- Currency Pair - Time-of-day - Market Volatility (drives spread in the interbank market)

Balance of payments = current account+financial sector - current account surplus/deficit must match capital deficit/surplus - Net borrowers see currency depreciate over time - Net lenders see currency appreciate over time

Economics Flashcards by Al Blanshard

3 Liquidity factors

Currency Pair
Time-of-day
Market Volatility
(drives spread in the interbank market)

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3 Bid-offer spread factors

Interbank spread
Transaction size
Relationship and credit profile

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The 5 Parity conditions

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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Covered interest rate parity (1)

A completely forex hedged investment in a foreign money market instrument should yield same return as domestic

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Uncovered interest rate parity (2)

Unhedged return should yield same return as domestic

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Forward rate parity (3)

Forward exchange rate will be an unbiased predictor of the future exchange rate

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Purchasing Power Parity (4)

Law of one-price - identical goods should hold same price in different countries

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Purchasing Power Parity - flaws

transaction costs
Not all goods are tradable
> Better at determining differences than magnitudes

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International Fischer Effect

The expected disparity between the exchange rate of two currencies is approximately equal to their countries’ nominal interest rates

Persistently high inflation -> depreciation
Persistently low inflation -> appreciation

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International Fischer Effect (formula)

Interest(f) - Interest(d) = inflation(f) - inflation(d)

Assumes currency risk is the same!

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Nominal interest rate

Nominal interest rate = Real interest + expected inflation

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The Carry Trade (rational)

High-yield currencies have not depreciated and low-yield currencies have not appreciated to the levels predicted by the interest rate differentials

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The Carry Trade (Actions)

1 - Borrow currency (1)
2 - exchange to currency (2)
3 - Invest currency (2)
4 - Liquidate at t=1
5 - exchange back to currency (1)

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Balance of payments

Balance of payments = current account+financial sector

current account surplus/deficit must match capital deficit/surplus
Net borrowers see currency depreciate over time
Net lenders see currency appreciate over time

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Current account trends influence the path of exchange rates though.. (3)

1) Flow supply/demand channel
2) The portfolio balance channel
3) The debt sustainability channel

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Current account trend (1):

Flow supply/demand channel

-> trading international goods requires exchange of currencies
- If trade surplus demand for currency rises
Trade deficit -> Depreciate
Trade surplus -> Appreciate

Current account trend (2):

Portfolio balance channel

-> Current account imbalances shift wealth from deficit nations to surplus nations

Current account trend (3):

Debt sustainability channel

Upper limit on the ability of countries to run persistently large current account deficits

Mundell-Fleming

High capital mobility

Mundell-Fleming

Low capital mobility

GDP equation

GDP = C + G + I + NX
C = Private consumption
G = Government spending
I = Investment
NX = (Exports - Imports)

Production Function

Aggregate Output, Y =

Y = TFP * f(K,L)
K = Capital
L = Labour

Cobb-Douglas

f(K,L) = K^alpha * L^(1-alpha)

alpha is share of output paid to capital and labour

Solow Growth accounting

ΔY/Y= ΔTFP/TFP+ α ΔK/K+(1-α)ΔL/L

- TFP cannot be measured - must be estimated as residual

Theories of Growth (3)

- Classical - Neoclassical - Endogenous

Classical Growth Theory

- Population grows when per capita income increases above subsistence level (due to tech/land growth) - Labour force faces diminishing marginal returns, so additional output tapers to 0 and per capita income returns to subsistence - so new tech results in a larger, but not richer population - Does not hold true as population growth has slowed with per capita income increase & technology progress has been faster than diminishing returns

Neoclassical Growth Theory equation

- Solow model, based on Cobb-Douglas | Y = TFP * K^alpha * L^(1-alpha)

Neoclassical steady state growth equation

Growth = Labour growth + Capital growth / (1 - alpha) | where alpha is the share of outputs paid to labour

Neoclassical Growth Theory implications

- Capital accumulation affects output but not long term growth rate - Diminishing returns on capital means long term growth is only sustainable through technology - Economies should converge due to the high marginal productivity of capital in developing economies - Savings cannot permanently increase growth rate, but can lead to temporary higher growth

Endogenous Growth Theory

- Growth is driven by internal factors, particularly human, knowledge and financial capital accumulation - Savings can result in a permanently higher growth rate (due to externalities)

Neoclassical and endogenous convergence predictions

Neoclassical - convergence of growth rates, not absolute | Endogenous - No convergence

Neoclassical model and open trade

In the neoclassical model, free trade should drive convergence - marginal productivity of capital is greater in poor countries, therefore capital flows to poor countries - Capital flows would be balanced by trade flows - rich countries run a surplus and poor run a deficit

Endogenous model and open trade

A more open trade policy would permanently rise the growth rate - Greater natural selection of companies - Access to greater economies of scale - Knowledge spillovers