Economics (8%) Flashcards
perfectly competitive market:
definition
In economic theory, perfect competition occurs when all companies sell identical products, market share does not influence price, companies are able to enter or exit without barriers, buyers have perfect or full information, and companies cannot determine prices.
it must take the market price of its output as given, so it faces a perfectly elastic, horizontal demand curve.
perfectly competitive market:
marginal revenue
the firm’s marginal revenue (MR) and the price of its product are identical.
negatively sloped demand curve: implications
A firm that faces a negatively sloped demand curve, however, must lower its price to sell an additional unit, so its MR is less than price (P).
imperfectly competitive market:
definition
Imperfect competition refers to a market structure where there are multiple sellers and buyers, but they have some degree of control over the price and quantity of goods or services. This means that firms can differentiate their products or manipulate prices to gain an advantage.
Breakeven Point
Occurs when total revenue (TR) equals total cost (TC), meaning price equals average total cost (ATC). The firm covers all its economic costs and earns normal profit.
Shutdown Point
Occurs when price is below average variable cost (AVC). The firm cannot cover its variable costs and should shut down in the short run. In the long run, the firm exits the market if it cannot cover total costs.
Economies of Scale
Cost per unit decreases as output increases, resulting in a downward-sloping long-run average cost (LRAC) curve. Achieved through factors like increased returns to scale, specialization, efficient technology, and bulk purchasing.
Diseconomies of Scale
Cost per unit increases as output increases, resulting in an upward-sloping LRAC curve. Caused by factors like management inefficiencies, duplication, and higher resource prices due to supply constraints.
Short-Run Total Cost (STC) Curves
reflect the cost for different plant sizes. Each STC curve has a corresponding short-run average total cost (SATC) curve.
Long-Run Total Cost (LRTC) Curve
An envelope curve derived from the lowest STC for each output level. The LRAC curve is the envelope of all SATC curves, representing economies and diseconomies of scale.
Minimum Efficient Scale
The lowest point on the LRAC curve where the firm operates at least cost per unit.
If an agricultural firm operating in a perfectly competitive market expands its production and unit sales by 10%, what is the most likely result?
Answer: a 10% increase in total revenue.
The marginal revenue per unit sold for a firm under perfect competition will most likely be:
Answer: equal to average revenue.
Market Structure:
Perfect Competition:
Characteristics
Many sellers and buyers.
Homogeneous products.
No single producer can influence the market price.
Firms are price takers.
Very low barriers to entry and exit.
No non-price competition.
Market Structure:
Perfect Competition:
Example
Example: Agricultural products like wheat or corn.
Market Structure:
Perfect Competition:
Impact on Profit
Firms earn normal profit in the long run as profits are driven down by competition.
Market Structure:
Monopolistic Competition:
Characteristics
Characteristics:
Many sellers.
Differentiated products.
Some degree of pricing power.
Low barriers to entry and exit.
Significant non-price competition (e.g., advertising).
Market Structure:
Monopolistic Competition:
Example
Bottled Drinks
Market Structure:
Monopolistic Competition:
Impact on Profit
Firms can earn some economic profit in the short run, but in the long run, profits are competed away.
Market Structure:
Oligopoly:
Characteristics
Characteristics:
Few large sellers.
Products can be homogeneous or differentiated.
Significant barriers to entry.
Some or considerable pricing power.
Non-price competition (e.g., advertising, product differentiation).
Market Structure:
Oligopoly:
Examples
Commercial airlines, automobile manufacturers.
Market Structure:
Monopolistic Competition:
Impact on Pricing
Firms’ pricing and output decisions are interdependent, leading to strategic behavior and potential for collusion.
Market Structure:
Monopoly:
Characteristics
Characteristics:
Single seller.
Unique product with no close substitutes.
Very high barriers to entry.
Considerable pricing power.
Some non-price competition (e.g., advertising).
Market Structure:
Monopoly:
Example
Local utility companies.
Market Structure:
Monopoly:
Impact on Profits
Monopolists can earn long-term economic profits, but they are often regulated by the government.
Factors Determining Market Structure
Number and size of firms.
Degree of product differentiation.
Power over pricing decisions.
Barriers to entry and exit.
Degree of non-price competition.
Porter’s Five Forces:
Threat of Entry
Potential for new competitors to enter the market.
Porter’s Five Forces:
Power of Suppliers
Suppliers’ ability to influence the price of inputs.
Porter’s Five Forces:
Power of Buyers
Buyers’ ability to influence the price and terms of purchase.
Porter’s Five Forces:
Threat of Substitutes
Availability of alternative products.
Porter’s Five Forces:
Rivalry among Existing Competitors
Intensity of competition among current firms.
True or False:
Firms in more competitive markets (perfect competition and monopolistic competition) have less control over prices and face constant pressure to innovate and reduce costs.
True
True or False:
Firms in less competitive markets (oligopoly and monopoly) can exert more control over prices and potentially earn higher profits, but they also face strategic considerations and regulatory scrutiny.
True
A market structure characterized by many sellers with each having some pricing power and product differentiation is best described as:
Monopolistic competition.
A market structure with relatively few sellers of a homogeneous or standardized product is best described as:
Oligopoly.
Monopolistic Competition:
Number of Buyers and Sellers
Large Number of Buyers and Sellers:
Numerous firms in the market, each with a small market share.
Buyers and sellers are well-informed about products and prices.
Monopolistic Competition:
Product Differentiation:
Each firm offers products that are close substitutes but not identical.
Differentiation can be based on quality, features, branding, or services.
Monopolistic Competition:
Barriers to Entry and Exit
Low Barriers to Entry and Exit:
Firms can enter or leave the market with relative ease.
Entry and exit costs are relatively low compared to monopoly or oligopoly.
Monopolistic Competition:
Non-Price Competition:
Firms rely heavily on advertising and marketing to differentiate their products.
Brand loyalty and customer service are crucial for maintaining market share.
Monopolistic Competition:
Pricing Power
Firms have some control over their pricing due to product differentiation.
They can raise prices without losing all customers, unlike in perfect competition.
Monopolistic Competition:
Demand Curve
Downward-Sloping Demand Curve
Firms face a downward-sloping demand curve, indicating that lower prices increase quantity demanded.
There are ranges where demand is elastic and ranges where it is inelastic.
Monopolistic Competition:
Long-Run Equilibrium:
In the long run, economic profit tends to zero due to new entrants in the market.
Monopolistic Competition:
Benefits
Variety and Innovation:
Product differentiation leads to greater variety and can meet diverse consumer preferences.
Provides incentives for innovation and improvement.
Oligopoly Market Structure:
Number of sellers
Small Number of Sellers:
Few firms dominate the market.
Each firm’s actions affect the others.
Oligopoly Market Structure:
Product Differentiation
Products can be homogeneous (e.g., cement) or differentiated by brand (e.g., breakfast cereals).
Oligopoly Market Structure:
Barriers to Entry
High entry costs and significant barriers, such as technology, brand loyalty, or regulatory requirements, limit new competitors.
Oligopoly Market Structure:
Pricing Power
Firms have substantial pricing power and can influence market prices.
Oligopoly Market Structure:
Non-Price Competition
Firms often engage in advertising and other strategies to differentiate their products.
Oligopoly Market Structure:
Kinked Demand Curve
Assumes competitors will match price decreases
but not price increases.
Results in a kinked demand curve and a discontinuous marginal revenue curve.
Explains price rigidity in oligopoly markets.
Oligopoly Market Structure:
Cournot Assumption
Firms decide on output assuming rivals will not change their output.
Each firm maximizes profit where marginal revenue equals marginal cost.
Leads to Cournot equilibrium, with prices higher and output lower than perfect competition but less extreme than monopoly.
Oligopoly Market Structure:
Nash Equilibrium
Firms choose strategies considering rivals’ reactions.
No firm can increase profit by unilaterally changing its strategy.
Reflects interdependent decision-making in oligopoly.
Oligopoly Market Structure:
Dominant Firm Model
A dominant firm sets prices, and other firms follow.
The dominant firm acts similarly to a monopoly within its market segment.
Price followers avoid undercutting the dominant firm due to higher costs or fear of price wars.
Oligopoly Market Structure:
Long-Run Equilibrium
Long-run economic profits attract new entrants, reducing market share and profits for existing firms.
Firms may innovate or engage in non-price competition to maintain market position.
Oligopolistic pricing strategy most likely results in a demand curve that is:
Kinked
Collusion is less likely in a market when
Companies have similar market shares.
In an industry composed of three companies, which are small-scale manufacturers of an easily replicable product unprotected by brand recognition or patents, the most representative model of company behavior is
Perfect competition
Measuring Market Power:
Via Elasticity of Demand and Supply:
Perfect Competition
very elastic
An elastic demand is one in which the change in quantity demanded due to a change in price is large.
Measuring Market Power:
Via Elasticity of Demand and Supply:
Oligopoly + Monopoly
demand is inelastic, companies may have market power.
Measuring Market Power:
Via Econometric Approaches:
Time-Series Regression
Uses historical sales data over time but may not reflect current market conditions.
Measuring Market Power:
Via Econometric Approaches:
Cross-Sectional Regression
Uses sales data from different companies or transactions in the same period, but requires extensive data and can be complex.
Measuring Market Power:
Simple Calculations:
Concentration Ratio
Concentration Ratio:
Measures the sum of market shares of the largest N firms.
Simple to compute but doesn’t directly quantify market power.
May not reflect potential competition or the impact of mergers accurately.
Measuring Market Power:
Simple Calculations:
Herfindahl-Hirschman Index (HHI)
Herfindahl-Hirschman Index (HHI):
Squares the market shares of the top N companies and adds them.
Ranges from 1 (monopoly) to 1/M (perfect competition, where M is the number of firms).
Reflects the impact of mergers better than the concentration ratio.
Does not account for potential market entry or demand elasticity.
Business cycles
Business cycles are recurrent expansions and contractions in economic activity affecting broad segments of the economy.
Classical cycle
Classical cycle refers to fluctuations in the level of economic activity (e.g., measured by GDP in volume terms).
Growth cycle
Growth cycle refers to fluctuations in economic activity around the long-term potential or trend growth level.
Growth rate cycle
Growth rate cycle refers to fluctuations in the growth rate of economic activity (e.g., GDP growth rate).
Business cycles:
four phases
recovery
expansion
slowdown
contraction.
Business cycles:
recovery phase
(“Trough”)
In the recovery phase of the business cycle, the economy is going through the “trough” of the cycle, where actual output is at its lowest level relative to potential output.
Economy is at a trough, starting to increase activity.
Output rises, closing the negative output gap.
Business cycles:
expansion phase
In the expansion phase of the business cycle, output increases, and the rate of growth is above average. Actual output rises above potential output, and the economy enters the so-called boom phase.
Output increases above potential.
Increased consumer spending, production, employment, and investment.
Possible shortages in production factors and rising prices.
Business cycles:
slowdown phase
(“Peak”)
In the slowdown phase of the business cycle, output reaches its highest level relative to potential output (i.e., the largest positive output gap). The growth rate begins to slow relative to potential output growth, and the positive output gap begins to narrow.
Growth rate begins to slow.
Positive output gap narrows.
Optimism persists, but hiring slows, and inflation decelerates.
Business cycles:
contraction phase
(“Downturn”)
In the contraction phase of the business cycle, actual economic output falls below potential economic output.
Output falls below potential.
Declining consumer and business confidence.
Increased layoffs, rising unemployment, and possible recession.
Credit cycles
Credit cycles describe the changing availability—and pricing—of credit.
Credit cycles:
strong peaks
Strong peaks in credit cycles are closely associated with subsequent systemic banking crises.
Leading economic indicators
have turning points that usually precede those of the overall economy.
Coincident economic indicators
have turning points that usually are close to those of the overall economy.
Lagging economic indicators
have turning points that take place later than those of the overall economy.
diffusion index
A diffusion index reflects the proportion of a composite index of leading, lagging and coincident indicators that are moving in a pattern consistent with the overall index. Analysts often rely on these diffusion indexes to provide a measure of the breadth of the change in a composite index.
Market Conditions and Investor Behavior:
Recovery
Risky assets repriced upward; equities rise before economy bottoms.
Market Conditions and Investor Behavior:
Expansion
Boom phase with strong growth; increased asset prices.
Market Conditions and Investor Behavior:
Slowdown
Risky assets peak; safe assets gain value.
Market Conditions and Investor Behavior:
Contraction
Preference for safe assets; government securities valued higher
Which rule is most likely used to determine whether the economy is in a recession?
Real GDP has two consecutive quarters of negative growth.
Variables to consider for identifying business cycle peaks and troughs in the absence of an official committee:
Unemployment
GDP growth
industrial production
inflation.
The characteristic business cycle patterns of trough, expansion, peak, and contraction are:
A.periodic.
B.recurrent.
C.of similar duration.
B is correct. The stages of the business cycle occur repeatedly over time.
During the contraction phase of a business cycle, it is most likely that:
A.inflation indicators are stable.
B.aggregate economic activity relative to potential output is decreasing.
C.investor preference for government securities declines.
B is correct. The net trend during contraction is negative.
An economic peak is most closely associated with:
A. accelerating inflation.
B. stable unemployment.
C. declining capital spending.
A. accelerating inflation.
Credit Cycles:
definition
Credit cycles describe the changing availability and pricing of credit, reflecting growth in private sector credit essential for business investments and household purchases of real estate.
They are connected to real economic activity, captured by business cycles that describe fluctuations in real GDP.
Credit Cycles:
Characteristics:
Economic Strength
Economic Strength: When the economy is strong, lenders are more willing to extend credit on favorable terms.
Credit Cycles:
Characteristics:
Economic Weakness
Economic Weakness: When the economy is weak, lenders tighten credit, making it less available and more expensive, often leading to declines in asset values like real estate.
Credit Cycles:
Interactions with Business Cycles:
Recessions
Business cycles can be amplified by credit cycles, leading to deeper recessions and more extensive expansions.
Credit Cycles:
Interactions with Business Cycles:
Recoveries
Recessions with financial disruptions (e.g., house and equity price busts) tend to be longer and deeper.
Credit Cycles:
Interactions with Business Cycles:
Comparing Length
Credit cycles often last longer than business cycles, with distinct peaks and troughs.
With which sector of the economy would analysts most commonly associate credit cycles?
A.Exports
B.Construction and purchases of property
C.Food retail
B is correct. Credit cycles are associated with availability of credit, which is important in the financing of construction and the purchase of property.
The reason analysts follow developments in the availability of credit is that:
A.loose private sector credit may contribute to the extent of asset price and real estate bubbles and subsequent crises.
B.loose credit helps reduce the extent of asset price and real estate bubbles.
C.credit cycles are of same length and depth as business cycles.
A is correct. Studies have shown that loose credit conditions contribute to the extent of asset price and real estate bubbles that tend to be followed by crises.
Employment:
Recovery Phase
Layoffs slow. Businesses rely on overtime before moving to hiring. Unemployment remains higher than average.
Employment:
Expansion Phase
Businesses move from using overtime and temporary employees to hiring. Unemployment rate stabilizes and starts falling.
Employment:
Slowdown Phase
Businesses continue hiring but at a slower pace. Unemployment rate continues to fall but at slowly decreasing rates.
Employment:
Contraction Phase
Businesses first cut hours, eliminate overtime, and freeze hiring, followed by outright layoffs. Unemployment rate starts to rise.
Employment:
Recovery Phase
Low but increasing as companies start to enjoy better conditions. Capex focus on efficiency rather than capacity.
Upturn most pronounced in orders for light producer equipment.
Typically, the orders initially reinstated are for equipment with a high rate of obsolescence, such as software, systems, and technological hardware.
Employment:
Expansion Phase
Customer orders and capacity utilization increase. Companies start to focus on capacity expansion.
The composition of the economy’s capacity may not be optimal for the current structure of demand, necessitating spending on new types of equipment.
Orders precede actual shipments, so orders for capital equipment are a widely watched indicator of the future direction of capital spending.
Employment:
Slowdown Phase
New orders intended to increase capacity may be an early indicator of the late stage of the expansion phase.
Companies continue to place new orders as they operate at or near capacity.
Employment:
Contraction Phase
New orders halted, and some existing orders canceled (no need to expand).
Initial cutbacks may be sharp and exaggerate the economy’s downturn. As the general cyclical bust matures, cutbacks in spending on heavy equipment further intensify the contraction. Maintenance scaled back.
Sales & Production:
Recovery Phase
Decline in sales slows. Sales subsequently recover. Production upturn follows but lags behind sales growth.
Over time, production approaches normal levels as excess inventories from the downturn are cleared.
Sales & Production:
Expansion Phase
Sales increase. Production rises fast to keep up with sales growth and to replenish inventories of finished products.
This increases the demand for intermediate products. “Inventory rebuilding or restocking stage.”
Sales & Production:
Slowdown Phase
Sales slow faster than production; inventories increase.
Economic slowdown leads to production cutbacks and order cancellations.
Sales & Production:
Contraction Phase
Businesses produce at rates below the sales volumes necessary to dispose of unwanted inventories.
Inventory:
Recovery Phase
Begins to fall as sales recovery outpaces production.
Inventory:
Expansion Phase
Ratio stable.
Inventory:
Slowdown Phase
Ratio increases. Signals weakening economy.
Inventory:
Contraction
Ratio begins to fall back to normal.
Although a small part of the overall economy, changes in inventories can influence economic growth measures significantly because they:
A.reflect general business sentiment.
B.tend to move forcefully up or down.
C.determine the availability of goods for sale.
B is correct. Inventory levels can fluctuate dramatically over the business cycle.
Inventories tend to rise when:
A.inventory–sales ratios are low.
B.inventory–sales ratios are high.
C.economic activity begins to rebound.
A is correct. When the economy starts to recover, sales of inventories can outpace production, which results in low inventory–sales ratios. Companies then need to accumulate more inventories to restore the ratio to normal level.
Inventories will often fall early in a recovery because:
A.businesses need profit.
B.sales outstrip production.
C.businesses ramp up production because of increased economic activity.
B is correct. The companies are slow to increase production in the early recovery phase because they first want to confirm the recession is over. Increasing output also takes time after the downsizing during the recession.
In a recession, companies are most likely to adjust their stock of physical capital by:
A.selling it at fire sale prices.
B.not maintaining equipment.
C.quickly canceling orders for new construction equipment.
B is correct. Physical capital adjustments to downturns come through aging of equipment plus lack of maintenance.
The inventory–sales ratio is most likely to be rising:
A.as a contraction unfolds.
B.partially into a recovery.
C.near the top of an economic cycle.
C is correct. Near the top of a cycle, sales begin to slow before production is cut, leading to an increase in inventories relative to sales.
Economic indicators
Economic statistics provided by government and established private organizations that contain information on an economy’s recent past activity or its current or future position in the business cycle.
Leading Indicators
Turning points that usually precede those of the overall economy; they are believed to have value for predicting the economy’s future state, usually near-term.
Coincident economic indicators
Turning points that are usually close to those of the overall economy; they are believed to have value for identifying the economy’s present state.
Lagging economic indicators
Turning points that take place later than those of the overall economy; they are believed to have value in identifying the economy’s past condition.
Leading/Lagging/Coincident:
Inventory-to-Sales
Lagging
Leading/Lagging/Coincident:
Loans Outstanding
Lagging
Leading/Lagging/Coincident:
Industrial Production Index
Coincident
Leading/Lagging/Coincident:
Real Personal Incomes
Coincident
Leading/Lagging/Coincident:
Manufacturing and Trade Sales
Coincident
Leading/Lagging/Coincident:
Stock Market
Leading
Leading/Lagging/Coincident:
Housing Prices
Leading
Leading/Lagging/Coincident:
Retail Sales
Leading
Leading/Lagging/Coincident:
Building Permits
Leading
Leading/Lagging/Coincident:
Average Weekly Hours
(Manufacturing)
Leading
Leading/Lagging/Coincident:
Consumer Expectations
Leading
Composite Indicators
Traditionally, most composite indicators to measure the cyclical state of the economy consist of up to a dozen handpicked variables published by organizations like the OECD or national research institutes. The exact variables combined into these composites vary from one economy to the other. In each case, however, they bring together various economic and financial measures that have displayed a consistently leading, coincident, or lagging relationship to that economy’s general cycle.
Diffusion Index
Reflects the proportion of the index’s components that are moving in a pattern consistent with the overall index.
Nowcasting
making forecasts about the current economic conditions
Fiscal Policy
Refers to the government’s decision about taxation and spending.
Monetary Policy
Actions taken by a nation’s central bank to affect aggregate output and prices through changes in bank reserves, reserve requirements, or its target interest rate.
True/False:
Economic decisions made by households and corporations influence the economy, but government decisions have a far greater impact.
True.
This is because governments often employ a significant portion of the population and are major spenders and borrowers.
Key Objective of Monetary and Fiscal Policy
The primary goal of these policies is to create a stable economic environment with positive growth and low, stable inflation.
Monetary Policy:
What does it aim to regulate?
Aims to regulate the quantity of money and credit to stabilize economic growth and inflation.
Fiscal Policy:
What does it aim to regulate?
Aimed at regulating economic activity.
Aggregate Demand:
Definition
Total amount companies and households plan to spend.
Fiscal Policy:
Influencing Aggregate Demand:
Expansionary Policy
Aimed at increasing AD
Fiscal Policy:
Influencing Aggregate Demand:
Contractionary Policy
Used to reduce AD during economic booms.
Fiscal Policy:
Economic Stabilization:
Role During Recessions
Increase spending to raise employment and output.
Fiscal Policy:
Economic Stabilization:
Role During Booms
Reduce spending and increase taxes to prevent overheating.
Fiscal Policy:
Automatic Stabilizers:
Definition
Mechanisms that automatically adjust government spending and taxes in response to economic conditions without the need for explicit policy changes.
Fiscal Policy:
Automatic Stabilizers:
Example
unemployment benefits and progressive tax systems.
Fiscal Policy:
Discretionary Fiscal Policy:
Definition
Deliberate changes in government spending or tax rates to influence aggregate demand.
Budget Surplus:
Definition
Budget Surplus: Government revenues exceed expenditures.
A rising surplus indicates contractionary policy.
Budget Deficit:
Definition
Budget Deficit: Government expenditures exceed revenues.
A rising deficit indicates expansionary policy.
National Debt Size Relative to GDP:
Arguments why it matters
High debt-to-GDP ratios can lead to higher interest rates, crowding out private investment, and potential solvency issues.
National Debt Size Relative to GDP:
Arguments why it doesn’t matter
Some argue that as long as debt is managed and the economy grows, high debt levels can be sustainable, especially if borrowing finances productive investments.
Keynesians
Economists who believe that fiscal policy can have powerful effects on aggregate demand, output, and employment when there is substantial spare capacity in an economy.
Monetarists
Economists who believe that the rate of growth of the money supply is the primary determinant of the rate of inflation.
The least likely goal of a government’s fiscal policy is to:
A.redistribute income and wealth.
B.influence aggregate national output.
C.ensure the stability of the purchasing power of its currency.
C is correct. Ensuring stable purchasing power is a goal of monetary rather than fiscal policy. Fiscal policy involves the use of government spending and tax revenue to affect the overall level of aggregate demand in an economy and hence the level of economic activity.
Which of the following best represents a contractionary fiscal policy?
A.Temporary suspension of payroll taxes
B.Public spending on a high-speed railway
C.Freeze in discretionary government spending
C is correct. A freeze in discretionary government spending is an example of a contractionary fiscal policy.
A “pay-as-you-go” rule, which requires that any tax cut or increase in entitlement spending be offset by an increase in other taxes or reduction in other entitlement spending, is an example of which fiscal policy stance?
A. Neutral
B. Expansionary
C. Contractionary
A is correct. A “pay-as-you-go” rule is a neutral policy because any increases in spending or reductions in revenues would be offset. Accordingly, there would be no net impact on the budget deficit/surplus.
Which of the following is not associated with an expansionary fiscal policy?
A. Rise in capital gains taxes
B. Cuts in personal income taxes
C.New capital spending by the government on road building
A is correct. A rise in capital gains taxes reduces income available for spending and hence reduces aggregate demand, other things being equal. Cutting income tax raises disposable income, while new road building raises employment and incomes; in both cases, aggregate demand rises and hence policy is expansionary.
Fiscal expansions will most likely have the greatest impact on aggregate output when the economy is in which of the following states?
A. Full employment
B. Near full employment
C. Considerable unemployment
C is correct. When an economy is close to full employment, a fiscal expansion raising aggregate demand can have little impact on output because there are few spare unused resources (e.g., labor or idle factories); instead, there will be upward pressure on prices (i.e., inflation). The greatest impact on aggregate output will occur when there is considerable unemployment.
Which one of the following is most likely a reason to not use fiscal deficits as an expansionary tool?
A.They may crowd out private investment.
B.They may facilitate tax changes to reduce distortions in an economy.
C.They may stimulate employment when there is substantial unemployment in an economy.
A is correct. A frequent argument against raises in fiscal deficits is that the additional borrowing to fund the deficit in financial markets will displace private sector borrowing for investment (i.e., crowding out).
The most likely argument against high national debt levels is that:
A. the debt is owed internally to fellow citizens.
B.they create disincentives for economic activity.
C.they may finance investment in physical and human capital.
B is correct. The belief is that high levels of debt to GDP may lead to higher future tax rates, which may lead to disincentives to economic activity.
Fiscal Policy Tools:
Government Spending:
Transfer Payments
Transfer Payments:
Welfare payments via social security systems (e.g., state pensions, unemployment benefits).
Provide basic income for low-income households and adjust income distribution.
Not part of GDP as they do not reflect production activity.
Fiscal Policy Tools:
Government Spending:
Current Government Spending
Regular spending on goods and services, such as health, education, and defense.
Significant impact on skill levels and labor productivity.
Fiscal Policy Tools:
Government Spending:
Capital Expenditure
Infrastructure investments (e.g., roads, schools, hospitals).
Increases a nation’s capital stock, affecting long-term productive potential.
Fiscal Policy Tools:
Government Spending:
Justifications for Spending:
Public Services
Provide universally beneficial services like defense.
Fiscal Policy Tools:
Government Spending:
Justifications for Spending:
Economic Growth
Infrastructure spending supports economic development.
Fiscal Policy Tools:
Government Spending:
Justifications for Spending:
Income Redistribution
Ensures minimum income levels and reduces income inequality.
Fiscal Policy Tools:
Government Spending:
Justifications for Spending:
Economic Objectives
Manage aggregate demand to control inflation, employment, and growth.
Fiscal Policy Tools:
Government Spending:
Justifications for Spending:
Subsidies for Innovation
Support high-risk investments in new technologies or markets.
Fiscal Policy Tools:
Government Revenues:
Direct Taxes:
Definition
Levied on income, wealth, and corporate profits (e.g., income tax, corporate tax).
Include property taxes and inheritance taxes.
Fiscal Policy Tools:
Government Revenues:
Indirect Taxes:
Definition
Taxes on goods and services (e.g., excise duties on fuel, VAT).
Can include taxes for social or environmental purposes (e.g., tobacco taxes, fuel duties).
Fiscal Policy Tools:
Government Revenues:
Indirect Taxes:
Advantages
Adjust quickly and influence spending behavior immediately.
Raise government revenue at low cost.
Fiscal Policy Tools:
Direct Spending:
Advantages
Immediate impact on aggregate spending and output.
Infrastructure spending increases long-term productive capacity.
Fiscal Policy Tools:
Direct Taxes:
Disadvantages
Hard to change quickly without notice.
Administrative adjustments (e.g., payroll systems) take time.
Fiscal Policy Tools:
Capital Spending:
Disadvantages
Long planning and implementation periods.
Often criticized for slow impact on economic stabilization.
Fiscal Multiplier:
Definition
Definition: The ratio of the change in output to the change in autonomous spending.
Fiscal Multiplier:
Importance
Importance: Measures the impact of government spending or tax changes on aggregate demand and output.
Which of the following is not a tool of fiscal policy?
A.A rise in social transfer payments
B.The purchase of new equipment for the armed forces
C.An increase in deposit requirements for the buying of houses
C is correct. Rises in deposit requirements for house purchases are intended to reduce the demand for credit for house purchases and hence would be considered a tool of monetary policy. This is a policy used actively in several countries and is under consideration by regulators in other countries to constrain house price inflation.
Which of the following is not an indirect tax?
A.Excise duty
B.Value-added tax
C.Employment taxes
C is correct. Both excise duty and value-added tax (VAT) are applied to prices, whereas taxes on employment apply to labor income and hence are not indirect taxes.
Which of the following statements is most accurate?
A. Direct taxes are useful for discouraging alcohol consumption.
B. Because indirect taxes cannot be changed quickly, they are of no use in fiscal policy.
C. Government capital spending decisions are slow to plan, implement, and execute and hence are of little use for short-term economic stabilization.
C is correct. Capital spending is much slower to implement than changes in indirect taxes; and indirect taxes affect alcohol consumption more directly than direct taxes.
Fiscal stance
Fiscal stance refers to whether a government’s fiscal policy is expansionary or contractionary.
Expansionary fiscal policy
Expansionary fiscal policy increases government spending or decreases taxes to boost aggregate demand.
Contractionary fiscal policy
Contractionary fiscal policy decreases government spending or increases taxes to reduce aggregate demand.
Actual budget deficit
The difference between government revenues and expenditures at any point in time.
Structural budget deficit
The deficit that would exist if the economy were at full employment or potential output, stripping out cyclical factors.
Issues with Fiscal Policy Implementation:
Recognition Lag
Time taken to recognize economic changes. Data collection and analysis delays can cause significant lag.
Issues with Fiscal Policy Implementation:
Action Lag
Time required to implement fiscal policy decisions. Legislative processes and bureaucratic procedures often delay policy action.
Issues with Fiscal Policy Implementation:
Impact Lag
Time between implementing policy changes and seeing their effects on the economy. For example, infrastructure projects take time to influence employment and demand.
Challenges in Executing Fiscal Policy:
Incomplete Information
Policymakers often lack real-time data, making it challenging to implement timely and appropriate measures.
Challenges in Executing Fiscal Policy:
Uncertainty in Economic Direction
Economic conditions can change unpredictably, complicating policy planning and implementation.
Challenges in Executing Fiscal Policy:
Macroeconomic Forecasting Limitations
Forecasting models may not accurately predict economic responses, adding uncertainty to policy impacts.
Fiscal Policy:
Wider Macroeconomic Issues:
Inflation vs. Unemployment
Balancing the dual objectives of low unemployment and stable inflation can be challenging. Increasing aggregate demand to reduce unemployment may lead to inflation.
Fiscal Policy:
Wider Macroeconomic Issues:
High Budget Deficits
Large deficits may be unsustainable and could lead to higher borrowing costs, reducing fiscal policy effectiveness.
Fiscal Policy:
Wider Macroeconomic Issues:
Full Employment
Determining the economy’s full employment level is difficult. Overestimating can lead to inflation if demand exceeds productive capacity.
Fiscal Policy:
Wider Macroeconomic Issues:
Supply Constraints
If economic issues are due to supply-side constraints rather than demand shortages, fiscal policy may not be effective.
Fiscal Policy:
Wider Macroeconomic Issues:
Crowding Out
Government borrowing can crowd out private sector investment by raising interest rates, reducing private investment and economic growth.
Which of the following statements is least accurate?
A.The economic data available to policy makers have a considerable time lag.
B.Economic models always offer an unambiguous guide to the future path of the economy.
C.Surprise changes in exogenous economic variables make it difficult to use fiscal policy as a stabilization tool.
B is correct. Economic forecasts from models will always have an element of uncertainty attached to them and thus are not unambiguous or precise in their prescriptions. Once a fiscal policy decision has been made and implemented, unforeseen changes in other variables may affect the economy in ways that would lead to changes in the fiscal policy if we had perfect foresight. Note that it is true that official economic data may be available with substantial time lags, making fiscal judgments more difficult.
Which of the following statements is least accurate?
A.Discretionary fiscal changes are aimed at stabilizing an economy.
B.Automatic fiscal stabilizers include new plans for additional road building by the government.
C.In the context of implementing fiscal policy, the recognition lag is often referred to as “driving while looking in the rearview mirror.”
B is correct. New plans for road building are discretionary and not automatic.
Which of the following statements regarding a fiscal stimulus is most accurate?
A.Accommodative monetary policy reduces the impact of a fiscal stimulus.
B.Different statistical models will predict different impacts for a fiscal stimulus.
C.It is always possible to precisely predict the impact of a fiscal stimulus on employment.
B is correct. Different models embrace differing views on how the economy works, including differing views on the impact of fiscal stimuli.
Which of the following statements is most accurate?
A.An increase in the budget deficit is always expansionary.
B.An increase in government spending is always expansionary.
C.The structural deficit is always larger than the deficit below full employment.
A is correct. Note that increases in government spending may be accompanied by even bigger rises in tax receipts and hence may not be expansionary.
Role of Central Banks:
Monopoly Supplier of Currency
Central banks are the sole suppliers of the domestic currency, ensuring the stability and trust in the currency.
Role of Central Banks:
Banker to the Government and Banks
Central banks act as the banker for both the government and commercial banks, facilitating financial operations and ensuring liquidity.
Role of Central Banks:
Lender of Last Resort
Central banks provide emergency funds to banks facing liquidity crises, preventing bank runs and maintaining financial stability.
Role of Central Banks:
Regulator and Supervisor of the Payments System
Central banks oversee and regulate the national payments system, ensuring robust, efficient, and standardized procedures.
Role of Central Banks:
Conductor of Monetary Policy
Central banks influence the economy by controlling the money supply and credit conditions through monetary policy tools.
Role of Central Banks:
Supervisor of the Banking System
Central banks (or designated authorities) supervise and regulate the banking system to ensure its soundness and stability.
Objectives of Monetary Policy:
Price Stability
Maintaining stable prices is the primary objective for most central banks, as it ensures economic predictability and confidence.
Objectives of Monetary Policy:
Full Employment
Some central banks aim to maintain full employment, ensuring that all willing and able individuals can find work.
Objectives of Monetary Policy:
Financial System Stability
Ensuring the stability of the financial system to prevent crises and maintain smooth financial operations.
Objectives of Monetary Policy:
Economic Growth
Promoting sustainable and non-inflationary economic growth to enhance the overall prosperity of the nation.
Fiat Money
Money that is not convertible into any other commodity.
A central bank is normally not the:
A.lender of last resort.
B.banker to the government and banks.
C.body that sets tax rates on interest on savings.
C is correct. A central bank is normally the lender of last resort and the banker to the banks and government, but the determination of all tax rates is normally the preserve of the government and is a fiscal policy issue.
Which of the following best describes the overarching, long-run objective of most central banks?
A.Price stability
B.Fast economic growth
C.Current account surplus
A is correct. Central banks normally have a variety of objectives, but the overriding one is nearly always price stability.
Which role is a central bank least likely to assume?
A.Lender of last resort
B.Supplier of the currency
C.Sole supervisor of banks
C is correct. The supervision of banks is not a role that all central banks assume. When it is a central bank’s role, responsibility may be shared with one or more entities.
Monetary Policy Tools:
Open Market Operations:
Definition
Open market operations involve the purchase and sale of government bonds by the central bank from and to commercial banks or designated market makers. These operations directly influence the amount of money in circulation:
Purchasing Government Bonds: Increases the reserves of commercial banks, enabling them to lend more, which increases broad money growth through the money multiplier process.
Selling Government Bonds: Decreases the reserves of commercial banks, reducing their capacity to make loans, and thereby decreasing broad money growth.
Monetary Policy Tools:
The Central Bank’s Policy Rate
Definition
The policy rate, also known as the official interest rate, is the rate at which the central bank lends money to commercial banks.
This rate influences both short-term and long-term interest rates and ultimately affects real economic activity:
Increasing the Policy Rate: Encourages commercial banks to raise their base rates, leading to higher borrowing costs for consumers and businesses, reducing borrowing, and slowing broad money growth.
Decreasing the Policy Rate: Lowers the borrowing costs, encouraging borrowing, and increasing broad money growth.
Common names for the policy rate include:
Bank of England
Two-week repo rate
Common names for the policy rate include:
European Central Bank
Refinancing rate
Common names for the policy rate include:
United States
Discount rate (with the federal funds rate being the interbank lending rate targeted by the Federal Open Market Committee, or FOMC)
Monetary Policy Tools:
Reserve Requirements
The reserve requirement is the minimum amount of reserves that banks must hold against deposits. Changes in reserve requirements directly impact the money creation process:
Increasing Reserve Requirements: Impact
Reduces the amount of money banks can lend, contracting the money supply.
Decreasing Reserve Requirements: Impacts
Increases the amount of money available for lending, expanding the money supply.
Channels of Monetary Transmission: Interest Rates
Changes in the policy rate influence short-term and long-term interest rates, affecting borrowing costs and investment decisions.
Channels of Monetary Transmission: Asset Prices
Changes in interest rates affect the valuation of assets (bonds, stocks), impacting household wealth and spending decisions.
Channels of Monetary Transmission: Expectations:
Central bank actions influence expectations about future economic conditions, impacting consumption, investment, and pricing behavior.
Channels of Monetary Transmission: Exchange Rates:
Interest rate changes can affect the exchange rate, influencing export and import prices and thus the net external demand.
Which of the following variables are most likely to be affected by a change in a central bank’s policy rate?
A.Asset prices only
B.Expectations about future interest rates only
C.Both asset prices and expectations about future interest rates
C is correct. The price of equities, for example, might be affected by the expectation of future policy interest rate changes. In other words, a rate change may be taken as a signal of the future stance of monetary policy—contractionary or expansionary.
Which of the following does a central bank seek to influence directly via the setting of its official interest rate?
A.Import prices
B.Domestic inflation
C.Inflation expectations
C is correct. By setting its official interest rate, a central bank could expect to have a direct influence on inflation expectations—as well as on other market interest rates, asset prices, and the exchange rate (where this is freely floating). If it can influence these factors, it might ultimately hope to influence import prices (via changes in the exchange rate) and also domestically generated inflation (via its impact on domestic or external demand). The problem is that the workings of the transmission mechanism—from the official interest rate to inflation—are complex and can change over time.
Monetary policy is least likely to include:
A.setting an inflation rate target.
B.changing an official interest rate.
C.enacting a transfer payment program.
C is correct. Transfer payment programs represent fiscal, not monetary policy.
Which is the most accurate statement regarding central banks and monetary policy?
A.Central bank activities are typically intended to maintain price stability.
B.Monetary policies work through the economy via four independent channels.
C.Commercial and interbank interest rates move inversely to official interest rates.
A is correct. Central bank activities are typically intended to maintain price stability. B is not correct because the transmission channels of monetary policy are not independent.
Qualities of Effective Central Banks:
Independence
Independence:
The ability to operate free from political interference ensures that central banks can make decisions based on economic conditions rather than political considerations. Degrees of independence vary, but operational independence—control over how monetary policy is implemented—is critical.
Qualities of Effective Central Banks: Credibility
Credibility:
Trust in the central bank’s commitment to its objectives is essential. Credibility ensures that economic agents (households, businesses, investors) believe that the central bank will maintain stable inflation and act to stabilize the economy.
Qualities of Effective Central Banks: Transparency
Transparency:
Clear communication about policy goals, decision-making processes, and economic assessments helps build credibility. Transparency allows the public and markets to understand the central bank’s actions and intentions, reducing uncertainty.
Qualities of Effective Central Banks: Accountability
Accountability:
Central banks must be accountable for their actions, explaining their decisions and outcomes, especially when targets are missed. Accountability reinforces credibility and trust in the institution.
Central Banks:
Targeting Strategies in Monetary Policy
Inflation Targeting
Inflation targeting involves setting an explicit target for the inflation rate, typically around 2%, and adjusting monetary policy to achieve this target.
Advantages:
1.Provides clear guidance on policy direction.
2.Enhances transparency and accountability.
3.Helps anchor inflation expectations.
Disadvantages:
1.May not address other economic issues such as employment or growth.
2.Requires accurate measurement and forecasting of inflation.
Central Banks:
Targeting Strategies in Monetary Policy
Interest Rate Targeting
Interest rate targeting focuses on manipulating short-term interest rates to influence economic activity. The central bank adjusts its policy rate to achieve desired economic outcomes.
Advantages:
1.Directly influences borrowing costs and economic activity.
2.Well-understood mechanism with established transmission channels.
Disadvantages:
1.Can be less effective during periods of very low interest rates.
2.May not directly control broader monetary conditions.
Central Banks:
Targeting Strategies in Monetary Policy
Exchange Rate Targeting
Exchange rate targeting involves pegging the domestic currency to another currency or a basket of currencies. The central bank buys or sells foreign currency to maintain the target rate.
Advantages:
1.Provides a clear and easily understood policy anchor.
2.Can help stabilize trade and investment flows.
Disadvantages:
1.Limits monetary policy flexibility.
2.Vulnerable to speculative attacks and requires large foreign exchange reserves.
Liquidity Traps
In deflationary environments, even zero or negative interest rates may not stimulate borrowing and spending.
This situation, known as a liquidity trap, limits the central bank’s ability to boost the economy.
The reason some inflation-targeting banks may target low inflation and not zero percent inflation is best described by which of the following statements?
A.Some inflation is viewed as being good for an economy.
B.It is very difficult to eliminate all inflation from a modern economy.
C.Targeting zero percent inflation runs a higher risk of a deflationary outcome.
C is correct. Inflation targeting is art, not science. Sometimes inflation will be above target and sometimes below. Were central banks to target zero percent, then inflation would almost certainly be negative on some occasions. If a deflationary mindset then sets in among economic agents, it might be difficult for the central bank to respond to this because they cannot cut interest rates much below zero.
The degree of credibility that a central bank is afforded by economic agents is important because:
A.they are the lender of last resort.
B.they set targets that can become self-fulfilling prophecies.
C.they are the monopolistic suppliers of the currency.
B is correct. If a central bank operates within an inflation-targeting regime and if economic agents believe that it will achieve its target, this expectation will become embedded into wage negotiations, for example, and become a self-fulfilling prophecy. Also, banks need to be confident that the central bank will lend them money when all other sources are closed to them; otherwise, they might curtail their lending drastically, leading to a commensurate reduction in money and economic activity.
A central bank that decides the desired levels of interest rates and inflation and the horizon over which the inflation objective is to be achieved is most accurately described as being:
A.target independent and operationally independent.
B.target independent but not operationally independent.
C.operationally independent but not target independent.
A is correct. The central bank described is target independent because it set its own targets (e.g., the target inflation rate) and operationally independent because it decides how to achieve its targets (e.g., the time horizon).
When the central bank chooses to target a specific value for its exchange rate:
A.it must also target domestic inflation.
B.it must also set targets for broad money growth.
C.conditions in the domestic economy must adapt to accommodate this target.
C is correct. The adoption of an exchange rate target requires that the central bank set interest rates to achieve this target. If the target comes under pressure, domestic interest rates may have to rise, regardless of domestic conditions. It may have a “target” level of inflation in mind as well as “targets” for broad money growth, but as long as it targets the exchange rate, domestic inflation and broad money trends must simply be allowed to evolve.
With regard to monetary policy, what is the expected benefit of adopting an exchange rate target?
A.Freedom to pursue redistributive fiscal policy
B.Freedom to set interest rates according to domestic conditions
C.Ability to “import” the inflation experience of the economy whose currency is being targeted
C is correct. Note that interest rates have to be set to achieve this target and are therefore subordinate to the exchange rate target and partially dependent on economic conditions in the foreign economy.
Which of the following is least likely to be an impediment to the successful implementation of monetary policy in developing economies?
A.Fiscal deficits
B.Rapid financial innovation
C.Absence of a liquid government bond market
A is correct. Note that the absence of a liquid government bond market through which a central bank can enact open market operations and/or repo transactions will inhibit the implementation of monetary policy—as would rapid financial innovation because such innovation can change the relationship between money and economic activity. In contrast, fiscal deficits are not normally an impediment to the implementation of monetary policy, although they could be if they were perceived to be unsustainable.
A country that maintains a target exchange rate is most likely to have which outcome when its inflation rate rises above the level of the inflation rate in the target country?
A.Increase in short-term interest rates
B.Increase in the domestic money supply
C.Increase in its foreign currency reserves
A is correct. Interest rates are expected to rise to protect the exchange rate target.
If an economy’s trend GDP growth rate is 3 percent and its central bank has a 2 percent inflation target, which policy rate is most consistent with an expansionary monetary policy?
A. 4 percent
B. 5 percent
C. 6 percent
A is correct. The neutral rate of interest, which in this example is 5 percent, is considered to be that rate of interest that neither spurs on nor slows down the underlying economy. As such, when policy rates are above the neutral rate, monetary policy is contractionary; when they are below the neutral rate, monetary policy is expansionary. It has two components: the real trend rate of growth of the underlying economy (in this example, 3 percent) and long-run expected inflation (in this example, 2 percent).
An increase in a central bank’s policy rate might be expected to reduce inflationary pressures by:
A. reducing consumer demand.
B.reducing the foreign exchange value of the currency.
C.driving up asset prices leading to an increase in personal sector wealth.
A is correct. If an increase in the central bank’s policy rate is successfully transmitted through the money markets to other parts of the financial sector, consumer demand might decline as the rate of interest on mortgages and other credit rises. This decline in consumer demand should, all other things being equal and among other affects, lead to a reduction in upward pressure on consumer prices.
Which of the following statements best describes a fundamental limitation of monetary policy? Monetary policy is limited because central bankers:
A.cannot control the inflation rate perfectly.
B.are appointed by politicians and are therefore never truly independent.
C.cannot control the amount of money that economic agents put in banks, nor the willingness of banks to make loans.
C is correct. Central bankers do not control the decisions of individuals and banks that can influence the money creation process.
In theory, setting the policy rate equal to the neutral interest rate should promote:
A. stable inflation.
B. balanced budgets.
C. greater employment.
A is correct. The neutral rate of interest is that rate of interest that neither stimulates nor slows down the underlying economy.
The neutral rate should be consistent with stable long-run inflation.
The Relationship Between Monetary and Fiscal Policy:
Types of Policy Mixes:
Easy Fiscal Policy / Tight Monetary Policy
Outcome:
Higher aggregate output but higher interest rates, which could dampen private sector demand. Government spending becomes a larger share of national income.
Fiscal Expansion:
Government increases spending or cuts taxes, raising aggregate demand.
Monetary Contraction:
Central bank reduces the money supply, raising interest rates
The Relationship Between Monetary and Fiscal Policy:
Types of Policy Mixes:
Tight Fiscal Policy / Easy Monetary Policy:
Outcome:
Stimulates private sector activity due to lower interest rates, shifting GDP share from public to private sector.
Fiscal Contraction:
Government reduces spending or increases taxes, lowering aggregate demand.
Monetary Expansion:
Central bank increases the money supply, lowering interest rates.
The Relationship Between Monetary and Fiscal Policy:
Types of Policy Mixes:
Easy Monetary Policy / Easy Fiscal Policy
Outcome:
Significant rise in aggregate demand, potentially lower interest rates, and growth in both private and public sectors.
Joint Expansion:
Both policies aim to increase aggregate demand.
The Relationship Between Monetary and Fiscal Policy:
Types of Policy Mixes:
Tight Monetary Policy / Tight Fiscal Policy
Outcome:
Higher interest rates, reduced private sector demand, and lower aggregate demand from both public and private sectors.
Joint Contraction:
Both policies aim to reduce aggregate demand.
Quantitative Easing
Central bank purchases government or private securities, increasing cash balances and lowering interest rates to stimulate spending.
Ricardian equivalence
Ricardian equivalence is an economic theory that says that financing government spending out of current taxes or future taxes (and current deficits) will have equivalent effects on the overall economy.
This means that attempts to stimulate an economy by increasing debt-financed government spending will not be effective because investors and consumers understand that the debt will eventually have to be paid for in the form of future taxes.
The theory argues that people will save based on their expectation of increased future taxes to be levied in order to pay off the debt, and that this will offset the increase in aggregate demand from the increased government spending.
This also implies that Keynesian fiscal policy will generally be ineffective at boosting economic output and growth.
In a world in which Ricardian equivalence holds, governments would most likely prefer to use monetary rather than fiscal policy because under Ricardian equivalence:
A.real interest rates have a more powerful effect on the real economy.
B.the transmission mechanism of monetary policy is better understood.
C.the future impact of fiscal policy changes are fully discounted by economic agents.
C is correct. If Ricardian equivalence holds, then economic agents anticipate that the consequence of any current tax cut will be future tax rises, which leads them to increase their saving in anticipation of this so that the tax cut has little effect on consumption and investment decisions. Governments would be forced to use monetary policy to affect the real economy on the assumption that money neutrality did not hold in the short term.
If fiscal policy is easy and monetary policy tight, then:
A.interest rates would tend to fall, reinforcing the fiscal policy stance.
B.the government sector would tend to shrink as a proportion of total GDP.
C.the government sector would tend to expand as a proportion of total GDP.
C is correct. With a tight monetary policy, real interest rates should rise and reduce private sector activity, which could be at least partially offset by an expansion in government activity via the loosening of fiscal policy. The net effect, however, would be an expansion in the size of the public sector relative to the private sector.
Which of the following has the greatest impact on aggregate demand according to an IMF study? 1 percent of GDP stimulus in:
A.government spending
B.rise in transfer benefits
C.cut in labor income tax across all income levels
A is correct. The study clearly showed that direct spending by the government leads to a larger impact on GDP than changes in taxes or benefits.
Given an independent central bank, monetary policy actions are more likely than fiscal policy actions to be:
A.implementable quickly.
B.effective when a specific group is targeted.
C.effective when combating a deflationary economy.
A is correct. Monetary actions may face fewer delays to taking action than fiscal policy, especially when the central bank is independent.
Which policy alternative is most likely to be effective for growing both the public and private sectors?
A.Easy fiscal/easy monetary policy
B.Easy fiscal/tight monetary policy
C.Tight fiscal/tight monetary policy
A is correct. If both fiscal and monetary policies are “easy,” then the joint impact will be highly expansionary, leading to a rise in aggregate demand, low interest rates, and growing private and public sectors.
State Actors
State actors are typically national governments, political organizations, or country leaders that exert authority over a country’s national security and resources. Examples include:
Presidents (e.g., South Africa’s president)
Parliaments (e.g., Malaysia’s parliament)
Prime ministers (e.g., British Prime Minister)
Non-State Actors
Non-state actors participate in global political, economic, or financial affairs without direct control over national security or country resources. Examples include:
Non-Governmental Organizations (NGOs)
Multinational companies
Charities
Influential individuals (e.g., business leaders, cultural icons)
Geopolitics:
Political Cooperation
Political cooperation involves countries working together towards shared goals, which can range from strategic or military concerns to economic influence and cultural preferences. Cooperative actions may include:
Rules standardization
Harmonization of tariffs
International agreements on trade, immigration, or regulation
Free flow of information and technology transfer
Geopolitics:
Non-Cooperation
Non-cooperative countries may have:
Inconsistent and arbitrary rules
Restricted movement of goods, services, people, and capital
Retaliatory actions
Limited technology exchange
Motivations for Cooperation:
National Security or Military Interest
Countries often cooperate to enhance their national security. Factors influencing this cooperation include:
Geographic considerations (e.g., landlocked countries needing access to resources)
Strategic trade routes (e.g., Panama’s role in global shipping)
Motivations for Cooperation:
Economic Interest
Economic cooperation aims to secure essential resources through trade or to level the global playing field for national firms. It encompasses:
Access to resources like energy, food, or water
Support for domestic companies operating globally
Factors Affecting Cooperation:
Geophysical Resource Endowment
Resource endowment, such as access to food, water, and energy, influences a country’s political leverage and vulnerability. For instance:
Resource-rich countries (e.g., Saudi Arabia with fossil fuels) may have more political leverage but could face internal instability.
Factors Affecting Cooperation:
Standardization
Standardization of rules and processes helps expand economic activities across borders, promoting higher economic growth and living standards. Examples include:
Regulatory Cooperation:
Basel Committee on Banking Supervision (BCBS) for banking sector governance
Process Standardization: Society for Worldwide Interbank Financial Telecommunication (SWIFT) for global financial infrastructure
Operational Synchronization: Containerization standards in shipping
Factors Affecting Cooperation:
Cultural Considerations and Soft Power
Cultural factors and soft power influence cooperation. Examples include:
Historical ties and shared cultural experiences
Soft power initiatives like the EU’s Erasmus+ program or South Korea’s global cultural advertisements
Geopolitics:
hierarchy of interests
those essential for survival at the top of the hierarchy and nice-but-not-essential elements lower in the hierarchy.
Geopolitics:
soft power
A means of influencing another country’s decisions without force or coercion. Soft power can be built over time through actions, such as cultural programs, advertisement, travel grants, and university exchange.
Which of the following actions by a country is most likely a form of geopolitical cooperation?
A.Acting as a conduit for trade
B.Engaging in rules standardization
C.Opting to use soft power over military retaliation
Engaging in rules standardization
Which of the following statements represents an aspect of geopolitical risk?
A.Modeling geopolitical risk is relatively easy to standardize.
B.An engaged country can be considered cooperative, even if it does not reciprocate.
C.The strength of a country’s institutions is relevant to the durability of its cooperative relationships.
C is correct. The strength of a country’s institutions can make cooperative relationships more durable.
Geopolitics:
Cooperation
a cooperative country is one that is both engaged and reciprocates.
The process by which countries work together toward some shared goal or purpose. These goals may, and often do, vary widely—from strategic or military concerns, to economic influence, to cultural preferences.
Globalization
Globalization is the process of interaction and integration among people, companies, and governments worldwide. It encompasses the spread of products, information, jobs, and culture across borders.
Globalization:
Microeconomic Impact
Globalization is evident at the microeconomic level. For example, the production of an automobile may involve components designed and manufactured in various countries and assembled in another country. This extensive international process allows companies to optimize quality and cost-effectiveness. It also opens investment opportunities in engineering, production, supply chain management, and logistics.
Globalization:
Cultural and Communicative Features
Globalization also affects culture and communication. The spread of global products and information is visible in daily life, such as diverse international products in a grocery store and global collaborations on social media. The internet and faster travel facilitate near-instantaneous cultural exchanges.
True/False:
Globalization results from economic and financial cooperation, primarily driven by non-state actors like corporations and individuals.
True
Motivations for Globalization:
Increasing Profits
Increasing sales:
Companies globalize to access new customers and markets, often requiring significant investment in local infrastructure and workforce.
Reducing costs:
Companies seek lower tax environments, reduced labor costs, and supply chain efficiencies to reduce costs.
Motivations for Globalization:
Access to Resources and Markets
Companies globalize to secure resources, talent, and new market opportunities, including short-term portfolio investments and long-term foreign direct investments (FDI).
Motivations for Globalization:
Intrinsic Gain
Intrinsic gains, such as personal growth and accelerated productivity, contribute to globalization’s momentum by fostering empathy and reducing geopolitical threats.
Costs of Globalization:
Unequal Accrual of Economic Gains
Economic gains from globalization are not evenly distributed, benefiting some actors while disadvantaging others, such as job losses in home countries.
Costs of Globalization:
Lower Environmental, Social, and Governance Standards
Companies may lower their standards to align with local regulations in lower-cost countries, impacting environmental quality and social welfare.
Costs of Globalization:
Political Consequences
Globalization can contribute to income and wealth inequality, leading to political resistance and nationalism.
Costs of Globalization:
Interdependence
Economic and financial cooperation can create dependencies on other countries’ resources, making supply chains vulnerable to disruptions.
Threats of Rollback of Globalization:
Reshoring the essentials:
Relocating production of critical items domestically.
Threats of Rollback of Globalization:
Reglobalizing production:
Duplicating or strengthening supply chains to reduce risks.
Threats of Rollback of Globalization:
Doubling down on key markets
Maintaining essential manufacturing in key markets while developing local production for local consumption.
True or False: Globalization is primarily carried out by governmental actors.
A.True
B.False
B is correct. Globalization is primarily carried out by non-governmental actors, such as corporations, individuals, or organizations, and is the result of economic and financial cooperation. Multinational corporations, for example, want a competitive advantage leading them to seek new markets, talent, and learning as well as trade, capital, currency, and cultural and information exchange. Corporate outsourcing of talent is an example of globalization.
Which of these actions would do the most to increase geopolitical risk?
A.Increase capital flows
B.Restrict foreign currency exchange
C.Engage in trade of goods and services
B is correct. Restricted foreign currency exchange—a characteristic of antiglobalization—would likely reduce political and economic cooperation and thus increase geopolitical risk. A is incorrect because an increase in capital flows would reduce geopolitical risk. C is incorrect because an increase in trade would reduce geopolitical risk.
International Monetary Fund (IMF):
Role
The IMF’s main mandate is to ensure the stability of the international monetary system, including exchange rates and international payments.
International Monetary Fund (IMF):
Providing a forum for cooperation on international monetary problems
This includes facilitating discussions among member countries on global monetary issues.
International Monetary Fund (IMF):
Facilitating the growth of international trade
By promoting employment, economic growth, and poverty reduction.
International Monetary Fund (IMF):
Supporting exchange rate stability
Through an open system of international payments.
International Monetary Fund (IMF):
Lending foreign exchange to members
Providing temporary financial assistance to countries with balance of payments problems, under strict conditions.
International Monetary Fund (IMF): Who is it?
The International Monetary Fund (IMF) is a major financial agency of the United Nations, and an international financial institution funded by 190 member countries, with headquarters in Washington, D.C. It is regarded as the global lender of last resort to national governments, and a leading supporter of exchange-rate stability.
World Bank Group
The World Bank is an international financial institution that provides loans and grants to the governments of low- and middle-income countries for the purpose of pursuing capital projects.[
World Trade Organization (WTO)
The World Trade Organization (WTO) is an intergovernmental organization headquartered in Geneva, Switzerland[6] that regulates and facilitates international trade.[7] Governments use the organization to establish, revise, and enforce the rules that govern international trade in cooperation with the United Nations System.[7][8] The WTO is the world’s largest international economic organization, with 164 member states representing over 98% of global trade and global GDP.[9][10][11]
Investors Perspective on International Monetary Fund (IMF)
Helps maintain financial stability and manage systemic risks, ensuring a stable environment for investments.
Investors Perspective on World Bank
Creates the basic economic infrastructure essential for developing financial markets and attracting investment in developing countries.
Investors Perspective on World Trade Organization (WTO)
Establishes a regulatory framework that supports global multinational corporations, which are crucial for diversified investment portfolios.
Autarky
Autarky (Nationalism + Non-Cooperation)
Description: Self-sufficient countries with little or no external trade or finance. State-owned enterprises control strategic industries.
Benefits: Strong political control, reduced external dependencies.
Costs: Economic isolation, potential for slower growth and development.
Example: North Korea.
Hegemony
Hegemony (Nationalism + Cooperation)
Description: Countries with regional or global influence that control resources through political or economic power. State-owned enterprises control key export markets.
Benefits: Political and economic dominance, influence on global affairs.
Costs: Potential for geopolitical conflict, economic volatility.
Example: China, particularly in its control over technology transfer and natural resources.
Multilateralism
Multilateralism (Globalization + Cooperation)
Description: Countries engaged in mutually beneficial trade relationships and extensive rules harmonization. Private firms are integrated into global supply chains.
Benefits: High economic growth, stability, and innovation through cooperation.
Costs: Vulnerability to global economic fluctuations and geopolitical risks.
Example: Singapore, known for its open economy and strategic location.
Bilateralism
Bilateralism (Globalization + Non-Cooperation)
Description: Countries that engage in one-on-one agreements with other countries.
Relations are often conducted at the exclusion of other groups.
Benefits: Flexibility in trade agreements, focused economic strategies.
Costs: Limited market access, potential for trade conflicts.
Example: Historical Japan, with strong export markets but limited import globalization.
For the following contrasting pairs of archetypes of globalization and cooperation, which one reflects the greatest differences in country behavior?
A.Bilateralism versus autarky
B.Multilateralism versus autarky
C.Multilateralism versus hegemony
B is correct. Multilateralism describes countries that participate in mutually beneficial trade relationships and extensive rules harmonization. Autarky describes countries seeking political self-sufficiency with little or no external trade or finance. In the Exhibit 7 display of these behavior patterns, these choices are most widely separated on both the globalization and cooperation continuums. A is incorrect because bilateral or regional approaches describe those countries leveraging regional trade relationships and may face the world as a group. Bilateralism shares with autarky a bias against globalization. These approaches diverge, however, regarding cooperation, with autarky being more non-cooperative. C is incorrect because multilateralism describes countries that participate in mutually beneficial trade relationships and extensive rules harmonization. Hegemony represents countries exerting political or economic influence of others to control resources. Multilateralism shares with hegemony an inclination toward globalization, as shown in Exhibit 7, but diverges from hegemony regarding cooperation; hegemony is more non-cooperative.
Types of Geopolitical Tools:
National Security Tools
National security tools influence or coerce state actors through direct or indirect impact on the country’s resources, people, or borders. These tools can be active (currently used) or threatened (likely to be used).
Armed Conflict: Direct and active tool causing physical destruction and migration. Example: Syrian Civil War.
Espionage: Indirect tool used to obtain political or military information.
Military Alliances: Cooperative tool to deescalate potential conflicts. Example: NATO.
Types of Geopolitical Tools:
Economic Tools
Economic tools are used to reinforce cooperative or non-cooperative stances through economic means.
Cooperative Economic Tools: Multilateral trade agreements (e.g., MERCOSUR), common markets (e.g., EU), common currency (e.g., euro).
Non-Cooperative Economic Tools: Nationalization (e.g., Argentina’s renationalization of YPF), voluntary export restraints, domestic content requirements.
Types of Geopolitical Tools:
Financial Tools
Financial tools reinforce cooperative or non-cooperative stances through financial mechanisms.
Cooperative Financial Tools: Free currency exchange, allowing foreign investment.
Non-Cooperative Financial Tools: Limiting access to local currency markets, restricting foreign investment, sanctions.
Types of Geopolitical Risk:
Event Risk
Event risk revolves around set dates, such as elections, new legislation, or political anniversaries, known in advance. These events often result in changes to investor expectations regarding a country’s cooperative stance.
Example: United Kingdom’s EU Referendum (Brexit)
Types of Geopolitical Risk:
Exogenous Risk
Exogenous risk involves sudden or unanticipated events that impact a country’s cooperative stance or the ability of non-state actors to globalize. Examples include sudden uprisings, invasions, or natural disasters.
Example: Japan’s Fukushima Nuclear Disaster (2011)
Types of Geopolitical Risk:
Thematic Risk
Thematic risks evolve and expand over time and include climate change, pattern migration, the rise of populism, and cyber threats.
Assessing Geopolitical Threats:
Likelihood
The probability that the risk will occur.
Assessing Geopolitical Threats:
Velocity
The pace at which the risk impacts the portfolio.
High-velocity risks
High-velocity risks: Immediate impacts, often causing market volatility (e.g., black swan events).
Example: COVID-19 Pandemic
Market Reaction: Significant decline in equity markets and volatility in bond yields.
Assessing Geopolitical Threats:
Size and Nature of Impact
The magnitude and nature of the risk’s effect on investments.
Medium-velocity risks
Medium-velocity risks: Affect companies’ processes, costs, and opportunities over time.
Low-velocity risks
Low-velocity risks: Long-term impacts on asset allocation and investment strategy.
Low-Velocity Risks
Prolonged impacts on revenues, costs, and valuation of companies and sectors.
Example: Long-term impacts of COVID-19 on mobility and consumption patterns
Scenario Analysis
Evaluating portfolio outcomes across different circumstances helps understand potential impacts.
Can be qualitative (building narratives) or quantitative (measuring portfolio sensitivity).
Tracking Risks
Identifying signposts (indicators or events) helps gauge the likelihood and impact of risks.
Differentiating between politics (indications) and policies (real impacts) is crucial.
Which of the following types of risks are known in advance? Select all that apply.
A.Event risk
B.Exogenous risk
C.Thematic risk
A and C are correct.
Event risk evolves around set dates, and thematic risk is a known risk that evolves and expands over a period of time. Exogenous risk is a sudden or unanticipated risk.
True or False: Higher-velocity geopolitical risks are most likely to have a prolonged impact on investor inputs.
Explain your selection.
A.True
B.False
B is correct. Higher-velocity risks are most likely to manifest in market volatility via prompt changes in asset prices. Lower-velocity geopolitical risks are likely to have a prolonged impact on investor inputs. The terrorist attacks of 11 September 2001 in the United States are an example of a higher-velocity geopolitical risk as the market had a sharp downturn and rebounded in a relatively short amount of time.
True or false: The probability and impact of geopolitical risks influence relative asset price discount rates across emerging and developed markets.
Explain your selection.
A.True
B.False
A is correct. For countries, regions, or sectors perceived to be at more consistent risk of geopolitical disruption, investors may require higher compensation, effectively increasing the discount rate used in valuation. When portfolio investment flows face greater volatility because of geopolitical factors, investors will factor in a higher risk premium. This explains why asset prices in emerging markets typically are maintained at a discount to those in developed countries perceived to have a lower threat of geopolitical risk, with the latter more likely to experience lower probability risks with lesser impacts.
Benefits of International Trade:
Gains from Exchange and Specialization:
Higher Prices for Exports
Countries can receive higher prices for their exports, increasing profits.
Benefits of International Trade:
Gains from Exchange and Specialization:
Lower Prices for Imports
Countries can pay lower prices for imported goods compared to producing them domestically, leading to cost savings and increased efficiency.
Benefits of International Trade:
Gains from Exchange and Specialization:
Efficient Resource Allocation
Trade enables countries to specialize in the production of goods for which they have a comparative advantage, resulting in more efficient allocation of resources and increased overall welfare.
Benefits of International Trade:
Economies of Scale:
Reduced Costs
Industries with increasing returns to scale, such as the automobile and steel industries, benefit from larger markets, which reduce the average cost of production as output increases.
Benefits of International Trade:
Economies of Scale:
Greater Efficiency
Firms become more efficient as they expand production and compete in larger, international markets.
Benefits of International Trade:
Product Variety and Competition:
Increased Product Variety
Consumers have access to a wider variety of goods and services, enhancing their choices and satisfaction.
Benefits of International Trade:
Product Variety and Competition:
Enhanced Competition
International trade increases competition, reducing the monopoly power of domestic firms and pushing them to improve efficiency and innovation.
Benefits of International Trade:
Intra-Industry Trade:
Export and Import within the Same Industry
Countries often engage in intra-industry trade, where they export and import different varieties of the same product. This is common in monopolistically competitive industries where firms produce differentiated products.
Benefits of International Trade:
Economic Growth and Innovation:
Increased GDP
Trade liberalization can lead to increased real GDP through more efficient resource allocation, learning by doing, and higher productivity.
Benefits of International Trade:
Economic Growth and Innovation:
Knowledge Spillovers
Trade fosters the exchange of ideas and technical expertise, leading to innovation and improved productivity.
Benefits of International Trade:
Economic Growth and Innovation:
Development of Institutions
Exposure to international markets can lead to the development of better institutions and policies that encourage innovation and economic growth.
Costs of International Trade:
Income Inequality:
Widening Gap
Trade can exacerbate income inequality within countries, as some sectors and workers benefit more than others.
Costs of International Trade:
Income Inequality:
Impact on Low-Skilled Workers
In developed countries, low-skilled workers may face increased competition from imports, leading to job losses and wage suppression.
Costs of International Trade:
Job Losses and Industry Adjustment:
Reallocation of Resources
As countries specialize based on comparative advantage, resources (including labor) must be reallocated from contracting industries facing import competition to expanding export industries.
Costs of International Trade:
Job Losses and Industry Adjustment:
Unemployment and Retraining
Less efficient firms may exit the market, leading to higher unemployment and the need for retraining programs for displaced workers.
Costs of International Trade:
Short-Term and Medium-Term Costs:
Adjustment Costs
The process of adjusting to new trade patterns can impose significant short-term and medium-term costs on certain groups, including workers, firms, and communities.
Costs of International Trade:
Short-Term and Medium-Term Costs:
Economic Dislocation
Communities dependent on industries that decline due to import competition may experience economic dislocation and social challenges.
Types of Trade Restrictions:
Tariffs:
Definition
Taxes imposed on imported goods.
Types of Trade Restrictions:
Tariffs:
Objective
Protect domestic industries and reduce trade deficits.
Types of Trade Restrictions:
Tariffs:
Impact
Increases the price of imported goods, reducing demand for imports and encouraging domestic production.
Types of Trade Restrictions:
Quotas:
Definition
Limits on the quantity of a good that can be imported within a specified period.
Types of Trade Restrictions:
Quotas:
Objective
Protect domestic industries from foreign competition.
Types of Trade Restrictions:
Quotas:
Impact
Restricts supply, raises prices, and reduces consumer surplus
Types of Trade Restrictions:
Voluntary Export Restraints:
Definition
Limits on the quantity of goods that an exporting country agrees to export to an importing country.
Types of Trade Restrictions:
Voluntary Export Restraints:
Objective
Avoid more severe trade restrictions from the importing country.
Types of Trade Restrictions:
Voluntary Export Restraints:
Impact
Similar to quotas but benefits are captured by the exporting country.
Types of Trade Restrictions:
Export Subsidies:
Definition
Payments made by the government to domestic firms for each unit of goods exported.
Types of Trade Restrictions:
Export Subsidies:
Objective
Encourage exports and improve the trade balance.
Types of Trade Restrictions:
Export Subsidies:
Impact
Distorts trade, encourages overproduction, and reduces global welfare.
Types of Trade Restrictions:
Domestic Content Requirements:
Definition
Regulations requiring a certain percentage of a product’s value to be produced domestically.
Types of Trade Restrictions:
Domestic Content Requirements:
Objective
Support local industries and jobs.
Types of Trade Restrictions:
Domestic Content Requirements:
Impact
Can increase production costs and reduce the efficiency of resource allocation.
Economic Implications of Trade Restrictions:
Tariffs:
Consumer Surplus
Decreases due to higher prices for imported goods.
Economic Implications of Trade Restrictions:
Tariffs:
Producer Surplus
Increases as domestic producers can sell more at higher prices.
Economic Implications of Trade Restrictions:
Tariffs:
Government Revenue
Increases from the tariff levied on imports.
Economic Implications of Trade Restrictions:
Tariffs:
National Welfare
Generally decreases due to deadweight loss from reduced consumption and inefficient production.
import license
Specifies the quantity of a good that can be imported into a country.
Quota rents
Profits that foreign producers can earn by raising the price of their goods higher than they would without a quota.
Trading blocs or regional trading agreements (RTAs)
Trading blocs or regional trading agreements (RTAs) involve groups of countries that sign agreements to reduce and progressively eliminate barriers to trade and the movement of production factors among members. These agreements may or may not include common trade barriers against non-members.
Types of Trading Blocs:
Free Trade Area:
Definition
An arrangement where all barriers to the flow of goods and services among members are eliminated.
Types of Trading Blocs:
Free Trade Area:
Features
Each country maintains its own policies against non-members.
Types of Trading Blocs:
Customs Union:
Definition
An FTA with a common external trade policy against non-members.
Types of Trading Blocs:
Common Market::
Definition
A customs union that also allows free movement of factors of production among members.
Types of Trading Blocs:
Economic Union:
Definition
A common market with integrated economic policies and institutions.
Types of Trading Blocs:
Economic Union:
Example
European Union (EU)
Types of Trading Blocs:
Free Trade Area:
Example
USMCA (United States-Mexico-Canada Agreement).
Chile and Australia have a free trade with each other but have separate trade barriers on imports from other countries. Chile and Australia are a part of a(n):
A.FTA.
B.economic union.
C.customs union.
D.common market.
A is correct. Chile and Australia do not a have customs union because they do not have a common trade policy with respect to other trade partners (C is incorrect). A common market or an economic union entail even more integration (B and D are incorrect).
An RTA that removes all tariffs on imports from member countries, and has common external tariffs against all non-members, but does not advance further in deepening economic integration is called a(n):
A.FTA.
B.economic union.
C.customs union.
D.common market.
C is correct.
Trade creation
When regional integration results in the replacement of higher cost domestic production by lower cost imports from other members.
Trade diversion
When regional integration results in lower-cost imports from non-member countries being replaced with higher-cost imports from members.
FX Market:
Functions:
Currency Conversion
Facilitates international trade by allowing entities to convert currencies.
FX Market:
Functions:
Hedging
Helps manage currency risk through various financial instruments.
FX Market:
Functions:
Speculation
Provides opportunities for profit from currency value fluctuations.
FX Market:
Functions:
Arbitrage
Allows exploitation of price differences across markets
FX Market:
Participants:
Corporates
Engage in FX transactions for cross-border trade and investment.
FX Market:
Participants:
Leveraged Accounts
Consist of hedge funds, proprietary trading shops, and other active trading accounts.
FX Market:
Participants:
Real Money Accounts
Include insurance companies, mutual funds, pension funds, and endowments.
FX Market:
Participants:
Governments
Conduct FX transactions for operational and policy purposes
FX Market:
Participants:
Central Banks
Intervene to influence exchange rates or manage FX reserves
Nominal Exchange Rates
The price of one currency in terms of another.
Real Exchange Rates
Adjusted for price levels in the respective countries
Spot Transactions
Immediate exchange of currencies at current exchange rates.
Forward Transactions
Agreements to exchange currencies at a future date at a predetermined rate.
FX Swaps
Combining spot and forward transactions to manage currency exposure and financing needs.
Direct Quote
Domestic currency as price currency
Another way of understanding a direct exchange rate quote is that it is the price of one unit of foreign currency in terms of your own currency.
Indirect Quote
Domestic currency as base currency
Two-Sided Prices
Bid (buy price) and offer (sell price) quotes for the base currency.
EUR/CHF = 1.1583–1.1585
Bid: CHF1.1583 per EUR1
Offer: CHF1.1585 per EUR1
A dealer based in New York City provides a spot exchange rate quote of 18.8590 MXN/USD to a client in Mexico City. The inverse of 18.8590 is 0.0530.
From the perspective of the Mexican client, the most accurate statement is that the:
A.direct exchange rate quotation is equal to 0.0530.
B.direct exchange rate quotation is equal to 18.8590.
C.indirect exchange rate quotation is equal to 18.8590.
B is correct. A direct exchange rate uses the domestic currency as the price currency and the foreign currency as the base currency.
If the bid/offer quote from the dealer was 18.8580–18.8600 MXN/USD, then the bid/offer quote in USD/MXN terms would be closest to:
A.0.05302–0.05303.
B.0.05303–0.05302.
C.0.053025–0.053025.
A is correct. An MXN/USD quote is the amount of Mexican pesos the dealer is bidding (offering) to buy (sell) USD1.
Note that in any bid/offer quote, no matter which base or price currencies are used, the bid is always lower than the offer.
A decrease in the real exchange rate (quoted in terms of domestic currency per unit of foreign currency) is most likely to be associated with an increase in which of the following?
A.Foreign price level.
B.Domestic price level.
C.Nominal exchange rate.
B.Domestic price level.
Types of Exchange Rate Regimes:
No Separate Legal Tender
Countries adopt another country’s currency
OR
Multiple countries share a common currency
Types of Exchange Rate Regimes:
Currency Board System (CBS)
Domestic currency exchangeable for a foreign currency at a fixed rate.
Types of Exchange Rate Regimes:
Fixed Parity:
Exchange rate pegged to a single currency or basket of currencies.
Government intervenes to maintain the rate within a narrow band.
Types of Exchange Rate Regimes:
Target Zone
Fixed parity with wider bands, allowing more flexibility
Types of Exchange Rate Regimes:
Crawling Pegs
Exchange rate adjusted frequently to reflect inflation or other economic indicators.
Passive Crawl: Exchange rate changes in line with inflation.
Active Crawl: Pre-announced rate changes to influence inflation expectations.
Implications for Trade and Capital Flows:
Pegged System
Provided stability during a crisis but limited monetary policy flexibility.
Implications for Trade and Capital Flows:
Managed Float
Offers a balance between stability and flexibility, allowing Malaysia to adjust to external shocks while pursuing domestic economic objectives.
Types of Exchange Rate Regimes:
Managed Float
Exchange rate influenced by government intervention to meet policy targets.
Is there an ideal exchange rate regime?
No.
No ideal regime can provide fixed exchange rates, full convertibility, and independent monetary policy simultaneously.
An exchange rate:
A.is most commonly quoted in real terms.
B.is the price of one currency in terms of another.
between two currencies
C.ensures that they are fully convertible.
B is correct. The exchange rate is the number of units of the price currency that one unit of the base currency will buy. Equivalently, it is the number of units of the price currency required to buy one unit of the base currency.
Which of the following is not a condition of an ideal currency regime?
A.Fully convertible currencies
B.Fully independent monetary policy
C.Independently floating exchange rates
C is correct. An ideal currency regime would have credibly fixed exchange rates among all currencies. This would eliminate currency-related uncertainty with respect to the prices of goods and services as well as real and financial assets.
Properties of an Ideal Currency Regime
An ideal currency regime would feature:
1.Credibly Fixed Exchange Rates: Eliminates currency-related uncertainty.
2.Full Convertibility: Ensures unrestricted capital flow.
3.Independent Monetary Policy: Allows countries to pursue domestic economic objectives.
Capital Restrictions
Government imposes capital restrictions to control both the inward and outward flow of capital for various economic, strategic, and defense-related reasons.
Capital Restrictions:
Objectives:
Economic Stability
Economic Stability:
Preventing capital flight during economic crises.
Capital Restrictions:
Objectives:
Strategic Interests
Strategic Interests:
Protecting strategic industries such as defense and telecommunications.
Capital Restrictions:
Objectives:
Regional Development
Encouraging investment in specific regions
Capital Restrictions:
Objectives:
Employment Goals
Promoting domestic employment by controlling foreign investments.
Capital Restrictions:
Types:
Inward Investment Restrictions:
Ownership Limits
Restrictions on foreign ownership in strategic industries.
Capital Restrictions:
Types:
Inward Investment Restrictions:
Investment Approval
Requirement for governmental approval for foreign investments.
Capital Restrictions:
Types:
Outward Investment Restrictions:
Repatriation Limits
Restrictions on repatriation of capital, interest, profits, royalty payments, and license fees.
Capital Restrictions:
Types:
Outward Investment Restrictions:
Investment Abroad
Limits on citizens’ ability to invest abroad, particularly in foreign exchange (FX)-scarce economies.
Types of Capital Controls:
Taxes
Special taxes on returns to international investments.
Transaction taxes on certain types of capital flows.
Types of Capital Controls:
Price Controls
Mandatory reserve requirements for foreign deposits in domestic banks.
Types of Capital Controls:
Quantity Controls
Ceilings on foreign borrowing.
Requirements for special
authorization for certain cross-border transactions.
Types of Capital Controls:
Administrative Controls
Government agency approval required for certain types of international asset transactions.
Effectiveness of Capital Controls:
Inflow Restrictions
Require comprehensive and forceful implementation to be effective.
Administrative costs are high, and effectiveness is often difficult to distinguish from other policies like monetary adjustments.
Effectiveness of Capital Controls:
Outflow Restrictions
Mixed results during financial crises.
Some countries experienced temporary relief, while others, like Malaysia, successfully shielded their economies and restructured.
