected changes in the exchange rate:
Foreign risk-free rate - Domestic risk-free rate = Expected percentage change in the exchange rate.
– If the foreign risk-free rate is higher than the domestic rate, the foreign currency is expected to depreciate relative to the domestic currency (i.e., the future spot exchange rate will increase).
Practical Considerations:
– If UIP holds, the current forward exchange rate would be an unbiased predictor of the future spot rate.
– However, UIP tends to hold better over long-term horizons and is less reliable for predicting exchange rates over short- and medium-term periods.
– This allows investors to potentially profit by overweighting higher-yielding currencies.
20
Q
Uncovered Interest Rate Parity (UIP) :
if - id = % Change in Se f/d
Se f/d : Spot expected foreign-domestic rate
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That is, if the foreign risk-free rate is higher, the foreign currency will weaken relative to the domestic currency (i.e., the S f/d rate will increase).
21
Q
Forward Rate Parity:
Definition:
– Forward rate parity states that forward exchange rates are unbiased predictors of future spot exchange rates.
– This means that while forward rates may sometimes overestimate or underestimate the future spot rate, they should, on average, match the future spot rate over time.
Implications:
– If both covered and uncovered interest rate parity hold, then forward rates would be accurate predictors of future spot rates.
– This would align with the relationship between forward rates, spot rates, interest rate differentials, and expected spot rate changes.
Practical Observations:
– Forward contracts ensure covered interest rate parity generally holds, eliminating arbitrage opportunities.
– However, uncovered interest rate parity rarely holds due to the lack of an arbitrage mechanism.
– As a result, forward rates are generally poor predictors of future spot rates, especially in the short run.
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22
Q
Forward Rate parity :
F f/d = Se f/d
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23
Q
Forward rates are generally poor predictors of future spot rates, at least in the short run.
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24
Q
Purchasing power parity (PPP) is based on the law of one price, which states that identical goods should have the same price. There are several versions of PPP.
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25
Purchasing Power Parity (PPP):
1- Absolute Version of PPP:
-- States that the equilibrium exchange rate is based on the ratio of prices in one country relative to another:
Exchange rate = Price level of foreign country / Price level of domestic country.
-- Assumes frictionless markets with no transaction costs or trade barriers.
-- In reality, factors such as costs and the inability to trade certain goods often prevent absolute PPP from holding.
2- Relative Version of PPP:
-- Recognizes that changes in exchange rates are driven by changes in price levels.
-- The percentage change in an exchange rate is approximately equal to the difference between the foreign and domestic inflation rates:
% Change in exchange rate ≈ Foreign inflation rate - Domestic inflation rate.
-- If the foreign country’s inflation rate is higher, its currency will weaken relative to the domestic currency.
3- Ex Ante Version of PPP:
-- Focuses on expected changes in exchange rates and inflation:
Expected % Change in exchange rate ≈ Expected foreign inflation rate - Expected domestic inflation rate.
-- Countries with persistently high inflation can expect their currencies to depreciate over time.
4- Practical Observations:
-- Real exchange rates tend to mean-revert over the long run, driving nominal exchange rates toward PPP equilibrium values.
-- However, significant deviations from PPP can occur in the short run due to market inefficiencies or other factors.
Absolute : S f/d = ( Pf / Pd ) --> [Prices foreign and domestic]
Relative : % Change in S f/d = approx = Foreign Inflation - Domestic Inflation
Ex-ante : % Change in Se f/d = approx = Expected Foreign Inflation - Expected Domestic Inflation
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Combining Interest Rates, Inflation, and Exchange Rates (Fisher Effect and Parity Conditions):
1- Fisher Effect:
-- The nominal interest rate is composed of the real interest rate and expected inflation:
Nominal interest rate = Real interest rate + Expected inflation.
2- Real Domestic-Foreign Interest Rate Differential:
-- The nominal interest rate differential can be adjusted for expected inflation to determine the real interest rate differential:
Real interest rate differential = Nominal interest rate differential - Inflation rate differential.
3- Real Interest Rate Parity:
-- If uncovered interest rate parity and ex ante purchasing power parity (PPP) hold, the real interest rate parity condition applies:
Real interest rate differential = 0.
-- Under this condition, the real yield spread between domestic and foreign countries is zero.
4- International Fisher Effect:
-- If real interest rate parity holds, the international Fisher effect will also hold:
Nominal interest rate differential = Expected inflation rate differential.
5- Practical Limitations:
-- Both the international Fisher effect and real interest rate parity assume currency risk is uniform across all countries.
-- This assumption does not hold in practice, especially for emerging markets, which have higher currency risk. Adjustments must be made to reflect these differences.
-- Fisher effect formula: i = r + πe
-- Real interest rate differential: rf - rd = (if - id) - (πf - πd)
-- Real interest rate parity (if UIP and ex-ante PPP hold): rf - rd = 0
-- International Fisher effect: if - id = πf - πd]
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Inflation and Currency Depreciation:
It’s true that higher inflation in a country tends to weaken its currency in the long run. This happens because:
1- Higher inflation reduces the purchasing power of the currency.
2- Export goods become less competitive, and investors might seek stronger currencies elsewhere.
However, in this example, purchasing power parity (PPP) explains how exchange rate movements offset inflation differentials to maintain parity between countries.
Why Does Currency Depreciation Offset Inflation?
When inflation in Mexico (5%) is higher than in Canada (3%):
1- PPP suggests that the exchange rate should adjust.
The Mexican peso (MXN) depreciates relative to the Canadian dollar (CAD).
This depreciation reflects the inflation differential of 2%.
2- Depreciation "equalizes" the inflation effect:
Although Mexican goods are more expensive domestically due to inflation, the weaker peso makes them cheaper for foreigners (like Canadians) in relative terms.
This depreciation restores the balance in purchasing power between the two currencies, offsetting the inflation gap.
Inflation weakens a currency domestically, but depreciation in the foreign exchange market compensates for this weakness internationally by adjusting the exchange rate. This ensures that goods and services remain comparable across countries, consistent with PPP.
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Parity Conditions and Their Linkages
1- Covered Interest Rate Parity (CIRP):
-- States that the nominal interest rate spread between two countries equals the percentage forward premium or discount of the exchange rate.
-- This relationship holds because of arbitrage opportunities using forward contracts.
2- Uncovered Interest Rate Parity (UIP):
-- States that the nominal interest rate spread equals, on average, the expected percentage appreciation or depreciation of the spot exchange rate.
-- This is an unhedged condition and relies on expectations about future spot rates.
3- Link Between CIRP and UIP:
-- If both covered and uncovered interest rate parity hold, the forward exchange rate would act as an unbiased estimate of the future spot exchange rate.
Ex Ante PPP and the Fisher Effect
1- Ex Ante Purchasing Power Parity (PPP):
-- States that the expected change in a spot exchange rate equals the expected difference between domestic and foreign inflation rates.
-- This focuses on the inflation differential as a driver of currency value changes.
2- Fisher Effect:
-- States that the nominal yield spread (difference in interest rates between two countries) equals the expected difference in inflation rates between those countries.
3- Link Between Ex Ante PPP and Fisher Effect:
-- If both conditions hold, the expected change in the spot exchange rate would equal the nominal yield spread.
-- This means that inflation differences and interest rate differences both align to explain exchange rate movements.
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Implications if All Key Parity Conditions Hold
If all key parity conditions (covered interest rate parity, uncovered interest rate parity, ex ante PPP, and the Fisher effect) hold, then:
1- Expected changes in the spot exchange rate would equal:
-- The forward premium or discount (%).
-- The nominal yield spread between countries.
-- The difference between expected national inflation rates.
2- Implication for Investors:
-- If these conditions held perfectly, there would be no consistent arbitrage opportunities or profits to be earned from currency movements.
-- Exchange rates would adjust fully to reflect differences in inflation, interest rates, and forward rates, leaving no mispricings to exploit.
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Yes, in essence, if ex-ante PPP and the Fisher effect both hold, they together imply uncovered interest rate parity (UIP). Here’s why:
1- Ex-Ante PPP:
-- The expected change in the spot exchange rate equals the expected inflation rate differential between two countries:
%ΔS ≈ πf - πd
2- Fisher Effect:
-- The nominal yield spread between two countries equals the expected inflation rate differential:
if - id ≈ πf - πd
3- Uncovered Interest Rate Parity (UIP):
-- UIP states that the nominal interest rate spread equals the expected change in the spot exchange rate:
if - id ≈ %ΔS
Linkage:
When ex-ante PPP and the Fisher effect both hold, the inflation rate differential drives both the expected change in the spot exchange rate and the nominal yield spread.
This alignment ensures that the nominal interest rate spread (from Fisher) is equal to the expected change in the exchange rate (from UIP).
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[Linkages Between Parity Conditions and the Fisher Effect
1- Linking Ex-Ante PPP and Fisher Effect
-- When both ex-ante Purchasing Power Parity and the Fisher Effect hold, the inflation differential drives both the expected exchange rate change and the nominal interest rate spread.
-- This linkage creates consistency across pricing in currency and fixed income markets.
-- From Ex-Ante PPP:
--- "%ΔS ≈ πf - πd"
-- From Fisher Effect:
--- "if - id ≈ πf - πd"
-- Therefore, combining both:
--- "if - id ≈ %ΔS"
--- This is equivalent to the Uncovered Interest Rate Parity (UIP), showing the consistency among the three theories.
2- UIP as a Derived Result from Ex-Ante PPP and Fisher
-- When both Ex-Ante PPP and Fisher Effect hold, UIP naturally follows.
-- Since both sides are equal to the inflation differential, they must also be equal to each other.
-- Proof:
--- If: "%ΔS ≈ πf - πd" (from Ex-Ante PPP)
--- And: "if - id ≈ πf - πd" (from Fisher Effect)
--- Then: "if - id ≈ %ΔS" (UIP)
3- Link Between IFE and Relative PPP
-- The International Fisher Effect (IFE) is based on the assumption that real interest rate parity holds.
-- It therefore requires the combination of the Fisher Effect and Relative PPP to be valid.
-- If both Relative PPP and real interest rate parity hold, then the difference in nominal interest rates reflects the inflation differential.
-- From IFE:
--- "if - id ≈ πf - πd"
-- This is exactly the same as combining:
--- "if = rf + πf" and "id = rd + πd" (Fisher Effect)
--- If "rf = rd", then "if - id = πf - πd"
4- Link Between CIP and Forward Rate Parity
-- If CIP holds and forward rates are unbiased, then Forward Rate Parity is consistent with UIP.
-- In practice, this alignment implies that the forward rate embeds expectations consistent with interest rate and inflation differentials.
-- From CIP:
--- "F ÷ S = (1 + if) ÷ (1 + id)"
-- When solving for (F - S) ÷ S, under small interest rate assumptions, this simplifies to:
--- "(F - S) ÷ S ≈ if - id"
-- If UIP also holds:
--- "if - id ≈ %ΔS"
-- Then:
--- "(F - S) ÷ S ≈ %ΔS"
--- Which is Forward Rate Parity (FRP)
Key Takeaways
-- Ex-Ante PPP and the Fisher Effect together imply UIP.
-- Real interest rate parity and relative PPP imply the International Fisher Effect.
-- CIP and FRP align under conditions of market efficiency and no arbitrage.
-- These relationships form a consistent web of parity conditions linking inflation, interest rates, and exchange rates.]
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For the international Fisher effect to hold, it is necessary for both uncovered interest rate parity and ex ante PPP must hold
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Assumption of Uncovered Interest Rate Parity (UIP):
-- Key Relationship:
In a country with a higher interest rate, its currency is expected to depreciate.
This depreciation offsets the higher returns from the higher interest rate, ensuring no excess profits can be earned.
-- Implications:
If UIP holds, there is no incentive to shift capital from one country to another simply because of interest rate differentials.
Extra returns from investing in high-interest-rate countries are offset by corresponding currency depreciation.
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Uncovered Interest Rate Parity and the FX Carry Trade
1- Uncovered Interest Rate Parity (UIP):
-- High-yield currencies are expected to depreciate, offsetting any gains from higher interest rates.
-- However, studies show that high-yield currencies often do not depreciate as much as UIP predicts, particularly in the short term.
2- FX Carry Trade:
-- The carry trade exploits UIP’s failure to hold.
-- Strategy:
-- Take a long position in a high-yield currency.
-- Take a short position in a low-yield currency (borrow at a lower rate and invest at a higher rate).
-- Profitability depends on two factors:
-- The high-yield currency not depreciating by the expected percentage.
-- Returns being sufficient to cover the borrowing costs of the low-yield currency.
3- Performance of the Carry Trade:
-- During low volatility:
-- Generates a steady stream of small gains.
-- During market turbulence ("flight to quality"):
-- Investors flock to safe-haven currencies, causing large losses for carry trades.
-- This results in a negative skew with a fat left tail in the distribution of returns, meaning rare but extreme losses.
For carry trading to be profitable, the high-yield currency must not depreciate by the percentage that would be expected if uncovered interest parity held. Additionally, the returns must be sufficient to cover the interest that is charged to borrow the low-yield currency.
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[Quiz - International Parity Conditions and FX Carry Trade Implications]
1- Key Concept Tested
-- This question examines which international parity condition supports the mechanics of FX carry trades.
-- FX carry trades involve borrowing in low-interest-rate currencies and investing in high-interest-rate currencies.
-- This strategy only yields profits if the low-yielding currency does not appreciate significantly, or if the high-yielding currency does not depreciate enough to eliminate the interest differential.
2- Correct Answer: C. Uncovered Interest Rate Parity (UIP)
-- The international parity condition referenced by McFadden is Uncovered Interest Rate Parity (UIP).
-- UIP suggests that the expected change in the exchange rate over time should offset the interest rate differential between two countries.
-- If UIP held, it would mean that returns from foreign and domestic assets would be the same once adjusted for expected currency movements.
3- Why UIP is Relevant for Carry Trades
-- Carry trades profit when UIP does not hold.
-- If high-yield currencies do not depreciate as much as UIP predicts, or if low-yield currencies do not appreciate accordingly, investors earn excess returns from the interest rate differential.
-- In practice, during times of low market volatility, these predicted currency movements often fail to materialize—making carry trades profitable.
4- Elimination of Incorrect Choices
-- A. Purchasing Power Parity (PPP): Refers to exchange rate changes driven by relative inflation rates. It is not directly relevant to short- or medium-term currency returns exploited in FX carry trades.
-- B. Covered Interest Rate Parity (CIP): Involves forward contracts to lock in arbitrage-free returns. FX carry trades are unhedged, so CIP is not applicable.
Key Takeaways
-- The success of FX carry trades depends on violations of UIP.
-- UIP implies that exchange rate movements should negate interest rate differentials—yet this is often not observed in practice.
-- McFadden’s statement implies that investors benefit from the failure of UIP to hold consistently in the real world.
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Relationship Between Current Account, Capital Account, and Exchange Rates
1- Role of Accounts in Economic Activity:
-- Current account: Reflects real economic activity, such as trading goods and services (exports/imports).
-- Capital account: Captures investment and financing activity, including cross-border financial flows.
2- Linkage Through Exchange Rates:
-- Decisions about trading goods/services differ from investment decisions, but exchange rates align these activities.
-- Persistent current account deficits (more imports than exports) often lead to currency depreciation, as the current account deficit must be offset by a capital account surplus (financial inflows).
3- Drivers of Exchange Rate Movements:
-- Over the short- and intermediate-term, exchange rate movements are primarily driven by investment/financing decisions, rather than trade.
Reasons:
-- Prices of real goods and services adjust slowly, while exchange rates and asset prices adjust quickly.
-- Production adjustments for real goods/services take time, whereas financial flows can be reallocated rapidly.
-- Investment/financing decisions involve funding current expenditures and reallocating assets within portfolios.
-- Expected exchange rate movements strongly influence investment/financing decisions.
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Current Account Imbalances and the Determination of Exchange Rates
1- The Flow Supply/Demand Channel:
It suggests that countries with persistent current account surpluses tend to see their domestic currency appreciate, while deficit countries experience depreciation. However, as a currency strengthens, it eventually reduces export competitiveness and weakens the country's terms of trade.
-- The degree of exchange rate response depends on:
--- The initial trade gap (difference between imports and exports).
--- The sensitivity of prices and demand for imports and exports to currency fluctuations.
-- Empirical Observations:
--- Companies in deficit countries often limit price increases to maintain market share, which delays full adjustment to currency fluctuations.
--- This adjustment lag can take several years to fully materialize.
2- The Portfolio Balance Channel:
This channel explains that current account imbalances shift financial wealth from deficit nations to surplus nations. Countries with persistent trade deficits must borrow to finance these imbalances, and over time, investors may reduce their holdings of deficit nations' debt. This reduction in demand for debt puts downward pressure on the currencies of deficit countries.
3- The Debt Sustainability Channel:
Current account deficits lead to growing foreign debt, which cannot be sustained indefinitely due to the existence of potential debt limits. When these limits are reached, currencies face downward pressure. Conversely, surplus countries accumulate foreign currency assets, which creates upward pressure on the long-run equilibrium value of their currency.
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Capital Flows and the Determination of Exchange Rates
Global Financial Integration and Exchange Rates
1- Global Financial Integration:
Global financial integration has significantly increased the ease of moving capital across borders, resulting in volatile exchange rates, interest rates, and price bubbles. Capital flows into emerging markets, though substantial, often end abruptly, causing severe economic disruption.
2- One-Sided Capital Flows and Carry Trades:
One-sided capital flows can persist for long periods, creating opportunities for positive excess returns in carry trading strategies. Governments in high-yield markets may implement tighter fiscal policies to stabilize prices and achieve sustainable economic growth, which can increase the long-run equilibrium value of the currency.
-- Sticky positive excess returns are partly explained by the gradual responses of monetary policymakers to changing conditions.
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Equity Market Trends and Exchange Rates : The relationship between equity markets and exchange rates is unstable and influenced by changing market conditions.
-- In the United States, the correlation between domestic equity returns and the US dollar is highly variable over short periods but tends to zero in the long term.
-- Since the 2008 financial crisis, this correlation has generally been negative. Investors flock to the US dollar as a safe haven during "risk-off" periods and exhibit the opposite behavior when taking on more risk.
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Debt Sustainability Channel
The Debt Sustainability Channel describes how current account imbalances impact the financial wealth of deficit and surplus nations:
1- Deficit Nations:
-- Persistent current account deficits require borrowing from surplus nations.
-- There is a limit to how much debt can be sustainably borrowed.
-- If the debt becomes too large, the country may need to print money to repay it, leading to:
--- Depreciation of the currency's long-run equilibrium value.
2- Surplus Nations:
-- Countries with persistent current account surpluses accumulate financial wealth by lending to deficit nations.
-- These countries can expect their currency’s value to appreciate over time as the long-run equilibrium adjusts upward.
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1- Capital Mobility
This refers to how easily financial capital (money for investments) can move between countries.
Mobile Capital:
-- Capital can move freely across borders with little or no restrictions (e.g., in developed economies with open financial systems).
-- Investors can quickly reallocate funds to take advantage of higher interest rates in other countries.
Immobile Capital:
-- Capital movement is restricted by factors such as government regulations, capital controls, or underdeveloped financial markets (e.g., in some emerging or developing economies).
-- Investors cannot easily move money abroad, even if foreign interest rates are more attractive.
2- Sensitivity to Interest Rate Differentials
This refers to how strongly investors respond to differences in interest rates between countries.
Sensitive to Interest Rate Differentials:
-- Investors are highly responsive to even small changes in interest rates.
-- If domestic rates rise relative to foreign rates, there will be large capital inflows as investors chase higher returns.
-- If domestic rates fall, capital outflows occur as investors seek better returns abroad.
Insensitive to Interest Rate Differentials:
-- Investors are less responsive to interest rate differences.
-- Other factors (e.g., exchange rate stability, political risk, or transaction costs) may outweigh interest rate considerations when deciding where to invest.
-- Even if interest rates are higher in one country, investors might not move their capital due to these non-interest-related concerns.
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Combined Implications in the Context of Monetary and Fiscal Policy:
Mobile and Sensitive Capital Flows:
-- Capital moves freely and responds strongly to interest rate changes.
-- Policies that increase interest rates (e.g., restrictive monetary or expansionary fiscal) attract significant foreign capital inflows, leading to currency appreciation.
Immobile or Insensitive Capital Flows:
-- Capital does not move easily or does not react strongly to interest rate changes.
-- Policies that raise interest rates are less effective in attracting foreign capital, so they are more likely to result in trade imbalances (e.g., increased imports) and downward pressure on the domestic currency.
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[Quiz - Exchange Rate Adjustment and Trade Balance Lag Effects]
1- Key Concept Tested
-- This question tests the understanding of how quickly exchange rate adjustments translate into changes in trade balances.
-- Specifically, it addresses a common oversimplification: assuming that currency depreciation immediately corrects trade imbalances.
2- Correct Answer: C. Lag in the response of import and export demand to price changes
-- McFadden's statement assumes immediate trade balance correction through currency depreciation.
-- This fails to account for lags in how importers and exporters adjust to relative price changes following an exchange rate movement.
-- These lags may arise from: --- Existing trade contracts with fixed terms.
--- Delayed consumer and producer response to relative price shifts.
--- Time needed to adjust production and sourcing decisions.
3- Explanation of the Oversight
-- McFadden references the flow supply/demand channel, where a weaker currency should reduce imports and boost exports.
-- However, empirical evidence shows that trade flows react slowly to exchange rate changes.
-- In the short run, trade balances do not adjust immediately because prices and quantities take time to respond.
4- Elimination of Incorrect Choices
-- A. Initial gap between imports and exports: This exists but is not what McFadden failed to account for.
-- B. Effect of an initial trade deficit: Her statement already assumes a trade deficit is being corrected by FX depreciation, so this is not the missed element.
Key Takeaways
-- The impact of currency movements on trade balances is not instantaneous.
-- Exchange rate adjustments influence trade through a lagged mechanism.
-- Analysts must be cautious when assuming quick correction of trade imbalances through FX changes.
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The Mundell-Fleming Model
The Mundell-Fleming model assumes an economy operates below capacity, enabling output to increase without triggering inflation. The model examines the effects of monetary and fiscal policies on interest rates, economic activity, capital flows, and exchange rates.
1- Expansionary Monetary Policy:
-- Effect on Interest Rates: Lowers interest rates, increasing investment and consumption.
-- Effect on Capital Flows: Lower interest rates prompt capital outflows as investors seek higher yields abroad.
-- Effect on Currency: Flexible exchange rates result in downward pressure on the domestic currency.
2- Expansionary Fiscal Policy:
-- Effect on Output: Boosts government spending and output.
-- Effect on Interest Rates: Raises real interest rates.
-- Effect on Currency:
--- If capital flows are highly sensitive to interest rate differentials, the domestic currency appreciates as higher rates attract foreign investors.
--- If capital flows are insensitive, the domestic currency depreciates because increased imports are not offset by capital inflows.
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Mundell-Fleming Model and Capital Mobility
The Mundell-Fleming model describes how the interaction of fiscal and monetary policies affects exchange rates, depending on the degree of capital mobility.
High Capital Mobility (Common in developed economies):
1- Expansionary Fiscal Policy:
-- The currency's movement is ambiguous due to competing effects of higher interest rates (currency appreciation) and increased imports (currency depreciation).
2- Restrictive Fiscal Policy:
-- The domestic currency depreciates as lower government spending reduces interest rates and capital inflows.
3- Expansionary Monetary Policy:
-- The domestic currency depreciates as lower interest rates encourage capital outflows.
4- Restrictive Monetary Policy:
-- The domestic currency appreciates as higher interest rates attract capital inflows.
Low Capital Mobility (Common in emerging markets):
1- Expansionary Fiscal Policy:
-- The domestic currency depreciates as increased imports outweigh limited capital inflows.
2- Restrictive Fiscal Policy:
-- The currency's movement is ambiguous due to trade flow effects and restricted capital movement.
3- Expansionary Monetary Policy:
-- The currency's movement is ambiguous due to the balance of trade and capital flow effects.
4- Restrictive Monetary Policy:
-- The domestic currency appreciates due to reduced imports and increased demand for the domestic currency.
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Monetary Models of Exchange Rate Determination
The Monetary Models focus on how monetary policy affects exchange rates through price levels and inflation, assuming fixed output.
Key Models and Assumptions:
1- Pure Monetary Approach:
-- Assumes purchasing power parity (PPP) holds at all times.
-- A 5% increase in price levels due to expansionary monetary policy leads to a 5% devaluation in the domestic currency.
-- Shortcoming: PPP does not hold in the short and medium terms, limiting the model's real-world applicability.
2- Dornbusch Overshooting Model:
-- Recognizes short-term price stickiness and long-term PPP adherence.
-- Mechanism:
--- An increase in the money supply reduces interest rates, prompting capital outflows as investors seek higher returns abroad.
--- The domestic currency initially overshoots by depreciating below its long-run PPP equilibrium level.
--- Over time, the exchange rate appreciates back to PPP, as domestic prices adjust and the economy stabilizes.
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[Quiz - FX Intervention Effectiveness in Emerging Markets]
1- Key Concept Tested
-- This question tests the understanding of central bank FX intervention capabilities, particularly the role of foreign exchange (FX) reserves in emerging market (EM) versus developed market (DM) economies.
-- Specifically, it targets the implication in Statement 4 regarding what makes EM central banks more effective in using FX intervention.
2- Correct Answer: A. FX reserve levels
-- EM central banks are more effective at influencing exchange rates because they typically hold higher FX reserve levels relative to daily FX turnover.
-- This greater reserve capacity enables them to conduct larger and more sustained interventions.
-- FX reserves act as a buffer or insurance to manage volatility and protect against speculative pressures.
3- Supporting Rationale
-- In EM countries, the ratio of reserves to FX market turnover is high.
-- In contrast, in DM countries, the FX market is far more liquid, making central bank interventions less effective due to the diluted influence of any single actor.
-- As a result, EM central banks can shift market expectations or resist pressure more effectively.
4- Elimination of Incorrect Choices
-- B. Domestic demand: This does not explain the relative effectiveness of FX interventions.
-- C. Capital flows: While capital flows affect exchange rates, McFadden already acknowledges capital flow influence earlier in the passage; Statement 4 isolates why EM interventions are more effective, not broader macro pressures.
Key Takeaways
-- High FX reserve levels empower EM central banks to manage exchange rates more effectively than DM central banks.
-- Reserve adequacy is a critical tool in currency defense and maintaining stability in less liquid markets.
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Dornbusch Overshooting Model Summary:
Short Run:
-- Assumes domestic prices are inflexible in the short term.
-- An increase in the nominal money supply decreases domestic interest rates.
-- Lower interest rates lead to capital outflows as investors seek higher yields abroad.
-- The domestic currency depreciates below its new long-run PPP equilibrium level due to the short-term rigidity of prices.
-- This overshooting effect reflects the immediate adjustment of exchange rates to maintain uncovered interest rate parity.
Long Run:
-- As domestic prices adjust, domestic interest rates rise to align with the long-term equilibrium.
-- The domestic currency appreciates toward its new long-run equilibrium value, consistent with the pure monetary model.
-- In the long term, PPP holds, and the exchange rate stabilizes at the level implied by the increased money supply and higher domestic prices.
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The increase in interest rates will trigger currency appreciation. Foreign investors will flock to the higher rates and thus increase the demand for the currency. But in the long run, the government debt will increase the risk and lead to currency depreciation.
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The Portfolio Balance Approach
The Portfolio Balance Approach highlights the long-term consequences of fiscal imbalances, which are not accounted for in the Mundell-Fleming model. Persistent fiscal deficits lead to an increasing supply of government debt, and investors require adequate compensation to hold this debt, achieved through:
1- Higher Interest Rates: Investors demand higher returns to compensate for the growing debt risk.
2- Currency Depreciation: An immediate depreciation can generate gains from subsequent appreciation.
3- A Combination of Both Effects: Balancing higher interest rates with currency movements.
Short-Run vs. Long-Run Effects of Expansionary Fiscal Policy:
-- Short Run:
--- Real interest rates rise, leading to currency appreciation.
--- Foreign investors are attracted by higher returns, increasing demand for the domestic currency.
-- Long Run:
--- Persistent fiscal deficits increase government debt, raising concerns over sustainability.
--- Investors may expect the central bank to monetize debt, creating inflationary pressures.
--- Currency depreciation becomes more likely as long-term risks materialize.
Ultimately, countries with persistent deficits will see their currencies decline over the long term, even if expansionary fiscal policies initially trigger appreciation. Investors will only hold such debt if interest rates are sufficiently high or positive future currency movements are anticipated.
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1- Expansionary Monetary Policy:
Mechanism: Central banks lower interest rates to stimulate economic growth.
Impact on Interest Rates:
-- Reduced interest rates make borrowing cheaper, encouraging investment and consumption.
-- Lower rates lead to capital outflows as investors seek higher yields elsewhere, causing downward pressure on the domestic currency.
2- Restrictive Monetary Policy:
Mechanism: Central banks raise interest rates to combat inflation or slow an overheated economy.
Impact on Interest Rates:
-- Higher interest rates increase the cost of borrowing, reducing investment and consumption.
-- Capital inflows increase as foreign investors are attracted by higher yields, causing upward pressure on the domestic currency.
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3- Expansionary Fiscal Policy:
Mechanism: The government increases spending or lowers taxes, leading to higher aggregate demand.
Impact on Interest Rates:
-- Rising budget deficits push up real interest rates due to increased government borrowing.
-- If capital flows are mobile and sensitive to interest rate differentials:
--- Higher interest rates attract foreign capital, leading to currency appreciation.
-- If capital flows are immobile or insensitive:
--- Foreign capital inflows are limited, and increased imports create downward pressure on the currency.
4- Restrictive Fiscal Policy:
Mechanism: The government reduces spending or raises taxes to curb deficits and control inflation.
Impact on Interest Rates:
-- Reduced borrowing needs lower interest rates, making credit more affordable.
-- Lower rates may decrease capital inflows, potentially weakening the domestic currency if investors seek better returns abroad.
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Fiscal and Monetary Policy Combinations:
1- Expansionary Fiscal Policy & Expansionary Monetary Policy:
-- Both policies aim to stimulate the economy, leading to an increase in aggregate demand.
-- Higher aggregate demand drives up imports, worsening the trade deficit.
-- The domestic currency depreciates due to increased demand for foreign goods and capital outflows caused by lower interest rates.
2- Expansionary Fiscal Policy & Restrictive Monetary Policy:
-- Fiscal policy boosts aggregate demand through increased government spending or tax cuts.
-- Monetary policy raises interest rates, which attracts foreign capital inflows.
-- The domestic currency appreciates due to higher interest rates, but aggregate demand may remain high, sustaining a trade deficit.
3- Restrictive Fiscal Policy & Expansionary Monetary Policy:
-- Fiscal policy reduces aggregate demand through government spending cuts or tax increases.
-- Monetary policy lowers interest rates, stimulating investment and consumption.
-- Imports may rise due to higher aggregate demand from monetary stimulus, causing a trade deficit and currency depreciation.
4- Restrictive Fiscal Policy & Restrictive Monetary Policy:
-- Both policies aim to reduce aggregate demand, slowing down economic activity.
-- Reduced aggregate demand lowers imports and improves the trade balance.
-- The domestic currency may appreciate as interest rates rise and aggregate demand declines.
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Capital Flows: Benefits and Risks
Benefits of Capital Inflows:
-- Supplement domestic savings to finance domestic investment.
-- Support economic growth by providing additional funds for productive activities.
Risks of Capital Inflows:
-- Can create asset price bubbles and lead to overvaluation of the domestic currency.
-- Abrupt reversals of inflows can trigger market crashes and economic instability.
Motivations Behind Capital Flows:
1- Pull Factors:
-- Attract foreign investors due to domestic conditions like:
--- Sound economic policies.
--- Lower inflation.
--- Privatizations or improved fiscal positions.
--- Financial market liberalization.
2- Push Factors:
-- External conditions that push investors abroad, such as:
--- Low domestic interest rates.
--- Desire to diversify portfolios and seek higher yields.
Managing Capital Flows:
-- Policymakers implement measures to avoid destabilizing inflows and outflows:
--- Impose restrictions on repatriating investments.
--- Tax currency transactions to limit speculative capital movements.
--- Central banks can intervene in the foreign exchange market by selling domestic currency to prevent excessive appreciation.
Objective of Policy Measures:
-- Prevent large, destabilizing capital inflows that can result in severe outflows, leading to economic crashes.
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Capital Controls and Exchange Rate Interventions
Capital Controls:
-- Economists traditionally opposed capital controls, arguing they distort global trade and finance.
-- However, institutions like the IMF now recognize that limited capital controls can have net benefits:
-- Prevent asset price bubbles.
-- Allow central banks to maintain independent monetary policy without being pressured by surging capital flows.
Currency Interventions:
-- Governments and central banks directly intervene in currency markets to influence exchange rates.
-- Effectiveness varies by market type:
-- Emerging Markets:
-- Interventions are more effective because government trading accounts for a larger share of currency market activity.
-- Developed Markets:
-- Interventions are less impactful due to the vast size and liquidity of currency markets.
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A sudden stop in capital inflows can trigger severe financial crises. An effective early warning system should meet these criteria:
1- Features of an Ideal Early Warning System:
-- Accurately predict actual crises with minimal false positives.
-- Use macroeconomic indicators that are readily available on a timely basis.
-- Capture a wide range of crisis symptoms.
2- Key Variables Found Significant in Studies:
-- Recent capital market liberalization: Liberalization can increase vulnerability to shocks.
-- Large inflows of foreign capital: Short-term funding inflows are particularly risky.
-- Banking crises: These often precede or occur simultaneously with currency crises.
-- Exchange rate regime: Fixed or partially fixed exchange rates are more prone to crises.
-- Sharp decline in foreign exchange reserves: A sudden drop signals distress.
-- Currency overvaluation: A significant rise in the exchange rate above its historical mean can indicate trouble.
-- Deteriorating terms of trade: Falling exports relative to imports exacerbate imbalances.
-- Money supply growth relative to bank reserves: Excessive growth increases instability.
-- High recent inflation: Rapid inflation undermines economic stability.
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!!! Mid-Market Rate = (Bid + Offer) / 2
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Marsh accurately notes that investment flows, not trade flows, are typically the primary driver of exchange rate movements in the short-term. However, the reason he has provided to support this claim is incorrect. In fact, real prices react more slowly to economic signals than exchange rates.
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This statement highlights two important points about exchange rate movements and their drivers:
1- Investment Flows as Drivers of Exchange Rates:
-- Exchange rates in the short term are primarily influenced by investment flows (e.g., cross-border capital movements), not trade flows (e.g., imports and exports).
-- The reason is that investment flows tend to be large, quick, and responsive to interest rate differentials, expected currency movements, or economic policies, whereas trade flows adjust more gradually.
2- Why the Reason Provided is Incorrect:
-- Marsh’s reasoning was likely based on the idea that exchange rates change faster than real prices because of their reliance on trade flows. However, this logic is flawed.
-- The correct reasoning is that real prices (goods and services) adjust more slowly to economic signals compared to exchange rates, which are financial prices and are highly sensitive to capital movements, investor sentiment, and global economic shifts.
-- For example:
--- If a country’s currency depreciates, it might take years for its exports to become more competitive due to sticky prices, production lags, or contract rigidities.
--- In contrast, exchange rates can react almost instantly to changes in interest rates, inflation expectations, or central bank announcements.
Conclusion: While Marsh correctly identifies investment flows as the dominant driver of short-term exchange rate movements, his rationale (potentially linking it to trade flow dynamics) misses the mark. Instead, the rapid response of exchange rates compared to the slower adjustment of real prices explains why investment flows are the primary driver.
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[Currency Crisis Warning Signs]
1- Capital Flow Dynamics
-- Recent liberalization of capital markets can expose economies to volatile flows.
-- Large foreign capital inflows, particularly short-term funds, increase vulnerability to sudden reversals.
2- Banking Sector Stress
-- Banking crises occurring just before or during currency instability signal systemic fragility.
3- Exchange Rate Regime
-- Fixed or partially fixed exchange rates limit currency flexibility and heighten crisis risk under pressure.
4- External Reserve Pressure
-- Sharp declines in foreign exchange reserves reduce a country's ability to defend its currency.
5- Currency Misalignment
-- A rapid and unsustainable spike in the domestic currency’s value may precede a sharp correction.
6- Trade and External Balance
-- Deteriorating terms of trade weaken external earnings and worsen the current account.
7- Monetary Imbalances
-- Money supply expanding faster than bank reserves reflects weak monetary control and undermines confidence.
8- Inflation Pressures
-- Persistently high inflation erodes purchasing power and can lead to speculative attacks on the currency.
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2.2 Economic Growth
-- compare factors favoring and limiting economic growth in developed and developing economies
-- describe the relation between the long-run rate of stock market appreciation and the sustainable growth rate of the economy
-- explain why potential GDP and its growth rate matter for equity and fixed income investors
-- contrast capital deepening investment and technological progress and explain how each affects economic growth and labor productivity
-- demonstrate forecasting potential GDP based on growth accounting relations
-- explain how natural resources affect economic growth and evaluate the argument that limited availability of natural resources constrains economic growth
-- explain how demographics, immigration, and labor force participation affect the rate and sustainability of economic growth
-- explain how investment in physical capital, human capital, and technological development affects economic growth
-- compare classical growth theory, neoclassical growth theory, and endogenous growth theory
-- explain and evaluate convergence hypotheses
-- describe the economic rationale for governments to provide incentives to private investment in technology and knowledge
-- describe the expected impact of removing trade barriers on capital investment and profits, employment and wages, and growth in the economies involved
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The growth rate of potential GDP (gross domestic product) is an upper limit on the economy’s sustainable rate of growth. Therefore, increasing the growth rate of potential GDP is the key to raising living standards and profits.
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Growth in Global Economy: Developed vs. Developing Countries
1- GDP and Per Capita GDP:
-- GDP: Measures a country’s overall economic output and is a key indicator of economic development.
-- Per Capita GDP: Represents the average income or standard of living, calculated by dividing GDP by the population.
-- Growth in Real GDP: Reflects the rate at which the economy is expanding.
-- Growth in Real Per Capita GDP: Indicates an improving standard of living.
2- Comparing GDP Across Countries:
-- When comparing GDP rates internationally, they must be converted into a common currency.
-- Flaws of Current Exchange Rates:
--- Current exchange rates are volatile and influenced by short-term financial flows, making them unreliable for economic comparisons.
-- Purchasing Power Parity (PPP):
--- PPP-adjusted rates provide a more accurate comparison by reflecting the relative cost of goods and services in each country. This approach accounts for differences in price levels, offering a more stable basis for evaluating economic performance and living standards.
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Savings and Investment in Developing Economies
--- A key barrier to growth in developing countries is low capital per worker, which limits productivity.
--- Low per capita incomes result in low domestic savings rates, creating a vicious cycle of poverty:
---- Low savings → Low capital investment → Low economic growth → Continued low savings.
--- To escape this cycle, developing economies rely on foreign investment to supplement domestic savings and fund the capital investments necessary for economic growth.
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Financial Markets and Intermediaries
--- Economic growth depends not only on the volume of savings but also on how efficiently those savings are utilized.
--- Financial markets and intermediaries enhance efficiency and foster growth by:
---- Screening and monitoring: Identifying viable funding opportunities and ensuring responsible use of funds.
---- Investment instruments: Developing attractive savings and investment products to mobilize capital.
---- Mitigating credit constraints: Reducing barriers to access funding, particularly for businesses and individuals with limited resources.
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Education and Health Care Systems:
A better-educated workforce benefits all economies, but the focus on educational levels varies by development stage. Advanced economies, with the capacity to develop cutting-edge technologies, achieve greater economic impact through investments in post-secondary education.
Developing economies, on the other hand, benefit more from investments in primary and secondary education, which improve workforce skills and enable better adoption of new technologies. While "brain drain" often leads to the migration of highly skilled workers to developed economies, enhancing basic education and vocational training can help these countries transition to more advanced economic models. Investment in education also complements physical capital, boosting productivity.
Health care is equally vital for growth. Developing economies often face challenges such as poor health and low life expectancy, which hinder growth. Events like the AIDS epidemic can devastate populations and undermine years of progress in economic development.
Political Stability, Rule of Law, and Property Rights:
Economic growth requires a stable political environment, a well-developed legal system, and respect for property rights. These conditions give investors the confidence to put their capital at risk. In contrast, uncertainty caused by wars or corruption deters investment and stifles growth.
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Free Trade and Unrestricted Capital Flows:
Open economies grow by leveraging global resources. Foreign investment enables countries, especially developing ones, to break poverty cycles by financing domestic investments.
1- Types of Foreign Investment:
-- Foreign Direct Investment (FDI): Foreign companies build property, plant, and equipment in the domestic economy, increasing physical capital.
-- Indirect Foreign Investment: Foreign entities buy domestic equity or fixed-income securities, providing funding for domestic businesses.
Governments aim to attract both forms of investment to enhance the capital stock and productivity, which boosts employment, wages, and potentially domestic savings.
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Benefits of Free Trade:
Open trade in goods and services enables residents to access a wider variety of products at lower costs, improving living standards and overall economic efficiency.
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Tax and Regulatory Systems:
Limited regulations encourage entrepreneurial activity by making it easier for new companies to emerge. This fosters growth as new businesses drive innovation and productivity. Economies with business-friendly environments tend to achieve higher levels of output and efficiency.
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Factors Limiting Growth in Developing Countries
1- Low Rate of Savings and Investment:
-- Limited domestic savings reduce funds available for capital investment, hindering economic expansion.
2- Undeveloped Financial Markets:
-- Inefficient financial systems fail to allocate resources effectively, limiting access to capital for businesses and individuals.
3- Weak or Corrupt Legal Systems:
-- A lack of transparent legal frameworks and corruption deters investment and disrupts economic activity.
4- Lack of Property Rights and Political Instability:
-- Without secure property rights and stable governance, investors lack the confidence to invest.
5- Poor Education and Health Services:
-- Inadequate education and healthcare systems reduce workforce productivity and life expectancy, constraining growth.
6- Tax and Regulatory Barriers:
-- Overly burdensome taxes and restrictive regulations discourage entrepreneurship and innovation.
7- Restrictions on International Trade and Capital Flows:
-- Barriers to trade and foreign investment limit access to global markets, resources, and funding needed for growth.
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Potential GDP measures the growth in an economy’s productive capacity. This is the maximum amount of output an economy can handle without triggering inflation.
In the long run, real earnings growth cannot exceed the potential GDP growth rate. If it did, the ratio of corporate profits to GDP would have to continuously increase. Instead, after-tax profits tend to be relatively stable as a percentage of GDP.
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The price of the aggregate value of equities can be expressed as a function of GDP
P = GDP (E/GDP) * (P/E)
Percentage change in the price :
% Δ in P = % Δ GDP + % Δ(E/GDP) + % Δ (P/E)
In the short run, the percentage change in any of these three items can drive the percentage change in the aggregate price. However, in the long run, the percentage change in GDP will dominate while changes in the other two items will be relatively small.
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E(re) = D1/P0 + ΔPE - ΔS + i + g
This formula represents the expected return on equity (E(re)) and breaks it into several components:
1- D1/P0 (Forward Dividend Yield):
-- Measures the annual dividend expected in the next year relative to the current stock price.
2- ΔPE (Change in the Price-to-Earnings Ratio):
-- Reflects the repricing return. A higher P/E ratio increases returns, while a lower P/E ratio reduces them.
3- ΔS (Change in the Number of Shares Outstanding):
-- Adjusts for the dilutive or accretive effect of changes in the number of shares.
4- i (Expected Inflation Rate):
-- Accounts for inflation's effect on equity returns.
5- g (Expected Real GDP Growth Rate):
-- Represents the anticipated growth in the economy, contributing to higher corporate earnings and returns.
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Note:
-- A decrease in outstanding shares (ΔS) indicates a share repurchase or net buyback, which is equivalent to a dividend payment. This action increases the expected return (E(re)).
-- Differences between an equity index's return and the economic growth rate can also arise from relative dynamism, which refers to the extent to which small- and medium-sized firms grow at rates different from the larger firms typically included in national-level stock indexes.
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Potential GDP and Fixed-Income Investment:
1- Estimates and Forecasting Challenges:
-- Potential GDP estimates are sourced from various organizations, but extrapolating past growth rates is not a reliable method for forecasting future growth.
-- Factors like policy changes and demographics can cause fluctuations in potential GDP growth rates, with even small changes having long-term effects.
2- Relevance to Fixed-Income Investors:
-- Potential GDP growth directly impacts real interest rates, a critical factor for asset pricing.
-- Real interest rates represent the return investors demand for deferring consumption.
3- Impact of Higher Potential GDP Growth:
-- Faster potential GDP growth leads to expectations of higher future real income.
-- With future income expected to grow, individuals place less value on each additional unit of income, requiring higher returns to save rather than spend.
-- This puts upward pressure on real interest rates and increases the expected returns on real assets.
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Importance of Potential GDP Growth for Fixed-Income Analysts:
1- Lower Credit Risk:
-- Higher potential GDP growth reduces credit risk, as future cash flows support debt repayment.
2- Indicator for Monetary Policy:
-- Central banks monitor the "economic slack," which is the gap between potential output and forecasted output.
-- For fixed-income analysts, this slack is a key indicator of potential monetary policy changes.
3- Sovereign Debt Ratings:
-- Credit rating agencies consider potential GDP when evaluating government debt.
-- Slower potential GDP growth often signals higher credit risk for sovereign debt.
4- Fiscal Deficits:
-- The context of fiscal deficits matters—deficits during recessions are less concerning than during economic expansions.
-- Structural deficits occur when fiscal imbalances persist even while GDP grows above potential, raising concerns about long-term fiscal sustainability.
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Production Function Summary:
1- Aggregate Production Function (APF):
-- The APF links inputs (capital 𝐾 K and labor 𝐿 L), technology, and economic output.
-- Formula:
𝑌 = 𝐴 ⋅𝐹( 𝐾, 𝐿 ) Y=A⋅F(K,L), where 𝑌 Y is aggregate output, 𝐴 A is total factor productivity (TFP), and 𝐹 ( 𝐾 ,𝐿) F(K,L) represents the input combination of capital and labor.
2- Total Factor Productivity (TFP):
-- TFP reflects the general productivity level or technology in the economy.
-- It has a multiplicative effect on the combination of capital and labor.
3- Cobb-Douglas Production Function:
-- Specific APF form: 𝐹 ( 𝐾, 𝐿 ) = 𝐾^𝛼 𝐿 ^(1 − 𝛼)
-- The parameter 𝛼 α determines the output paid to capital ( 𝐾 K) and labor ( 𝐿 L) and has a value between 0 and 1.
4- Marginal Products of Inputs:
-- Marginal Product of Capital (MPK): The additional output from an extra unit of capital; this represents the rental price of capital.
-- Marginal Product of Labor (MPL): The additional output from an extra unit of labor; this represents the real wage rate.
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Marginal Products of Inputs:
1- Marginal Product of Capital (MPK):
-- Represents the additional output generated from one extra unit of capital.
-- It is equivalent to the rental price of capital in a competitive economy.
2- Marginal Product of Labor (MPL):
-- Represents the additional output generated from one extra unit of labor.
-- It is equivalent to the real wage rate in a competitive economy.
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The Cobb-Douglas production function has two important properties: constant returns to scale and diminishing marginal productivity.
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1- Definition of 𝛼 :
-- α=r/Y, where r represents the rental price of capital and Y is the aggregate output of the economy.
-- α is the share of GDP paid to the suppliers of capital, representing the ratio of capital income to total output.
2- Labor Share:
-- 1−α is the share of income paid to labor. It complements the capital share and represents the proportion of GDP allocated to labor compensation.
3- Key Properties of the Cobb-Douglas Production Function:
-- Constant Returns to Scale: Doubling all inputs (capital and labor) results in a doubling of output.
-- Diminishing Marginal Productivity: The marginal productivity of each input decreases as its quantity increases, holding other factors constant.
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Constant Returns to Scale: 1- If all inputs are increased by the same percentage, output will increase by the same percentage. 2- Output per worker, or labor productivity, is calculated as follows:
Formula: Y / L = (A * K^a * L^(1-a)) / L = A * (K / L)^a * (L / L)^(1-a) = A * (K / L)^a
Assuming:
y = Y / L (output per worker)
k = K / L (capital per worker)
Then: y = A * F(k, 1) = A * k^a
Where:
-- y = output per worker
-- k = capital per worker
Key Points: -- Output per worker (labor productivity): Depends on the amount of capital per worker (k), technology (A), and share of capital in GDP (a).
-- Diminishing Marginal Productivity: Each additional unit of labor or capital adds less to total output, each additional unit of capital will add less to the total output..
-- If a is close to zero, additional capital produces diminishing extra output.
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Growth Accounting
1- Growth Accounting Equation:
-- The growth accounting equation expresses the production function in terms of growth rates: ΔY / Y = ΔA / A + a * (ΔK / K) + (1 - a) * (ΔL / L),
where:
ΔY / Y is the output growth rate.
ΔA / A is the growth rate of total factor productivity (TFP).
ΔK / K is the growth rate of capital input.
ΔL / L is the growth rate of labor input.
a: Elasticity of output with respect to capital.
-- 1 - a: Elasticity of output with respect to labor.
2- Purpose: -- The growth accounting equation is used to:
--- Estimate technological progress contributions.
--- Measure the sources of growth in an economy.
--- Assess potential output.
ΔY / Y = ΔA / A + a * (ΔK / K) + (1 - a) * (ΔL / L)
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Labor Productivity Growth Accounting:
-- Another method to estimate potential GDP without estimating capital input or TFP.
-- Formula:
Growth rate in potential GDP = Long-term growth rate of labor force + Long-term growth rate in labor productivity.
Long-term growth rate of labor force : Output per hour worked (%ΔL/L)
Long-term growth rate in labor productivity : Total hours worked
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Extending the Production Function:
The production function can be expanded beyond just capital (K) and labor (L) to include additional inputs that contribute to economic output:
1- Natural resources (N): Inputs derived from the environment, such as land, minerals, and energy.
2- Labor supply (L): The workforce available for production.
3- Human capital (H): The education, skills, and experience of the labor force.
4- Information, computer, and telecommunications (K_IT): Technology infrastructure contributing to efficiency and innovation.
5- Non-ICT capital (K_NT): Physical capital excluding information and communication technologies.
6- Public capital (K_P): Infrastructure and other assets provided by the government.
7- Technological knowledge (A): Advances in technology and innovation that enhance productivity.
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Capital Deepening and Total Factor Productivity (TFP):
1- Capital Deepening:
-- Adding more capital to a fixed number of workers increases per capita output but at a decreasing rate, reflecting the diminishing marginal product of capital (MPK).
-- Capital deepening occurs as the capital-to-labor ratio rises, but it becomes less effective as MPK declines.
-- Profit-maximizing producers stop adding capital when MPK equals the marginal cost of capital. This limits the long-term contribution of capital deepening to growth.
2- Role of TFP:
-- Improvements in Total Factor Productivity (TFP) have a multiplicative effect, enhancing output per worker at every level of capital per worker.
-- Technological progress increases the MPK, making additional capital investments more effective.
-- Sustained growth in per capita output requires ongoing technological advancements to overcome the diminishing returns of capital deepening.
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Capital deepening increases output per worker, but its effectiveness diminishes due to the declining marginal product of capital. Technological improvements raise the efficiency of all inputs, increasing output at all levels of capital per worker.
Sustained growth in output per worker requires technological progress to complement capital deepening.
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Natural Resources and Economic Growth
1- Types of Natural Resources:
-- Natural resources include renewable resources (e.g., forests) and nonrenewable resources (e.g., oil, coal).
-- While essential for growth, access to these resources is more important than ownership.
2- Impact on Growth:
-- Countries with abundant natural resources generally experience higher per capita income and growth rates.
-- However, resource wealth can sometimes hinder growth, as seen in countries like Venezuela and Nigeria, where resource reliance led to underdeveloped institutions and economic imbalances.
3- Dutch Disease:
-- Resource-driven currency appreciation can make other sectors of the economy globally uncompetitive, a phenomenon known as Dutch disease (based on the Netherlands’ experience following natural gas discoveries).
4- Concerns about Nonrenewable Resources:
-- Economists worry that reliance on nonrenewable resources could eventually constrain growth.
-- However, technological advancements may offset these concerns by enabling production with fewer resources per unit of output.
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Labor Force and Economic Growth
The labor force comprises the working-age population that is either employed or unemployed. Growth in the labor input is influenced by several factors:
1- Population Growth:
-- Population growth depends on fertility and mortality rates, with developed countries typically experiencing slower growth due to lower fertility rates.
-- Age Distribution: A higher proportion of people over 65 increases the dependency burden on the working population.
-- Population growth affects overall GDP but not per capita GDP, as both grow at the same rate due to increased population.
2- Labor Force Participation Rate:
-- Measures the percentage of the working-age population participating in the labor force.
-- Participation has increased due to more women entering the workforce, boosting per capita GDP. However, this trend has a limit and cannot continue indefinitely.
3- Net Migration:
-- Immigration boosts the labor force and can counterbalance low birth rates in developed economies.
4- Average Hours Worked:
-- Average hours worked fluctuate with the business cycle.
-- Over the long term, advanced economies have seen a decline in hours worked per week.
These factors collectively determine the growth and productivity of the labor force, influencing the overall economy.
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Labor Quality: Human Capital
Economic growth depends not only on the quantity of labor but also on its quality, which is determined by human capital:
1- Definition of Human Capital:
-- Human capital represents the accumulation of knowledge and skills acquired through education, training, and experience.
-- Skilled workers are more productive, contributing to higher economic output.
2- Investment in Education:
-- Although education is costly, it typically offers significant returns for workers in the form of higher productivity and wages.
-- Educated individuals play a key role in driving technological innovations that benefit the broader economy.
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Capital: ICT and Non-ICT
1- Net Investment and Capital Stock:
-- Net investment is the difference between gross investment and capital depreciation.
-- A positive net investment increases the physical capital stock, leading to higher GDP growth.
2- Investment and Economic Growth:
-- Countries with high investment rates (e.g., China, India) historically experience faster economic growth.
-- Countries with low investment rates (e.g., Mexico) tend to experience slower growth.
3- Sustainability of Growth from Capital Deepening:
-- While capital deepening (increased capital per worker) yields diminishing returns over time, it can drive rapid growth in the short to medium term.
-- Developing countries benefit significantly from dramatic increases in their physical capital stock.
4- ICT vs. Non-ICT Investments:
-- ICT investments (e.g., information, computers, telecommunications):
--- Particularly impactful in developed countries by enhancing collaboration and productivity.
-- Non-ICT capital investments:
--- Have less impact on potential GDP growth compared to ICT investments.
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Public infrastructure includes items like roads, bridges, dams, and electric grids. These public goods provide benefits for private sector businesses. (few/none substitutes)
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Technology
1- Role in Economic Growth:
-- Technology is the most important factor driving per capita GDP growth, especially in developed countries.
-- Advances in technology shift the production function upward, allowing for greater output with fewer inputs.
2- Importance of Investment in R&D:
-- High rates of investment in research and development (R&D) are critical for technological progress.
-- Developed countries invest a larger share of GDP in R&D, while developing countries often adopt technology developed elsewhere.
3- TFP and Labor Productivity:
-- Total factor productivity (TFP) is measured as a residual and depends on accurate inputs for labor and capital.
-- Labor productivity depends on human and physical capital stock, which is higher in developed countries. However, developing countries often experience faster growth rates in productivity.
4- Growth in Labor Productivity Formula:
-- Growth in labor productivity = Growth in TFP + Growth due to capital deepening
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[Quiz – Estimating Capital Deepening Contribution to Labor Productivity Growth]
1- Overview of the Concept
-- Labor productivity growth arises from two sources: growth in total factor productivity (TFP) and capital deepening.
-- Capital deepening refers to an increase in capital per worker, contributing to productivity gains.
-- The contribution of capital deepening can be isolated by subtracting TFP growth from overall labor productivity growth.
2- Formula Used
-- Labor productivity growth decomposition:
--- "GrowthLaborProductivity = GrowthTFP + GrowthCapitalDeepening"
-- Therefore:
--- "GrowthCapitalDeepening = GrowthLaborProductivity - GrowthTFP"
--- Where:
---- GrowthLaborProductivity: Given in Exhibit 1.
---- GrowthTFP: Also provided in Exhibit 1.
---- GrowthCapitalDeepening: Derived residual value indicating contribution from capital inputs.
3- Step-by-Step Country Calculations
-- Altamira:
--- GrowthLaborProductivity = 3.28%
--- GrowthTFP = 1.90%
--- GrowthCapitalDeepening = 3.28% - 1.90% = 1.38%
-- Barroqua:
--- GrowthLaborProductivity = 2.95%
--- GrowthTFP = 1.80%
--- GrowthCapitalDeepening = 2.95% - 1.80% = 1.15%
-- Callastica:
--- GrowthLaborProductivity = 2.70%
--- GrowthTFP = 1.70%
--- GrowthCapitalDeepening = 2.70% - 1.70% = 1.00%
4- Final Conclusion
-- Altamira benefits the most from capital deepening with the highest contribution of 1.38% among the three countries.
Key Takeaways
-- Capital deepening is a key driver of labor productivity when TFP gains are moderate.
-- Altamira relies more heavily on capital investment relative to TFP-driven innovation.
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Explanation of α (alpha) Close to 0 in the Cobb-Douglas Production Function:
1- Effect on Capital: -- When α is close to 0, the share of output attributed to capital (K) is very small.
-- Adding an extra unit of capital will result in a much smaller increase in output compared to previous units of capital. This reflects the diminishing marginal productivity of capital.
2- Effect on Labor: -- With a low α, the share of output attributed to labor (L) is high.
-- Adding an extra unit of labor will significantly increase output, approximately the same as the increase from adding previous units of labor.
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Explanation of α (alpha) Close to 1 in the Cobb-Douglas Production Function:
1- Effect on Capital:
-- When α is close to 1, the share of output attributed to capital (K) is very large.
-- Adding an extra unit of capital will result in an increase in output almost as much as adding the previous unit of capital. This implies that capital has a dominant role in production.
2- Effect on Labor:
-- With a high α, the share of output attributed to labor (L) is very small.
-- Adding an extra unit of labor will not contribute significantly to output, reflecting the minimal role of labor in driving production growth.
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[Interpretation of α in Growth Theory
1- In the Growth Accounting Equation
-- α represents the elasticity of output with respect to capital.
-- It measures the percentage change in output resulting from a 1% change in capital, holding other factors constant.
-- A higher α implies that capital has a stronger effect on economic growth.
-- Formula: "ΔY/Y = α(ΔK/K) + (1 - α)(ΔL/L) + ΔA/A"
2- In the Cobb-Douglas Production Function
-- α reflects the share of output allocated to capital in the production process.
-- It indicates the portion of total income (e.g., GDP) attributed to capital rather than labor.
-- A higher α suggests that capital contributes more to output relative to labor.
-- Formula: "Y = A * K^α * L^(1 - α)"
List of Variables
-- Y: Total output or real GDP
-- A: Total factor productivity (TFP)
-- K: Capital input
-- L: Labor input
-- α: Output elasticity of capital / capital share in output
-- Δ: Change operator (e.g., ΔY = change in output)]
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The Spillover Effect refers to the positive impact that an educated individual can have on others in their environment:
1- Individual Impact:
-- A person with more education increases their own output and productivity.
2- Group Impact:
-- The knowledge and skills of the educated individual make others around them more productive, leading to broader improvements in efficiency and innovation.
3- Broader Economic Effects:
-- A more educated workforce drives higher rates of technological progress and fosters greater economic growth through innovation and shared productivity gains.
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Importance of labor productivity growth for economic growth and investments:
1- Permanent Increase in Labor Productivity Growth:
-- Leads to a higher sustainable rate of economic growth in an economy.
-- Enhances the potential return on equities, benefiting investors.
2- Understanding Productivity Trends:
-- Helps investors make informed decisions about long-term economic and market potential.
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[Quiz – Estimating Potential GDP Growth Rate Using Labor Productivity Growth Accounting]
1- Overview of the Concept
-- The labor productivity growth accounting equation estimates the potential GDP growth rate by summing:
--- The long-term growth rate of the labor force.
--- The long-term growth rate in labor productivity.
2- Formula
-- Potential GDP growth rate formula:
--- "PotentialGDPgrowth = GrowthLaborForce + GrowthLaborProductivity"
--- Where:
---- GrowthLaborForce: Long-term labor force growth rate.
---- GrowthLaborProductivity: Long-term growth rate in labor productivity.
3- Application to the Case
-- Data for each country (from the case):
--- Altamira:
---- Labor force growth = 1.50%
---- Labor productivity growth = 3.28%
---- Potential GDP growth = 1.50% + 3.28% = 4.78%
--- Barroqua:
---- Labor force growth = 1.90%
---- Labor productivity growth = 2.95%
---- Potential GDP growth = 1.90% + 2.95% = 4.85%
--- Callastica:
---- Labor force growth = 2.10%
---- Labor productivity growth = 2.70%
---- Potential GDP growth = 2.10% + 2.70% = 4.80%
4- Conclusion
-- Barroqua has the highest potential GDP growth rate at 4.85% based on the labor productivity growth accounting framework.
Key Takeaways
-- Potential GDP growth is the sum of labor force growth and labor productivity growth.
-- Barroqua leads due to a strong combination of both drivers.
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Paradigms of Per Capita Growth:
1- Classical Model:
-- Per capita economic growth is temporary.
-- Growth is constrained by limited resources and diminishing returns, leading to a steady-state equilibrium.
2- Neoclassical Model:
-- Long-term per capita growth is driven solely by technological progress.
-- Assumes diminishing returns to capital deepening and focuses on exogenous technology as the key growth factor.
3- Endogenous Growth Models:
-- Incorporate technology directly into the model as a result of economic activities (e.g., R&D, innovation).
-- Suggest that growth is sustained by factors such as knowledge accumulation and human capital investment.
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Classical Growth Model
1- Core Concept:
-- Developed by Thomas Malthus in 1798.
-- Focuses on population growth in a world of limited resources.
-- Production function includes labor as a variable input and land as a fixed factor.
2- Mechanism:
-- When per capita income rises, population growth accelerates.
-- Diminishing marginal returns to labor reduce productivity, eventually lowering per capita income.
3- Why the Model Failed:
-- Slower population growth: Population growth rates declined as per capita income increased.
-- Sustained income growth: Technological progress offset diminishing returns, enabling sustained per capita income growth.
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Neoclassical Model: Summary and Explanation
The neoclassical model, developed by Robert Solow in the 1950s, explains long-term economic growth based on the Cobb-Douglas production function. This framework examines how capital (K), labor (L), and technological progress (TFP) drive economic output while accounting for diminishing marginal productivity.
Core Assumptions:
1- Diminishing Marginal Productivity:
-- Both capital and labor inputs contribute to output, but additional units of capital or labor yield smaller incremental increases in productivity.
2- Steady-State Growth:
-- Over time, the economy reaches a steady state where the output-to-capital ratio and the output per worker grow at constant rates due to balanced changes in capital and labor.
3- Drivers of Long-Term Growth:
-- In the long run, output per capita is driven by:
--- Savings/Investment Rate (s): Higher savings rates increase capital accumulation.
--- Technological Change (TFP): The primary driver of sustained growth, represented by θ (growth in TFP).
--- Population Growth (n): Labor force growth impacts capital needs and economic expansion.
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Key Implications:
1- Capital Accumulation and Capital Deepening:
-- Capital deepening (increasing the capital-to-labor ratio) temporarily boosts output. However, due to diminishing returns, its effect on long-term growth diminishes as the economy approaches the steady state.
2- Technological Progress:
-- Unlike capital accumulation, technological progress (TFP) has a permanent effect on economic growth. It shifts the production function upward, enabling sustained increases in productivity and output.
3- Convergence:
-- The model predicts income convergence across countries:
--- Economies with lower initial capital stocks grow faster as they benefit more from capital deepening, leading to eventual alignment of per capita income levels.
4- Role of Savings and Population Growth:
-- Higher savings rates increase capital accumulation but have no long-term impact on the steady-state growth rate.
-- Higher population growth increases the capital requirements to maintain steady-state growth, which may lower the output per worker.
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Impacts of Exogenous Factors:
1- Savings Rate (s):
-- A higher savings rate increases the capital-to-labor ratio and output per worker in the steady state but does not change long-term growth rates.
2- Labor Force Growth (n):
-- Higher labor force growth reduces the equilibrium capital-to-labor ratio, lowering output per worker.
3- Depreciation Rate (δ):
-- Higher depreciation reduces net capital accumulation, leading to lower steady-state levels of output per worker.
4- Growth in TFP (θ):
-- The only factor that permanently increases both the output per worker and the output growth rate.
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The neoclassical growth model highlights the critical role of technological progress as the sole determinant of sustained economic growth. While capital accumulation and savings contribute to short-term growth, their effects diminish over time.
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Key Results:
1- Growth Rate of Output Per Capita: ΔY/Y=θ/(1−a)+n
Where:
-- θ: Growth rate of TFP.
-- 1−a: Elasticity of output with respect to labor.
2- Growth Rate of Output: ΔY/Y=θ/(1−a)+n
Where: n is the Labor force growth rate.
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Impact of Factors on Steady State Growth
1- Savings Rate (s):
-- A higher savings rate increases the capital-to-labor ratio and output per worker.
-- Key Note: It does not affect the steady state growth rates of output per capita (Δy/y) or total output (ΔY/Y).
2- Labor Force Growth (n):
-- Higher labor force growth reduces the equilibrium capital-to-labor ratio since more capital is needed for the additional workers.
-- This reduces output per worker.
3- Depreciation Rate (δ):
-- A higher depreciation rate reduces the equilibrium capital-to-labor ratio and output per worker.
-- Less net capital accumulation occurs.
4- Growth in TFP (θ):
-- An increase in TFP growth accelerates the growth in output per worker and raises steady state growth.
-- Key Note: TFP growth is the only factor that directly impacts the growth rate of output per worker in the steady state.
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Steady State and Transition Period
Before Reaching Steady State:
-- Economies can temporarily grow faster or slower than the steady state growth rate, causing fluctuations in the output-to-capital ratio.
-- Over time, growth rates converge to the trend rate, determined by the growth rate of TFP (θ).
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Key Insights from the Neoclassical Model
1- Capital Accumulation:
-- Capital accumulation impacts the level of output but not the long-run growth rate.
-- Economies reach a steady state where the growth rate of output is determined by:
ΔY/Y = θ/(1−a) + n,
where:
--- θ: Growth rate of total factor productivity (TFP).
--- n: Labor force growth rate.
2- Capital Deepening vs. Technology:
-- Rapid growth initially occurs when a country accumulates capital (capital deepening).
-- However, diminishing returns to capital mean that capital deepening alone cannot sustain long-term growth.
-- Sustained growth in GDP per capita requires improvements in TFP (technological progress), which enhances productivity.
3- Convergence:
-- Developing countries with lower initial capital levels and higher marginal productivity of capital can grow faster than developed economies.
-- Over time, this leads to income convergence between developed and developing nations, assuming similar TFP growth rates.
4- Effect of Savings on Growth:
-- Higher savings rates temporarily boost the growth rate by increasing the capital-to-labor ratio and output per worker.
-- However, the growth rate eventually returns to the steady state rate determined by TFP and labor force growth.
-- While higher savings rates improve levels of per capita output and productivity, they do not result in permanent increases in the growth rate.
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The long-run output growth only depends on the growth in the labor force and technology. Higher savings rates only temporarily impact the growth rate !!!!!
The long-run output growth only depends on the growth in the labor force and technology. Higher savings rates only temporarily impact the growth rate !!!!!
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Solow's Findings and TFP
1- Solow's studies showed that 80% of U.S. per capita growth (1909–1949) was driven by total factor productivity (TFP).
-- TFP represents the portion of growth not explained by labor or capital inputs and is considered the residual or "unexplained" factor in the neoclassical model.
-- A similar study for the period 1929–1982 confirmed this finding.
2- Exogenous Nature of Technology:
-- In the neoclassical model, technology is exogenous—it is determined outside the model and cannot be influenced by other economic variables such as savings or investment.
-- This implies that the steady-state rate of economic growth is independent of savings and investment rates, relying solely on:
-- Growth in TFP (technological progress).
-- Growth in the labor force.
-- Although higher savings rates may temporarily boost growth by increasing the capital-to-labor ratio, their long-term impact on growth rates is negligible.
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Criticism and Revised Approaches
1- Criticism of the Model:
-- The neoclassical model struggles to explain the observed positive correlation between savings rates and growth rates across countries.
-- Economists find this troubling, as higher savings appear to have a stronger relationship with growth than the model predicts.
2- Jorgenson's Revised Approach:
-- Introduced refinements to the measurement of inputs, aiming to reduce the portion of growth attributed solely to TFP.
-- Recognized that capital spending on high-tech goods (e.g., ICT) boosts productivity more effectively than general capital spending (e.g., tools or infrastructure).
-- The revised approach retains the concepts of diminishing marginal returns and exogenous technology but acknowledges the differentiated impact of capital investments on growth.
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[Absolute Convergence and the Neoclassical Growth Model
1- Definition of Absolute Convergence
-- Absolute convergence refers to the idea that poorer economies (with lower levels of capital per worker) will eventually catch up to richer economies in terms of per capita output, assuming they share the same structural characteristics.
-- Under absolute convergence, all economies converge to the same steady-state level of per capita income regardless of initial conditions.
2- Neoclassical Growth Model (Solow-Swan) and Convergence
-- The basic Solow-Swan neoclassical growth model assumes diminishing returns to capital and exogenous technological progress.
-- It predicts conditional convergence, not absolute convergence.
-- This means economies converge to their own steady-state levels of per capita output, which depend on savings rates, population growth, and technology—not all countries converge to the same level.
-- Key Point:
--- Absolute convergence would require that all countries have identical savings rates, population growth rates, and access to the same level of technology (i.e., identical structural characteristics).
Key Takeaways
-- Absolute convergence requires identical economic structures across countries.
-- The neoclassical (Solow-Swan) model does not inherently imply absolute convergence.
-- Instead, it implies conditional convergence based on country-specific fundamentals.
-- Only under strict conditions does the model suggest absolute convergence.
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Drivers of Convergence
1- Capital Deepening:
-- Developing countries can converge by increasing their capital-to-labor ratio.
2- Technology Adoption:
-- Adopting advanced technology from developed nations (analogous to R&D spending) allows lagging economies to catch up.
-- Without adequate investment in technology, developing countries will continue to fall behind.
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Implications for Investors
1- Countries with low per capita incomes and strong convergence potential offer higher investment returns.
-- Corporate profits in these countries are expected to grow faster due to higher long-term growth rates.
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Endogenous Growth Models
1- No Convergence Prediction:
-- These models argue that developed countries can indefinitely maintain their lead by continually investing in innovation and human capital.
-- There is no inherent mechanism to equalize growth rates across countries.
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Historical Evidence
1- Mixed results show that some poorer countries achieved convergence through:
-- Legal, political, and economic reforms.
-- Institutional changes, such as improving governance and fostering innovation.
2- Countries that failed to implement such changes often remained stuck in poverty, reinforcing the importance of institutional quality for economic growth.
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Investors should invest in countries with lower per capita incomes that are converging to higher per capita incomes. This will generate high rates of investment return. Corporate profits will grow at a faster rate because the long-term growth rate is higher.
Countries can converge through capital deepening or adopting the technology of advanced countries.
Developed countries can stay ahead of developing countries indefinitely.
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Endogenous Growth Theory: Key Concepts and Implications
1- Explanation of Technological Progress:
-- Unlike neoclassical models, endogenous growth theory incorporates technological progress within the model, rather than treating it as an external factor.
2- No Steady State Convergence:
-- The economy does not necessarily converge to a steady state.
-- There are no diminishing marginal returns to capital, allowing continuous growth.
3- Broader Definition of Capital:
-- Capital includes physical capital, human capital, and R&D investments.
-- Growth depends on the accumulation of this expanded definition of capital, funded by savings.
4- Permanent Growth Effects:
-- Increasing the savings rate can permanently raise the GDP growth rate, unlike in the neoclassical model where the effect is only temporary.
5- R&D and Spillover Effects:
-- Companies invest in R&D to increase future profits, but the benefits of R&D spill over to the entire economy.
-- Ideas generated by R&D can be copied and utilized by other firms, enhancing overall productivity.
-- Companies also benefit indirectly from the R&D spending of others, amplifying the economy-wide impact of innovation.
6- Growth Determinants:
-- Sustainable GDP growth per capita is not limited to exogenous factors like labor or externally driven labor productivity improvements.
-- Continuous investment in human capital and technology allows long-term growth without diminishing returns.
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Implications of Endogenous Growth Theory
1- Policy Impact:
-- Policies that promote education, innovation, and R&D can significantly boost long-term growth.
-- Governments can play a role in funding or incentivizing R&D to maximize spillover effects.
2- Savings and Growth:
-- Higher savings rates directly contribute to sustained economic growth.
3- Innovation-Driven Economies:
-- Economies with strong innovation ecosystems are likely to experience higher, sustained growth rates compared to those relying solely on physical capital deepening.
4- Developing Economies:
-- Developing countries can enhance long-term growth by investing in human capital and fostering an environment conducive to innovation and R&D.
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Classical Model
- Core Idea:
Productivity increases lead to population growth, but diminishing returns to labor and fixed land resources eventually reduce per capita income.
Economic growth is viewed as temporary and constrained by natural limits.
- Why It Fails:
1. Population growth slowed as incomes rose in developed economies.
2. Technological advancements offset diminishing returns, allowing sustained per capita income growth.
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Endogenous Growth Model
Core Idea:
-- Unlike the neoclassical model, technological progress is determined within the model through factors like R&D, innovation, and human capital.
Key Points:
1- Capital Accumulation:
-- Capital includes physical investments, human capital (education and skills), and R&D.
-- No diminishing returns to capital, so higher savings and investment can permanently increase growth rates.
2- Spillover Effects:
-- Innovations (e.g., R&D) benefit the entire economy, not just the innovating company.
3- Convergence:
-- Developed countries can maintain their lead indefinitely by continuing to innovate.
-- No prediction of convergence, unlike the neoclassical model.
4- Policy Implications:
-- Governments should subsidize R&D and education to foster innovation and long-term economic growth.
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Implications of the Neoclassical Model
1- Capital Accumulation:
-- Capital accumulation impacts the level of output but does not sustain long-term growth.
-- Over time, the economy reaches a steady state, where output and capital grow at the same rate, driven by labor force and technological growth.
2- Capital Deepening vs. Technology:
-- Capital deepening (increasing capital per worker) boosts output per worker temporarily but is subject to diminishing returns.
-- Sustained growth in output per capita depends on technological progress, not just increasing capital.
3- Convergence:
-- Developing economies are expected to grow faster than developed ones, closing the gap in per capita incomes over time.
-- Conditional Convergence: Countries converge only if they share similar rates of savings, population growth, and technology.
-- Absolute Convergence: This is less likely unless countries have similar structural characteristics.
4- Effect of Savings on Growth:
-- Higher savings rates lead to higher capital accumulation, temporarily boosting growth.
-- In the long run, the growth rate returns to the steady-state rate, determined by technological progress and labor force growth.
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The Impact of an Open Economy on Growth (Solow Model Context)
The Solow Model originally assumes a closed economy where domestic investment is limited to domestic savings. However, opening an economy to trade and capital flows significantly alters its growth dynamics:
1- Access to Global Savings:
-- Domestic investment is no longer constrained by domestic savings.
-- Countries can attract foreign capital to fund investments, boosting economic growth.
2- Specialization and Comparative Advantage:
-- Countries can specialize in industries where they have a comparative advantage.
-- This specialization improves overall productivity by allocating resources more efficiently.
3- Economies of Scale:
-- Access to global markets allows companies to expand their production and take advantage of economies of scale.
-- Larger markets lead to higher efficiency and lower costs.
4- Technology Importation:
-- Countries can import advanced technology from developed nations, increasing productivity without the need for domestic innovation.
5- Increased Competition:
-- Global trade introduces competition from foreign companies.
-- This forces domestic companies to become more efficient and innovate to remain competitive.
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Convergence of Capital-to-Labor Ratios in an Open Economy (Neoclassical Model)
The neoclassical model suggests that when economies are open, the convergence of capital-to-labor ratios between developed and developing countries will occur more rapidly. This process unfolds as follows:
1- Higher Marginal Product of Capital in Developing Countries:
-- Developing countries have less capital, which means the marginal product of capital is higher.
-- This leads to greater potential returns on investment compared to developed countries.
2- Global Investment Flows:
-- Investors from capital-rich (developed) countries allocate savings to capital-poor (developing) countries to take advantage of higher returns.
3- Rapid Growth in Physical Capital Stock:
-- Capital inflows accelerate the growth of the physical capital stock in developing countries.
-- This faster accumulation of capital boosts productivity and economic growth in these nations.
4- Trade Deficits and Surpluses:
-- Capital-poor countries run trade deficits to fund these capital inflows.
-- Developed countries, as the source of capital, run corresponding trade surpluses.
5- Temporary Growth Boost in Developing Countries:
-- The influx of foreign investment temporarily raises growth rates in capital-poor countries above their steady-state levels.
6- Diminishing Returns on Capital:
-- As capital stock rises in developing countries, the marginal product of capital decreases.
-- This reduces returns on investment, causing trade deficits to shrink over time.
7- Convergence of Growth Rates:
-- After the global reallocation of savings, both developed and developing countries reach similar steady-state growth rates.
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Impact of International Trade on Economic Growth
Reasons International Trade Can Permanently Increase Growth:
1- Selection Effect:
-- Competition from foreign firms forces inefficient domestic firms to exit the market.
-- Efficient firms are incentivized to innovate and improve productivity.
2- Scale Effect:
-- Access to larger global markets allows firms to achieve economies of scale, reducing costs and improving efficiency.
3- Backwardness Effect:
-- Less advanced countries benefit from knowledge and technology spillovers from more developed trading partners.
4- Encouragement of R&D and Human Capital Investment:
-- Open trade fosters greater investment in research, development, and education to stay competitive globally.
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Policy Approaches to Trade
1- Inward-Oriented Policies:
-- These involve restricting imports to develop domestic industries.
-- Historically, such policies have limited growth and innovation due to reduced competition and lack of access to global knowledge and technology.
2- Outward-Oriented Policies:
-- These integrate domestic industries into global markets by promoting trade and reducing barriers.
-- Empirical evidence shows that countries with outward-oriented policies have achieved higher growth rates, leveraging competition, scale, and innovation.
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Producers will continue to increase their capital stock per worker (capital deepening) until the marginal product of capital is equal to its marginal cost. According to the neoclassical model, capital deepening can raise the rate of per capita GDP growth if, as in this example, the economy is operating below its steady state and the marginal product of capital exceeds its marginal cost.
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In the steady state equilibrium, the capital-to-labor ratio will increase at the growth rate of output per capita. However, the increasing capital-to-labor ratio does not affect the marginal product of capital, which remains constant in the steady state.
[Capital-to-Labor Ratio and Marginal Product of Capital in Steady State
1- Capital-to-Labor Ratio in the Steady State
-- In the neoclassical growth model, the capital-to-labor ratio (K ÷ L) evolves over time as economies accumulate capital and experience labor force growth.
-- At the steady state, capital and labor grow at consistent rates, and capital per worker grows at the same rate as output per capita.
-- This implies that the capital-to-labor ratio increases at the same rate as per capita output, which is determined by the rate of technological progress.
-- Formula for growth in output per capita:
--- "Δ(Y ÷ L) ≈ g"
--- Since "K ÷ L" grows at the same rate:
--- "Δ(K ÷ L) ≈ g"
-- Relationship:
--- The capital-to-labor ratio grows at rate g, the rate of technological progress, which also drives output per capita growth in the long run.
2- Marginal Product of Capital in Steady State
-- The marginal product of capital (MPK) refers to the additional output produced from one additional unit of capital, holding other inputs constant.
-- In the Cobb-Douglas production function, MPK is a function of the capital-to-labor ratio.
-- However, in the steady state, technological progress increases both capital and output at the same rate, keeping MPK constant.
-- Cobb-Douglas Production Function:
--- "Y = A * K^α * L^(1 - α)"
-- Marginal Product of Capital:
--- "MPK = ∂Y ÷ ∂K = α * (Y ÷ K)"
-- In steady state: --- Y ÷ K remains constant → MPK remains constant
-- Relationship:
--- Although K ÷ L increases over time at rate g, the ratio Y ÷ K stays constant in the steady state due to balanced growth.
--- Therefore, MPK = α * (Y ÷ K) remains unchanged, even as capital per worker rises.
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A higher savings rate cannot produce a permanent increase in the per capital GDP growth rate according to the neoclassical model. This view posits that a permanent increase in this growth rate can only be caused by an increase in the rate of total factor productivity growth. A higher savings can increase the amount of GDP per capita, but not the growth rate.
Endogenous growth model, according to this view, an increase in the savings rates can permanently increase the sustainable rate of per capita GDP growth.
