Economics Flashcards
Absolute version of PPP
Prices of goods and services will not differ internationally once exchange rates are considered
Covered interest rate parity
Relationship that ensures that the return on a hedged (covered) foreign risk-free investment is the same as the return on a domestic risk-free investment
- *Currency with the higher nominal interest rate will trade at a forward discount
- *When covered interest rate parity holds, an investor will make the same return holding either currency
Ex-ante PPP
Expected changes in the spot exchange rate are equal to expected differences in national inflation rates
Forward rate parity
Forward exchange rate is an unbiased predictor of the future spot exchange rate
International fisher effect
Nominal interest rate differentials across currencies are determined by expected inflation differentials
Law of one price
If two investments have the same or equivalent future cash flow regardless of future events, the two investments should have the same current price
Portfolio balance approach
Theory of exchange rate determination focused on portfolio investment decisions of global investors that they willingly hold all outstanding securities denominated in each currency at prevailing prices and exchange rates
**Looks at long-term applications of fiscal policy. Governments may find it increasingly difficult to fund sustained deficits leading to depreciation of currency
Purchasing Power Parity (PPP)
Exchange rates move to equalize the purchasing power of different currencies
Real Interest Rate Parity
Real interest rates will converge to the same level across different markets
Relative version of PPP
Hypothesis that changes in nominal exchange rates over time are equal to national inflation rate differentials
Triangular Arbitrage
Arbitrage transaction involving three currencies that attempts to exploit inconsistencies among pairwise exchange rates
Uncovered Interest Rate Parity
Expected return on unhedged (i.e. uncovered) investment should equal the return on a comparable domestic currency investment
Assumptions:
- Investors are risk neutral
- Real interest rates are = globally
Relative PPP + international fisher relation
E(🔺S) = R(A) - R(B)
Absolute convergence
Developing countries, regardless of their characteristics, will eventually catch up with developed counties and match them in per capita output
Capital deepening
An increase in capital-to-labor ratio
K/L
Club convergence
Notion that only rich and middle-income countries sharing a set of favorable attributes will converge to the income level of the richest countries
FOREX Quotations
Bid - sell at the bid / dealer will buy
Ask - buy at ask / dealer will sell
X/Y; X = price currency; Y = base currency
Rule of Thumb - Bid price will always be less than the offer price
Factors Affecting Bid-Ask Spread
- Spread in the (wholesale) interbank market
a) Currency pair (liquidity)
b) Time of day window
c) Market volatility - Size of transaction (big is worse)
- Dealer/client relationship
- Forward spreads are positively related to maturity (wider as maturity increases due to increase in risk)
Cross Rates (Triangular Arbitrage)
Exchange rate between two currencies implied by their exchange rates with a common third currency
Structuring Arbitrage Trade is Key**
Rule of thumb:
Dealer Bidding Too Low:
Dealer(Bid) > Cross-rate(Ask)
Dealer Asking Too Low:
Dealer(Ask) < Cross-rate(Bid)
Mark-to-Market Value of a Forward Contract (formula)
V(price currency)t =
(FPt - FP)(contract size)
————————————
[1 + Rp(days remaining/360)]
FPt = bid price R = interest rate of price currency
Covered Interest Rate Parity (Formula)
[1+rprice(n/360)]
Spot x ———————
[1+rbase(n/360)]
Ex-ante version of Relative PPP
Expected spot price = changes in expected inflation
i.e. Countries with higher inflation expect to see their currencies depreciate by the inflation differential
Domestic Fisher Relation
R = r + E(inflation)
R = nominal interest rate r = real interest rate
Carry Trade
A leveraged Investment strategy that involves taking long positions in high-yield currencies and short positions in low-yield currencies
Investment - borrowing cost - currency depreciation
Note: In times of high volatility, the country with the higher interest rate typically sees its currency depreciate by a greater amount
**Negative skewness and excess kurtosis of return distribution
Current Account Influences
- Flow mechanism -Size of initial deficit (large deficit will have a bigger pressure on exchange rates)
- Influence of changes in exchange rates on domestic imports and export prices
- Price elasticity of demand
- Portfolio composition mechanism
- Debt sustainability mechanism
***Deficits eventually cause currency to depreciate
Capital (Financial) Account Influence
Determined by relative real rates of return. Higher real rate countries attract capital flows, which results in appreciation of domestic currency.
**Note: Opposite of the uncovered interest rate parity
Mundell-Fleming Model
Looking at short term interest rate impact from monetary and fiscal policy when capital mobility is both high and low
Monetary / Fiscal Capital Mobility H / L
Exp / Exp Uncertain / Dep
Rest / Rest. Uncertain / App
Exp / Rest. Dep / Uncertain
Rest / Exp App / Uncertain
Warning Signs of Currency Crisis
- Terms of train deteriorate (ratio of exports to imports
- Fixed or partially-fixed exchange rates
- Official foreign exchange reserves decline
- Currency value risen above historical mean
- Inflation increases
- Liberalized cap mkts, free flow of capital
- Money supply relative to bank reserves increases
Pure Monetary Approach
PPP holds at any point in time. Expansionary (restrictive) monetary policies lead to higher (lower) inflation and depreciation (appreciation) of currency
Dornbusch overshooting model
Prices may not reflect policy changes in sync (sticky output prices). This leads to overreaction to policy changes.
Exp (restrictive) monetary policies lead to higher (lower) inflation and excessive depreciation (appreciation) of currency
Central bank objectives
- Ensure that the domestic currency does not appreciate excessively
- Allow the purist of independent monetary policies
- Reduce excessive inflow of capital
Effectiveness of Central Bank intervention
In FX markets, it depends on the size of the central bank reserves relative to trading volume of their currency (not effective for developed nations)
Equity Market Trends and Exchange rates
Exchange rates and equity market returns are unstable (short-term) and tend toward zero long-term.
In short-term, correlations tend to swing from being highly positively correlated to being highly negative depending on market conditions - i.e. unstable
Rule to determine Arbitrage - Borrow domestic or foreign?
Borrow domestic lend foreign if:
(rd - rf) < (forward - spot) / spot
Borrow foreign lend domestic if:
(rd - rf) > (forward - spot) / spot
Pre-conditions for economic growth
- Savings and Investment - private and public sector investment must provide sufficient level of capital per worker
- financial markets/intermediaries - efficient allocation of resources. Creation of
- Political stability, rule of law, and property rights - protection of investment via judicial law, reduction of uncertainty due to wars or corruption
- Investment in human capital - investment in skill set and well being of workers
- Tax and regulatory system - less regulation and lower tax burden spurs economic growth
- Free trade and unrestricted capital flows - positively related to growth. Trade allows countries to have comparative advantage
Stock Market Appreciation
P = (GDP) x (E/GDP) x (P/E)
In long run; growth in equity prices = GDP growth rate
Potential GDP
Maximum amount of output an economy can sustainably produce without inducing an increase in the inflation rate.
Used to gauge inflationary pressures in the economy; actual >(
GDP growth rate implications for fixed-income investors
When actual GDP > potential GDP
Inflationary pressures are high; to offset inflation pressure, country will look to restrict monetary policy, which will increase nominal and real interest rates and reduce inflation
Increase in nominal & real interest rates results in reduction in bond prices (inverse relationship)
Cobb-Douglas Production Function
Y = TK(^a)L(^1-a)
Where (a) and (1-a) are shares of output allocated to labor and capital
Alpha < 1; T = total factor productivity
Three attributes:
- Diminishing marginal productivity (because alpha < 1) of labor and capital
- constant returns to scale (if both capital and labor are increased by same amount, output will increase by that amount)
- In equilibrium, marginal product of capital (MPK) = rental price of capital (r)
Capital deepening
Increase of capital per labor when MPR > r until MPK = r; movement along the productivity curve; results in higher standard of living
Capital deepening will occur immediately after a technological change (i.e., growth in total factor productivity)
Growth Account Relations used to forecast potential GDP
- Cobb-Douglas production function:
Growth in potential GDP = (🔺technology) + alpha x(🔺capital) + (1-alpha) x (🔺labor)
In words:
Growth rate in potential GDP = long-term growth rate of technology + (alpha x long-term growth rate of capital) + (1-alpha) x (long-term growth rate of labor)
Forecasting potential GDP using the labor productivity growth accounting equation
Growth rate in potential GDP = LT growth in labor force + LT growth in labor productivity
LT growth rate in labor productivity is reflective of both technology change and capital deepening
Impact of Natural Resources on GDP
Ownership of natural resources is not important as long as there is access via trade
Ownership of natural resources may actually hinder growth a.k.a. Dutch disease - countries put all their efforts to maximize output of natural resources at the detriment of other industries
Labor supply factors
- Demographics - aging of population
- Labor force participation - labor force (working or actively looking for work) / working age population
- Immigration - enabling the import of labor force for countries with low population growth
- Average hours worked - high tax rate may take a negative toll on workers and require them to work extra, legislation limiting hours worked
Capital and Technology Supply Factors
- Human capital - knowledge (education) and skill set of workers
- Physical capital
ICT - information and communication technology
non-ICT - machinery, transportation
- Technological development (Includes investment in physical & human capital)
- Public infrastructure - investment in construction of public roads, bridges, etc.,
Classical growth theory
No permanent improvement in standard of living from new technologies
Technological advances lead to:
- Short-term economic growth
- Temporary improvement of standard of living
Economic lead will lead to further population growth and reverses any improvement in standard of living back to a mean
Neoclassical Growth Theory
**More important
Economic growth resulting from lucky discoveries of new technologies
Technological advances lead to:
- short-term economic growth
- Permanent higher living standard
- Capital deepening occurs affecting output but not the growth rate until steady state is reached (i.e. MPK = r)
- Developing counties (low K/L) will have a lower diminishing marginal productivity of capital
Benefit of open markets is temporary
Difference from Classical:
Removes population from the equation
Economic growth is independent of population growth
Technology is exogenous (outside of model)
Sustainable growth rate of output per capita (g)
g* = growth rate of TFP / 1 - alpha
Also the steady state growth rate of labor productivity
Output-to-capital ratio is constant
growth in Capital-to-labor ratio and output per worker occur at the same rate
Steady state growth rate of output
G* = [growth in TFP / (1 -alpha)] + labor force growth
Endogenous Growth Theory
Technological progress is endogenous and built into the model
Total factor productivity is a function of K/L; as capital per labor output increases, capital deepening will occur which will result in additional capital per labor output (perpetual motion)
Innovation leads to higher profits which lead to more investment which leads to societal returns
Open markets lead to higher rate of growth permanently for all markets
Regulatory Tools used by regulators
- Price mechanism - taxes and subsidies to further regulatory objectives
- Restriction/Requirement of certain activities
- Provision of public goods or financing of private projects - regulators provide public goods (e.g. national defense) or fund private projects (e.g. small business loans)
Prudential supervision
Regulation of financial markets to reduce system-wide risks that come from financial institutions interlinked with each other and to protect investors (small, unsav)
Classifications of regulations
- Statutes - laws made by legislative bodies
- Administrative regulations - rules issued by government agencies or other bodies authorized by the government)
- Judicial law - findings of the court (interpretation of law; legal framework)
Independent regulators
Given recognition by government agencies and have power to make rules and enforce them
Not funded by the government and politically independent
E.g., Public Company Accounting Oversight Board (PCAOB)
Self-regulatory bodies (SRBs)
Private organizations that represent as well as regulate their members.
Increase the overall level of regulatory recourse , utilize industry professionals
Self-regulating organizations (SROs)
Recognized by the government and given enforcement powers
E.g., FINRA recognized by SEC
Regulatory capture theory
Based on the assumption that a regulatory body will (at some point) be influenced or controlled by the industry that is being regulated
More likely a concern with SROs than governmental agencies
Regulatory Competition & Arbitrage
Regulatory differences between jurisdictions can lead to competition in which regulators compete to provide the most business-friendly regulatory environment
Regulatory arbitrage occurs when businesses shop for a country that allows a specific behavior rather than changing behavior
Also entails exploiting the difference between the economic substance and interpretation of a regulation
Adjustment to exchange rates to restore current accounts to a balanced position depends on what?
- Level of initial deficit
- Response of import and export demand to changes in import and export prices
- Response of import and export prices to changes in the exchange rate
Factors impacting steady state growth
Saving rate, growth rate of labor force, and the depreciation rate all change the level of output per worker but do not permanently change the growth rate of output per worker
Taylor Rule
Taylor rule prescribed central bank policy rate (i) =
r(n) + CI + a(CI - CI) + b(y-y)
a & b = .5 each
r(n) = neutral policy rate CI = current inflation CI* = target inflation Y = log of current level of output Y* log of target level of output
Coase Theorem
States if an externality can be traded and there are no transaction costs, then the allocation of property rights will be efficient and the resource allocation will not depend on the initial assignment of property rights
