Final Exam Flashcards
Why Do Bubbles Happen
When people buy assets for no reason other than that they think the price will go up.
Define Aggregate Demand Curve
Shows the relationship between the overall price level and the level of total demand in the economy.
Define The Wealth Effect
When people are less wealthy, they reduce their consumption.
A negative relationship between the overall price level and consumption spending.
Relationship Between Prices (Price Level) And The Interest Rate
When prices rise, the interest rate also tends to rise.
The increased borrowing costs create an indirect negative relationship between the price level and investment spending.
Relationship Between Price Level And Government Spending
Much of government spending is independent of the price level.
Relationship Between Price Level And Net Exports
When price level increases, net exports should decrease.
Negative relationship between price level and net exports.
Graphing Changes In The Price Level (Price Increase And What Causes A Shift)
A price increase is represented by a downward shift of the planned aggregate expenditure line
Anything other than a change in the price level itself that leads to a different equilibrium in the aggregate expenditure model will cause the aggregate demand curve to shift.
Consumption - What Causes The Aggregate Demand Curve To Shift (Increase (right), Decrease (left))
Increase (shift right): high expectations about future income, tax cuts.
Decrease (shift left): low expectations about future income, higher interest rates.
Investment - What Causes The Aggregate Demand Curve To Shift (Increase (right), Decrease (left))
Increase (shift right): confidence in the future economy, tax credit for businesses.
Decrease (shift left): recessions, taxes on capital increase, higher interest rates.
Government Spending - What Causes The Aggregate Demand Curve To Shift (Increase (right), Decrease (left))
Increase (shift right): increased government spending spurs spending during a recession.
Decrease (shift left): decreased government spending in response to concerns about increasing debt leads to less spending.
Net Exports - What Causes The Aggregate Demand Curve To Shift (Increase (right), Decrease (left))
Increase (shift right): new free trade agreement, economic growth abroad (increases demand for Canadian goods).
Decrease (shift left): other countries increase their tariffs, the dollar strengthens making domestic goods more expensive for international consumers.
Expenditure Multiplier Formula And Finding Stimulus Spending
Expenditure Multiplier = 1/(1-b)
b is the Marginal Propensity to Consume
(amount of put in by government) (expenditure multiplier) = money that will be spent
Aggregate Supply Curve vs Market Supply Curve
Aggregate supply curve: production in the economy as a whole, difference between short run and long run.
What Does Long Run Imply
It is however long it takes for prices of inputs to fully adjust to changes in economic conditions.
Define Business Cycle (define, boom, bust/recession)
Fluctuations around the level of potential output.
Boom: when output is higher than potential output
Bust/recession: output is below potential output
How Are Economic Booms Possible (short run) And How They Return (long run)
Short run: Production can be expanded beyond long run potential by pressing all of the factors of production beyond their normal capacity.
Long run: Intense demand for labour and capital when an economy is operating above capacity will drive prices upward.
Define Supply Shocks
Significant events that directly affect production, can be positive or negative.
What Shifts The Long Run Supply Curve (right, left)
Right: if the potential output of the economy expands.
Left: if the economy loses productive capacity.
Technology - What Causes The Long Run Aggregate Supply Curve To Shift (Increase (right), Decrease (left))
Increases: innovation allows for greater production using the same amount of inputs.
Decreases: reduction in incentive to innovate.
Capital - What Causes The Long Run Aggregate Supply Curve To Shift (Increase (right), Decrease (left))
Increases: foreign investment in factories and machines increases available capital.
Decreases: depreciation and wear break down capital.
Labour - What Causes The Long Run Aggregate Supply Curve To Shift (Increase (right), Decrease (left))
Increases: immigration increases the available supply of labour.
Decreases: aging population takes workers out of the labour force.
Education - What Causes The Long Run Aggregate Supply Curve To Shift (Increase (right), Decrease (left))
Increases: universal primary education gives everyone a chance to go to school.
Decreases: reduction of federal university grants.
Natural Resources - What Causes The Long Run Aggregate Supply Curve To Shift (Increase (right), Decrease (left))
Increases: new energy sources allow factories to produce more with the same inputs.
Decreases: climate change permanently reduces the amount of land that can be farmed.
Do The LRAS And SRAS Always Shift Together?
No
Everything that shifts LRAS shifts SRAS but not the other way around.
The only things that can shift LRAS is factors that affect how we produce.
Increase In AD (short run and long run)
ex. increase in government spending.
short run: output increases, price increases
long run: output unchanged, price increases
Decrease In AD (short run and long run)
ex. reduction in consumer confidence.
short run: output decreases, price decreases
long run: output unchanged, price decreases
Temporary Supply Shocks
only shifts the SRAS curve
stagflation and high inflation.
Wages are stick downward: takes a long time for them to fall.
Define Stagflation
When output decreases while prices increase.
Permanent Supply Shocks
Will shift both the LRAS and SRAS curves
Is It A Demand Or Supply Shock
Demand: a shock that affects consumers or government spending.
Supply: a shock that affects investment.
Short Run Demand Shock (positive, negative)
Positive: output increases, price increases
Negative: output decreases, price decreases
Long Run Demand Shock (positive, negative)
Positive: No change in output, price increases
Negative: No change in output, price decreases
Temporary Short Run Supply Shock (positive, negative)
Positive: output increases, price decreases
Negative: output decreases, price increases
Temporary Long Run Supply Shock (positive, negative)
Positive: no change in output, no change in price
Negative: no change in output, no change in price
Permanent Long Run Supply Shock (positive, negative)
Positive: output increases, price decreases
Negative: output decreases, price increases
Long Run Effect Of Government Spending To Counter Negative Demand Shocks
Previous level of output will be restored, slightly higher price level.
Government Spending And Shocks
Short term policy action that is often applied to address short term demand shocks
Define Fiscal Policy
Government decisions about levels of taxation and public spending.
Tax Policy
Directly affects consumption (C) in aggregate demand due to the effect on disposable income (income after taxes). Ex. Tax rate increase → less disposable income → less spending → aggregate demand curve shifts left
Define Expansionary Fiscal Policy
Government spending/taxation intended to increase aggregate demand (ex. Increased government spending or lowered taxes to boost demand- this is often termed Keynesian policy)
Define Keynesian Policy
Increased government spending or lowered taxes to boost demand.
Define Contractionary Fiscal Policy
Intended to decrease aggregate demand, when the economy is growing too fast.
Decreasing output & price levels. (ex. Decrease govt spending)
Define Information Lag
Policy makers must make decisions for the future when they only know where the economy was a few months ago.
Crowding out
Government spending can crowd out (reduce) private-sector spending. As the government borrows money, interest rates increase, which then decreases investment by the private sector.
Define Formulation Lag
The time it takes to decide on and pass legislation by Parliament.
Define Implementation Lag
After policy has been passed, it takes time for it to take effect. (Ex. takes time for funds to be disbursed, employees hired, and materials purchased)
Define Automatic Stabilizers
Taxes and government spending that affect fiscal policy because they previously existed. They are not affected by lags.
What Are The Lags In Policy Making
Information lag, formation lag, and implementation lag.
Automatic Tax Policy
A tax system where people pay higher taxes depending on their tax bracket. The higher your income, the more taxes you pay automatically. This decreases spending to cool down the economy
Discretionary Tax Policy
Policy makers change tax rates owed on income due to recession/boom.
Define Ricardian Equivalence
The theory that if the government cut taxes, people realize that this will mean an increase in taxes later on. So people will spend less which makes the government stimulus strategy ineffective.
Define Public Debt
Total amount of money that a government owes at a point of time.
Define Budget Deficit
An amount of money a government spends beyond the revenue it brings in
Difference Between Deficit and Debt
Deficit is how much the govt revenue falls each year, whereas debt is the total amount the govt owes (includes deficits and surpluses)
Define Budget Surplus
An amount of revenue a government brings in beyond what it spends.
Define Treasury Securities
Government accepts money from people with the obligation to pay them back by a certain date.
Define Treasury Bills (T-bills)
loans to the govt that mature in less than a year. People bid for T-bills because they’re a safe investment where you can securely park money.
Define Treasury Notes
Paid in 2,3,5,7 year increments. You receive higher interest payments for these. The longest-term option is called a treasury bond, which matures in 30 years.
Define Real Return Bonds (RRB)
Government of Canada ensures inflation would not eat away at the investment by paying an amount tied to changes in CPI, while interest rate remains fixed.
Why Is Government Debt Good
the govt can be flexible in unexpected circumstances. It can also pay for investments that will lead to economic growth in the future.
Why Is Government Debt Bad
(direct costs) the interest govt has to pay back to people it borrowed from.
(indirect costs) govt debt can distort the credit market and slow economic growth because it causes crowding out in private borrowing.
Define Asset Backed Commercial Paper (ABCP)
short term investment that matures between 1-270 days, is backed by residential mortgages and commercial loans with low risk. Canadian financial institutions rely on them to finance long-term investment.
Define Information Asymmetry
When one participant in a transaction knows more than another.
Define Adverse Selection
when buyers/sellers have differing information on the quality of a good or the riskiness of the transaction. (Ex. a company knows it’s bankrupt but doesn’t tell stockholders)
Define Moral Hazard
Tendency for people to behave in riskier ways when they don’t face the full consequences of their actions. (Ex. a borrower secures a loan and considers making riskier investments that they didn’t outline in the agreement)
What Are The Main Functions Of Banks
Intermediary between savers and borrowers: connects you to a range of people who may have savings that you can borrow.
Providing liquidity: to have cash easily when you want it.
Diversifying Risk: risks are shared among many people/assets, so it won’t hurt only one person.
Define Market For Loanable Funds
savers supply funds to borrowers for their investment spending. Loanable funds is the money on the table that can be borrowed.
The Real Interest Rate
The price of money
Equilibrium Interest Rate & Quantity Of Money Traded In A Market For Loanable Funds
where the savings curve (supply) intersects the investment curve (demand).
Determinants Of Savings
wealth (rich people save more)
current economic factors (people lose jobs so they save less to pay for their needs)
expectations for future economic decisions (people expect income to be lower in the future so they save now)
uncertainty (more likely to save as a precaution for the future)
borrowing constraints (when borrowing is hard, people/firms will save more to finance purchases later on)
social welfare policies (incentive to save is affected by public policy that determine future benefits)
culture
Determinants Of Investment
Interest rate
expectations about future profitability and economic conditions
uncertainty (investors are uncertain about the economy’s path)
changes in the government’s budget deficit (when govt borrows more, it increases demand for loanable funds)
Define Crowding Out
The reduction in private borrowing that is caused by an increase in government borrowing.
What Are Interest Rates Driven By
length of time and degree of risk
Define Default
a borrower fails to pay back a loan according to the agreed terms.
Define Rise Free Trade
interest rate at which you would lend if there was no risk of default. This is calculated using interest rates of Canadian government debt (because they are unlikely to default).
What Is Credit Spread / Risk Premium
Difference between risk-free rate & interest rate
General Rule About Risk Of Default, Interest Rate, And The Risk Free Rate
In general, the longer the loan term and more likely there is a risk of default, the higher the interest rate is relative to the risk-free rate.
Define Liquidity
measure of how easily an asset can be converted to cash without loss of value. Ex. a car is liquid because it can be sold/checked easily, whereas a house is illiquid.
Define Market Maker
institutions that make a market by always being able to buy or sell (such as a bank, broker, mutual fund)
Major Financial Assets
Equity, Debt, Derivatives
Define Equity
when you own part of a company & share in its profits. (Ex. stocks– which can turn an illiquid asset like a company into a liquid one through the stock market)
Define Debt
the alternative to equity, most common being a loan. Safer than stocks but less rewarding.
Define Bond
Type of debt
an easily tradable asset (more liquid than loans). A bond issuer must repay the loan at a specific date and pay a periodic, set interest (fixed-income securities). Also receive a final payment of the original loan amount at the maturity date (principal, face value). Scheduled payments are called coupon payments (paid usually every 3-6 months).
Define Securitization
Turns many loans into a single larger asset to avoid individual defaulting.
Define Derivatives
an asset whose value is based on the value of another asset, such as a home loan, stock, bond, or barrel of oil. These transfer risk to people who can handle it.
Define Future Contract
managing your risk by transferring both good & bad risks about future price of an asset to another party.
Major Players In The Financial System
Banks and financial intermediaries, savers and proxies, entrepreneurs and businesses, speculators.
Banks And Financial Intermediaries (commercial banks and investment banks)
Commercial Banks: what you typically think of in a “bank”. When you make a deposit, get a mortgage, student loan, you’re dealing with a commercial bank.
Investment Banks: “bay street” banks. Provide liquidity to financial markets by acting as market makers. Issue stocks/bonds by agreeing to buy any that remain unsold (underwriting).
Savers And Proxies (proxies, mutual fund, pension fund)
Proxy: decide who to lend people’s money to. These include banks, mutual funds, pension funds, life insurance companies.
Mutual fund: portfolio of stocks and other assets managed by professionals.
Pension fund: provide income to retirees.
- Defined-benefit: fixed-payout to employees who meet certain entry req.
- Defined-contribution: don’t guarantee a defined pension level, provides payouts that depend on how the stock market performs
Entrepreneurs And Businesses
Are often looking to borrow money to finance their latest ventures. Without them, the system wouldn’t exist.
Speculators
Anyone who buys and sells assets purely for financial gain. Some believe that they help find “correct prices” for an asset. Other’s think they cause prices to swing wildly.
Risk And Return
if you face a high risk of losing money, you’ll want the chance of high return. EX. Assets like cash and fixed-income bonds have low risk, low return. Assets in emerging countries have a high return, high risk.
Define Diversification
Creating a portfolio of many different assets in several companies to reduce risk.
Define Market (Systemic) Risk
Risk that is shared by the entire market, such as inflation.
Define Idiosyncratic Risk
Unique to particular companies/assets. Diversification in your portfolio reduces idiosyncratic risk.
Define Fundamental Analysis
Trying to predict how much a company will make in the future to use that as a basis for calculating it’s worth right now.
Define Net Present Value (NPV)
measure of current value of a stream of cash flows expected in the future. Tells you the “correct” prices of shares in a company.
Define Technical Analysis
analyzes the past movements of a stock’s price to predict its future.
Define Efficient Market Hypothesis
states that market prices always incorporate all available information; it’s impossible to find a stock that is incorrectly priced.
Define Arbitrage
taking advantage of market inefficiencies to earn profit
Private Savings In A Economy With No Government Or Trade
Private savings = investment
How To Calculate Investment
Investment = private savings + public savings
How To Calculate National Savings
National savings = investment + net capital flow
Define Capital Outflow
Occurs when money saved domestically is invested in other countries.
Define Capital Inflow
When savings from another country finance domestic investment.
Define Net Capital Outflow
Difference between capital outflow and capital inflow.
Define Current Account Deficit
When a country import more than it exports.
What Functions Do Money Serve
A store of value: amount of purchasing power that money holds overtime. EX. a $100 bill stays 100, although it’s value may increase/decrease technically.
A medium of exchange between people
A unit of account (comparison) to make informed decisions on offers
Define Intrinsic Value
There is stability of value, and the currency’s value remains even when not used as money (ie. gold).
Define Commodity Backed Money
(usually paper money) that can be legally exchanged for a fixed amount of a commodity (generally gold). Ex. The Gold Standard of Canada and England which is now replaced by fiat.
Define Fiat Money
money created by rule without commodity to back it. The dollar has value because a government is trusted to keep using the dollar (while not creating too much of it).
Fractional Reserve Banking
keeps a reserve of less than 100. how a bank creates money
table 15.1 TB
Define Demand Deposits
funds held in a bank account that can be withdrawn in full at any time.
Define Reserves (+ required reserves, excess reserves, desired reserves)
the cash/deposits that a bank keeps in its vaults at the Bank of Canada.
required reserves are the minimum needed to be placed,
excess reserves go over the min.
Desired reserves is the amount the bank keeps on hand for depositors.
Reserve Ratio
= amount of cash kept as reserves / demand deposits.
Basic Accounting Equation (assets)
assets = liabilities + owners’ equity
Define Money Multiplier (+ equation)
ratio of money created by banks to the money created by govt central bank.
Ex. Reserve ratio of 10% means the multiplier is 1/0.10 = 10. With $1900 in liabilities, a bank will keep (reserve) 0.10x1900= $190. So, it will lend $1710.
Ex. when there is $1000 worth of reserves, you find the money multiplier 1/0.1= 10. Then, 10x1000= $10000 generated.
Money multiplier = 1 / Reserve Ratio (R)
The smaller the reserve ratio, the larger the money multiplier. This makes money worthless.
Define Bank Run
a bank is thought to not be able to satisfy depositors demands, so they all withdraw their deposits simultaneously.
Define Monetary Base
things that can be used in transactions immediately; cash and bank reserves
Define M1+
currency held by the public (notes and coins), chequing account balances, trust and mortgage loan companies, credit unions, and caisses populaires (demand deposits)
Define M2
everything in M1 plus personal savings accounts, non-personal notice deposits where money is locked away for a certain period of time. (can’t be accessed quickly without penalty fees) Ex. GICs
Think of M2 as a measure of “multiplied” money
What To Use When Measuring Money Supply (M1+, M2)
M1+: spending (liquidity)
M2: savings
Bank Of Canada (Central Bank)
main functions are issuing Canada’s bank notes, conducting monetary policy (managing the money supply), being a fiscal agent for the federal govt (acts as a govt bank), and being a lender of last resort for other banks.
makes monetary policies based on maintaining a stable money supply that meets the needs of the economy, while keeping prices constant overtime. (inflation control)
Tools Of Monetary Policy
Reserve requirement, open market operations, over night rate
Reserve Requirement (monetary policy)
(rarely used) the regulation that sets the minimum fraction of deposits banks must hold in reserve.
Open Market Operations (Expansionary Monetary Policy, Contractionary Monetary Policy)
central bank buys or sells bonds to a bank.
- Expansionary monetary policy: increase money supply to increase agg demand. If the central bank buys bonds from a bank, it increases the bank’s reserves. This creates a ripple effect and the commercial bank will increase lending.
- Contractionary monetary policy: Bank of Canada sells bonds to a bank, reducing the buying bank’s reserves, and destroys the money they receive to reduce money supply
Overnight Rate (Policy Interest Rate) (Monetary Policy)
(most used) interest rate at which banks lend reserves to one another, usually just overnight
Define Zero Lower Bond
the natural lower limit on interest rates.
Liquidity Preference Model (Keynes)
(Keynes) quantity of money people want to hold is a function of interest rate. If the interest rate is high, people will hold more bonds. If it’s low, they hold/demand liquid assets like cash.
Look at graphs
Define Real Values
quantities measured in terms of real, tangible goods/services
Define Nominal Values
how much money it takes to purchase something
Define Aggregate Price Level
measure of the avg price level for GDP (measured by either CPI or GDP price deflator)
Define Neutrality Of Money
in the long run, changes in the money supply only affect nominal values. EX. if $10 is inflated to $100, the nominal value has changed by 100 times, but its real value is the same (can buy 10 apples for $10 → 10 apples for $100)
Classical Theory Of Inflation
the relationship between money supply, output (GDP), and overall price levels
LOOK AT THE DIAGRAM
Quantity Theory Of Money
states explicitly that the price level is determined by the quantity of money. Inflation/deflation are primarily a result of changes in quantity of money.
Velocity Of Money
number of transactions in which a dollar is used during a given period. Your consumption is someone else’s income, and they’ll eventually spend their income. If the avg dollar is spent five times a year, then the velocity of that year would be five.
EX. 1000 units of output produced, with a price level of $1, and the money supply is $500. So, ($1 x 1000)/$500 = 2. Meaning each dollar in the money supply was spent twice.
Velocity of money (V) = [(Price level (P)) (Real output (Y))] / (Money supply (M))
(M)(V)=(P)(Y)
Define Cost Push Inflation
prices of any key input increases suddenly. EX. A shortage of oil causes increased price of oil, which increases price of goods throughout the economy.
Define Demand Pull Inflation
when an economy goes through a boom, companies look to expand rapidly to meet rising demand, and competition for scarce resources increases. The opposite rarely happens, where fewer dollars are spent on the same amount of goods, pushing prices down
What Does Inflation Impose (stable/predictable)
Menu costs, shoe leather costs, tax distortions (bracket creep)
Define Menu Costs
the cost (money, time, opportunity) of changing prices to keep pace with inflation. Ex. restaurant changes menu when there’s changing prices
Define Shoe Leather Costs
the time, money, effort that is spent managing cash during inflation. The time you spend transferring assets
Define Tax Distortions (Bracket Creep)
tax laws only take nominal income into consideration, not what you can buy with it. Your tax bracket may be higher due to inflation, so you pay a higher tax, even though your purchasing power is the same, penalizing you for inflation
Unpredictable Inflation Imposes… (Nominal and real interest rate)
If a company isn’t sure by how much prices of inputs’ prices will rise, they can’t accurately adjust their profit margins.
Nominal interest rate: reported interest rate, not adjusted for inflation.
Real interest rate: rate adjusted for anticipated effects of inflation.
Investors adjust nominal interest rates for the expected rate of inflation.
real interest rate = nominal interest rate - inflation rate
If inflation is higher than nominal interest, the value of both savings and debts decreases. High inflation redistributes wealth from those who save to those who borrow.
Define Inflating away Debt
through monetary policy, governments can control inflation to decrease their debts (EX. printing more money)
Define Deflation
an overall fall in prices in the economy. Inflation rates are negative
Define Deflationary Spiral/Trap
consumption and investment both decrease during deflation because people know their money is worth more in real terms than nominal terms. So, it’ll reduce the level of aggregate demand in the economy. This then reduces prices, so deflation will continue
Define Disinflation
overall inflation rates (while still positive) are falling. This is usually achieved when the central bank aggressively tries to contain inflation via contractionary monetary policy.
Define Hyperinflation
long-lasting and painful increases in the price level. This can render a currency completely valueless. It also leads to countries using other currencies to conduct business instead of their own
Psychological Inertia Of Hyperinflation
as inflation rises, and govt plans to reduce it seem to fail, people get used to the idea that things can only get worse. So businesses raise their own prices because they expect prices will keep rising. This creates a vicious cycle. (self-fulfilling prophecy)
Why Do Governments Favour Modest Inflation (2-3% per year)
A little inflation reduces the risk of any deflation (which is believed to be worse)
Inflation leaves more room for the central bank to engage in expansionary monetary policy in the case of recession.
Liquidity trap: The situation where nominal interest rates equals an inflation rate near 0, making people prefer to hold their cash.
Makes it easier for firms to adjust real wages in the labour market in response to changing labour demands.
Define Potential Output (full employment output)
amt of output a country could produce if all of its people and capital resources were fully engaged. Here, frictional and structural employment would occur but not cyclical.
Define Output Gaps
actual output differs from potential. can be negative or positive, strongly correlated to inflation
Central Banks And Price Level And Employment
Central banks can conduct monetary policy but this will only affect price levels, with no lasting impact on employment.
Ex. If inflation is higher than output, firms buy machines to expand operations, workers will want higher wages. So, the central bank uses contractionary monetary policy, increasing interest and reducing money supply. Although inflation decreases, the slowing of the economy actually increases unemployment
Philips Curve
as inflation runs higher, unemployment is low; when inflation is low, unemployment is high.
EX. If a government wants 0 inflation, it must accept 7 percent unemployment. If they want 3 percent inflation, they must accept 4 percent unemployment
Short Run Philip’s Curve
doesn’t take into account inflation expectations.
Look at diagram
Long Run Philip’s Curve
a vertical line that is impossible to get the level of unemployment under a specific percent. This minimum level of unemployment is called the non-accelerating inflation rate of unemployment (NAIRU) aka natural rate of unemployment, or full employment.
Look at diagram
Non Accelerating Inflation Rate Of Unemployment (NAIRU) (natural rate of unemployment/full employment)
The NAIRU changes overtime, so calculating the exact NAIRU isn’t easy. So, an economy can’t truly know if it’s at full employment at a given time. If employment is below NAIRU, inflation accelerates. If involuntary unemployment rises, unemployment is above the NAIRU.
Define Balance Of Trade
value of exports minus imports (trade deficit/surplus)
Define Foreign Direct Investment (FDI)
a firm runs part of its operation abroad, or invests in another company abroad. This includes factories (which people argue are sweatshops)
Define Foreign Portfolio Investment
investment funded by foreign sources but operated domestically. This includes financial assets like stocks and govt issued securities in foreign countries.
Define Net Capital Outflow
net flow of funds invested outside a country. Capital inflows (savings from abroad invested domestically) and outflows (domestic savings abroad).
(Trade Deficit=net capital inflow. Trade Surplus=net capital outflow)
Balance Of Payment Identity
net capital outflow of a country equals its net exports. This is how countries sustain deficits in trade.
NCO = NX
Demand For Loanable Funds In The Open Economy
When domestic interest rates are low, domestic savers will invest overseas (high outflow), and international investors will invest less domestically (low inflow). This results in higher capital outflow (and vice versa).
See graph
Why Is Foreign Investment Beneficial
increases GDP of host country by giving additional resources, increases GDP of investing country by giving ways to earn higher returns on capital
Flight To Quality
investors suddenly find lower-risk domestic govt bonds more attractive.
look at graphs
Foreign Exchange Market (forex)
the buying and selling of foreign currencies. Exchange rates between two nations are reciprocals of each other.
Exchange Rate Appreciation
value of a currency increases relative to another currency. Same goes for depreciation.
Ex. CAD appreciates against the euro, $1 CAD goes from 0.76 to 0.86 euro. So, a hotel room that costs 76 euros would cost $100 CAD at first, but with appreciation it becomes:
76 euros x ($10.86) = $88.37 CAD
Whan CAD Depreciates In Value…
net exports increase, exchange rates & the trade deficit fall.
What Does Demand & Supply Of Foreign Currency Depend On
consumer preferences for foreign products, interest rates for investors, and perceived risk of investing in a country. For all of these, the foreign consumer must have the right currency so D&S increases
look at diagram
Define Dollarizes
If a country dollarizes and gives up its own national currency (Ex. Ecuador uses USD), it can’t create its own monetary policies, because the country can’t print more money in a recession or reduce the amt of money circulating when the economy is overheating.
Floating Exchange Rate
value is determined by the market, at equilibrium. Examples include the dollar, peso, yen
Fixed Exchange Rate
set by the govt (China does this) (usually in reference to the US dollar or other major global currency).
Creates more predictability/stability of their currency.
The exchange rate can be below or above market equilibrium.
To maintain fixed exchange the govt must be prepared to intervene in the forex market to either buy or sell currency. Govts increase demand for their currency by using their own reserves of foreign currencies to buy local currency
Speculative attack
speculators make govts give up their fixed rates by dumping currency quickly, so the govt begins to run out of foreign reserves while buying up their own currency. Govt can no longer have a fixed rate, the currency value drops fast, and the speculators come back and buy the cheapened currency.
Competitive Devaluation (Currency War)
multiple countries try to boost economies by lowering their exchange rates. This is done because it makes their exports more attractive to foreigners.
Nominal Exchange Rate
the stated rate at which one country’s currency can be traded for another
Real Exchange Rate
value of goods in one country relative to another. Uses the price level in each country to adjust for purchasing power parity (PPP- chapter8).
real exchange rate = nominal exchange rate x (domestic price level foreign price level)
International Monetary Fund (IMF)
a lender of last resort, makes loans to countries. IMF criticized for requiring economies to undertake contractionary fiscal policy & tighter monetary policy during a crisis, jeopardizing the economy.
Debt Crisis
if a country needs financing, a large share of their govt debt is held by foreign investors
look at diagram
Exchange Rate Crisis
if a govt devalues the exchange rate, it creates a loss for those holding investments in the country
Define Contagion
where a single country gets into trouble with investors (Thailand), nervous investors pull out their money in surrounding countries (Indonesia, Philippines, etc.)
