Quant + ECO Flashcards
numerical data
quantitative
categorical data
qualitative
discrete data
quantitative - countable
Continuous data
quantitative - factional
Nominal data
qualitative - cannot be ordered..
Ordinal data
qualitative - can be ranked
structured data
organised in a defined way
unstructured data
big data / commentary
Winzorised mean
substitute variables for top x% and bottom x%
Harmonic Mean
(N/sum(a/x))
Percntile calculation
=(N +1) (y/100)
Coefficient of Variation (CV)
standard deviation of x / average value of x
Positive skewness
Mean > Median > mode
Negative skewness
Mode > Median > mean
degree if skewness
zero = normal dist, greater than 0.5 considered significant
Leptokurtic
fat tails (more peaked)
Playkurtic
thin tails (less peaked)
Mesokurtic
Normal distribution
Excess kurtosis
= sample kurtosis - 3
Random variable
uncertain quantity/number
Outcome
an observable value of a random variable
Event
single outcome or a set of outcomes
Mutually exclusive events
are events that cannot happen at the same time
Exhaustive events
include all possible outcomes
Empirical probability
analysing past data
Priori probability
formal reasoning
subjective probability
personal judgement
Addition rule
P(A or B) = P(A) + P(B) - P(AB)
Multiplication rule
P(AB) = P(A|B) x P(B)
total probability rule
P(A) =P(A|B) x P(B) + opposite side
Covariance
w2sd2 + w2sd2 + 2ww(cov)
Bayes formula
prior probability of event x (P(new info given event) / P(unconditional probabilityh of new info) )
Types of counting problems
Labelling (order doesn’t matter/nCR function)
permutation (order does matter/nPR function)
Probability distribution
describes the probabilities of all the possible outcomes for a random variable. The probabilities of all possible outcomes must sum to 1.
discrete random variable
is one for which the number of possible outcomes can be counted, and for each possible outcome, there is a measurable and positive probability.
probability function
denoted p(x), specifies the probability that a random variable is equal to a specific value.
continuous random variable
one for which the number of possible outcomes is infinite, even if lower and upper bounds exist.
cumulative distribution function
simply distribution function, defines the probability that a random variable, X, takes on a value equal to or less than a specific value, x.
discrete uniform random variable
one for which the probabilities for all possible outcomes for a discrete random variable are equal (X = {1, 2, 3, 4, 5}, p(x) = 0.2.)
continuous uniform distribution
is defined over a range that spans between some lower limit, a, and some upper limit, b, which serve as the parameters of the distribution. Just have to use a range instead and work out percentages within upper and lower limit
binomial random variable
may be defined as the number of “successes” in a given number of trials, whereby the outcome can be either “success” or “failure.” The probability of success, p, is constant for each trial, and the trials are independent. A binomial random variable for which the number of trials is 1 is called a Bernoulli random variable.
binomial random variable calc
product of desired probabilities x relevant counting problem data
normal distribution
completely described by its mean, μ, and variance, σ2
* Skewness = 0,
* Kurtosis = 3
* A linear combination of normally distributed random variables is also normally distributed
unbounded
univariate distributions
distribution of a single random variable
multivariate distribution
probabilities associated with a group of random variables (correlations = key differnece)
confidence interval
Range of values around the expected outcome within which we expect the actual outcome to be some specified percentage of the time
confidence intervals to rememebr
- The 90% confidence interval for X is X − 1.65s to X + 1.65s.
- The 95% confidence interval for X is X − 1.96s to X + 1.96s.
- The 99% confidence interval for X is X − 2.58s to X + 2.58s.
standard normal distribution
z = (observation - population mean) / standard deviation
Roy’s safety-first criterion
sub in min level of required return for the population mean in the z equation. Then choose the portfolio that minimises the likelihood of going below the minimum threshold
Log-normal distribution
calculated by the function ex
* The lognormal distribution is skewed to the right.
* The lognormal distribution is bounded from below by zero so that it is useful for modeling asset prices, which never take negative values.
Continuous compounding
EAR = e^Rcc – 1
Student’s t-distribution
- It is symmetrical.
- It is defined by a single parameter, the degrees of freedom (df), where the degrees of freedom are equal to the number of sample observations minus 1, n – 1, for sample means.
- It has more probability in the tails (“fatter tails”) than the normal distribution.
- As the degrees of freedom (the sample size) gets larger, the shape of the t-distribution more closely approaches a standard normal distribution.
Chi-squared distribution
- Distribution of the sum of squared values of n
- Bounded from below by zero
- Asymmetric
- Degrees of freedom = n – 1
- As df increase, approaches normal distribution
F-distribution
- Quotient of two chi-square distributions with M and n degrees of freedom
- Bounded from below by zero
- Asymmetric
- As df increase, approaches normal distribution
Monte Carlo simulation
technique based on the repeated generation of one or more risk factors that affect security values (only as good as inputs)
Monte Carlo simulation method
- Specify distributions of random variables, such as interest rates and underlying stock prices
- Use computer random generation of variables
- Price the derivatives using those values
- Repeat steps 2 and 3 thousands of times
- Calculate mean/variance of distribution
Monte Carlo simulation uses
- Value complex securities.
- Simulate the profits/losses from a trading strategy.
- Calculate estimates of value at risk (VaR) to determine the riskiness of a portfolio of assets and liabilities.
- Simulate pension fund assets and liabilities over time to examine the variability of the difference between the two.
- Value portfolios of assets that have nonnormal returns distributions.
Probability sampling
sampling when we know the probability in the population of each sample member
(Simple) random sampling
every population member has an equal probability of being selected
Non-probability sampling
use judgement of researcher or low-cost/readily available data, to select sample items
Sampling error
difference between a sample statistic and true population parameters ( x – u )
Non-probability sampling may lead to greater sampling error than probability sampling
Stratified random sampling
- Create subgroups from population based on important characteristics
- Select samples from each subgroup in proportion to size of the subgroup
Cluster Sampling
Create subsets (clusters), each of which is representative of an overall population (e.g., personal incomes of residents by county)
One-stage cluster sampling
take random sample of clusters and include all data from those clusters
Two-stage cluster sampling
select clusters and take random samples from each
Non-probability sampling methods
- Convenience sampling – use readily available data
- Judgemental sampling – select observations from population based on analyst’s judgement
central limit theorem
For any population with mean u and variance o2, as the size of a random sample gets large, the distribution of sample means approaches a normal distribution with mean u and variance o2/n.
This allows for inferences about and confidence intervals for population means, based on sample means. Sample needs to be greater than 30 as a general rule.
standard error of the sample mean
standard deviation of population / square root of the sample size
Unbiased
expected value equal to parameters
Efficient
sampling distribution has smallest variance of all unbiased estimators
Consistent
larger sample -> better estimator
dist = normal, variance = known, sample = small
Z stat
dist = normal, variance = unknown, sample = small
t stat
dist = nonnormal, variance = known, sample = small
NA
dist = nonnormal, variance = unknown, sample = small
NA
dist = normal, variance = known, sample = large
Z stat
dist = normal, variance = unknown, sample = large
t stat
dist = nonnormal, variance = known, sample = large
Z stat
dist = nonnormal, variance = unknown, sample = large
t stat
Jackknife
calculate multiple sample means, each with one observation removed
Bootstrap
take many samples of size n, calculate their sample means and calculate standard deviations of these means
Sample selection bias
sample noy really random
Survivorship bias
sampling only surviving firms, mutual funds, hedge funds
Look-ahead bias
using information not available at the time to construct sample
Time-period bias
relationship exists only during the time period of sample data
Hypothesis test method
- State the hypothesis – relation to be tested
- Select a test statistic
- Specify the level of significance
- State the decision rule for the hypothesis
- Collect the sample and calculate statistics
- Make a decision about the hypothesis
- Make a decision based on the test results
Type I error
Rejecting true null hypothesis (H0) significance level is probability of type I error
Type II error
failing to reject false null hypothesis (H0)
power of a test
is 1 – probability of type II
standard error
sample standard deviation / square root of observations
p-value
smallest level of significance at which the null can be rejected
Hypothesis test of mean (normal dist, known variance)
z stat
Hypothesis test of mean (normal dist, unknown variance)
t stat
Hypothesis of equality of means (two independent normal populations)
t stat - check notes for detailed formula
Hypothesis test concerning the mean difference of two normally distributed populations.
t stat - (mean of sample differences - hypothesised difference) / (stanard deviation of sample differences / square root (n))
Hypothesis of variance of a normally distributed population
chi-squared stat
Hypothesis of equality of variances of two normally distributed populations based on two independent random samples.
F test, larger sample/smaller sample
degrees of freedom are n1 -1 and n2 -1
Parametric tests
based on assumptions about population distributions and population parameters
Nonparametric tests
make few, if any, assumptions about the population distribution and test things other than parameter values (e.g. runs tests, rank correlation tests)
Parametric correlation test
t stat - n-2 degrees of freedom
non-parametric correlation test
spearman rank correlation test -
contingency table independence test
total for row z x total for column y / total for all columns and rows
Test statistic for contingency table independence test
Chi squared - sum of expected frequencies over total - df = (r-1)(c-1)
simple linear regression
to explain the variation in a dependent variable in terms of the variation in a single independent variable
dependent variable
Variable whose variation is explained by the independent variable.
independent variable
variable used to explain the variation of the dependent variable
Slope of linear regression calc
COV(X.Y) / variance X
Assumptions of linear regression
- There is a linear relation between dependent and independent vatiables
- Variance of the errors is constant (homoskedasticity)
- Error terms are independently distributed (uncorrelated with each other)
- Error terms are normally distributed
R2
measures the percentage of total variation in Y variables explained by the variation in X.
= correlation(xy)^2
SSR/SST = R2 = explained/total variation
Total sum of squares (SST)
measures the total variation in the dependent variable. SST is equal to the sum of the squared differences between the actual Y-values and the mean of Y:
Sum of squares regression (SSR)
measures the variation in the dependent variable that is explained by the independent variable. SSR is the sum of the squared distances between the predicted Y-values and the mean of Y.
Sum of squared errors (SSE)
measures the unexplained variation in the dependent variable. It’s also known as the sum of squared residuals or the residual sum of squares. SSE is the sum of the squared vertical distances between the actual Y-values and the predicted Y-values on the regression line.
SST
= SSR + SSE
SSE
= square root MSE
MSR
=SSR/k
F test
MSR/MSE
MSE
=SSE/(n-2)
Log-Lin model
dependent variable is logarithmic while the independent variable is linear.
Lin-Log model
dependent variable is linear while the independent variable is logarithmic.
Log-Log model
dependent variable and the independent variable are logarithmic.
Factors that influence elasticity of demand
- Availability and closeness of substitutes
- Proportion of income spend on the item
- Time elapsed since previous price change (longer = more elastic)
what parts of demand curve are elastic
above unit elastic = elastic, below unit elastic = inelastic
Total revenue maximised at point elastic.
point elasticity of demand
P/Q x change(Q)/change(P)
cross price elasticity
Cross price elasticity > 0; the goods are substitutes
Cross price elasticity < 0; the goods are compliments
Income Elasticity of Demand
% change in QD/ % change in income
Normal good; income increases, demand decreases, elasticity >0
Inferior good; income increases, demand decreases, elasticity < 0
Substitution effect
Substitution effect always increases consumption of the good for which the price has fallen
Income effect
positive for a normal good and negative for an inferior good
normal goods
as the price decreases, the quantity purchased increases (due to both substitution and income effects).
Giffen good
good is an inferior good where for a certain range of prices, the quantity purchased decreases as the price decreases due to the income effect domination the substitution effect
Veblen good
is a status symbol good for which a decrease in price leads to a decrease in quantity purchased, as people put less value on the good when its price is lower
AR > AVC
Short run = stay in market
Long-run = exit market
economies of scale
A situation in which average cost per unit of good or service fall as volume rises. In reference to mergers, the savings achieved through the consolidation of operations and elimination of duplicate resource.
diseconomies of scale
increase cost per unit resulting from increased production
Perfect Competition
many firms, very low barriers to entry, very good substitutes, price competition only, no pricing power
Monopolistic competition
Many firms, low barriers to entry, good substitutes but differentiated, competition on price and marketing features, some pricing power
Oligopoly
Few firms, high barriers to entry, very good substitutes or differentiated, price and marketing, features competition, Some to significant pricing power.
Monopoly
Single firm, very high barriers to entry, no good substitutes, advertising competition, significant pricing power
Perfect competition assumptions
- Homogenous product
- Large number of independent firms; each small relative to the total market
- Perfectly elastic demand curves
- No barriers to entry or exit
- Supply and demand determine market price
- Always return to zero economic profits in the long run
Monopolistic competition assumptions
- Large number of firms in the industry
- Each firm has a small market share
- Collusion not possible
- Firms produce differentiated products (close but not perfect substitutes)
- Relatively elastic demand, downward sloping
- Firms compete on price, quality, and marketing
- Low barriers to entry
MR does not equal demand
Monopolistic competition allocative efficiency
- Social cost of not producing where P = MC
- Long-run average cost is not minimised
- Excessive advertising may take place
- Fewer producers could be more efficient
- However, increased product diversity has positive value for customers
- Brand names provide signals about quality
- Product innovation and differentiation have value
- Advertising provides valuable information to consumers
o High advertising expenditures increase fixed costs and total costs
o If advertising greatly increases sales, ATC can decline because AFC fall
Oligopoly assumptions
- Small number of sellers – downward sloping demand less elastic than monopolistic competition
- Interdependence among competitors and their demand curves
- Significant barriers to entry (scale of operations)
- Products may be similar or differentiated
Kinked demand model
- Competitors will not follow a price increase
- Competitors will follow a price decrease
- Model gives a discontinuous marginal revenue curve gap
- Model does not specify what determines the market price PK
Cournot model
- Duopoly, both firms have identical marginal cost curves
- Firms choose selling price based on other firm’s price in previous period
- Both produce the same quantity in equilibrium
- Market price lower than monopoly, higher than perfect competition
Stackelberg model
- Duopoly model, one firm is “leader” and chooses its price first
- Other firm chooses its price based on leader firm’s choice
- Leader firm changes higher price, receives greater proportion of total profits
Nash Equilibrium
Choices of all firms are such that no other choice makes any firm better off (increases profits or decreases losses). Strategic games model the best choice for a firm depending on the actions and reactions of competitors
Oligopoly profits with collusion
Firms can earn a greater profit if they collude: fix industry output at the monopoly quantity, and share the profits. If competitors cannot detect cheating, a firm can increase profits if it violates the collusion agreement and increases output.
Collusion will be more successful with
ewer firms, homogenous products, similar cost structures, certain and severe retaliation for cheating, little competition form firms outside the agreement
Monopoly - Barriers to entry:
- Economies of scale (natural monopoly)
- government licensing and legal barriers
- Resource control
Perfect Price discrimination is efficient.
- Charge each consumer the maximum the consumer is willing to pay for each unit
- No deadweight loss
- Produce same quantity as perfect competition
- No consumer surplus; entire surplus goes to producer
Natural monopoly – significant economies of scale
- ATC declines as output increases
- Often high fixed cost industries
- Marginal cost tends to be low
- Examples: Utilities
Average cost pricing (monopoly)
reduce price to where ATC intersects the market demand curve. Increases output and social welfare, economic profit = 0
Marginal cost pricing (monopoly)
reduce price to where MC intersects the demand curve (MC=Price). May lead to a loss, require a government subsidy, if MC < ATC
Firms supply function.
Perfect competition - MC curve above average variable cost, Market supply = sum of supply of market participants
other market structures - Not well-defined supply function (can’t construct quantity supplied as a function of price), Supply driven by intersection of MR and MC; price is then determined by the demand curve
Pricing strategy
PC = price = MR = MC
Mon = MR = MC, P > MR
Oli = dpends on other firms
N-firm Concentration Ratio
sum of the percentage market shares of the N largest firms in an industry.
Herfindahl-Hirschman Index (HHI)
= sum of square market shares of N largest firms in a market
more sensitive to mergers than N-firm ratio, widely used by regulators
Ignores Barriers to entry ignores demand elasticity
Gross Domestic Product (GDP)
market value of all final goods and services produced in a country/economy:
* Produced during the period
* Only goods thate are valued in the market
* Final goods and services only (not intermediate)
* Rental value for owner-occupied housing (estimated)
* Government services (at cost) not transfers
Income approach (GDP)
earnings of all households + Businesses + government
Expenditures approach (GDP)
C + I + G + (X – M)
Nominal GDP
sum of all current-year goods and services at current-year prices
Real GDP
sum of all current year goods and services at base-year prices
GDP Deflator
(Nominal GDP/Real GDP) x 100
GDP (national income approach)
national income + capital consumption allowance + statistical discrepancy
national income
employees’ wages and benefits + corporate and government profits pre-tax + interest income + unincorporated business owners’ income + rent + indirect business taxes – subsidies
(Components may vary slightly among countries)
Capital consumption allowance
output to replace worn-out physical capital
Savings
= I + (G - T) + (X - M)
Good market
in equilibrium: aggregate income = aggregate expenditure
Money market
equilibrium: individuals and businesses are willing to hold the real money supply at current interest rates
AD curve slopes downward because of:
- Wealth effect: price level decreases, purchasing power of nominal wealth increases, consumption increases
- Interest rate effect: price level decreases and nominal money supply constant, interest rate decreases, consumption and investment increase
- Real exchange rate effect: price level decrease relative to other countries, exports increase, imports decrease.
In the very short run -aggregate supply is
perfectly elastic
five important sources of economic growth
- Labor supply
- Human capital
- Physical capital stock
- Technology
- Natural resources
potential GDP
= aggregate hours worked × labor productivity
Production function
Y = A × f (L, K)
Credit cycles.
- Lenders are typically more willing to lend and offer lower interest rates during expansions, and less willing to lend and require higher interest rates during contraction
- Credit cycles tend to be longer in duration than business cycles
- They may contribute to stronger expansions, deeper contractions, and asset price bubbles
Neoclassical
causes of business cycle (tech), rec (allow wages and prices to adjust)
Keynesian
causes of business cycle (AD shifts with changes in expectations, contractions persist due to sticky wages), rec (use fiscal and monetary policy to restore full employment)
New Keynesian
causes of business cycle (same but other sticky inputs), rec (use fiscal and monetary policy to restore full employment)
Monetarist
causes of business cycle (inappropriate changes in money supply), rec (steady predictable increases in money supply)
Austrian
causes of business cycle (Govt intervention), rec (don’t force interest rates to artificially low levels)
New Classical
causes of business cycle (rational responses to external shocks, e.g., tech), rec (don’t intervene)
Core inflation
prices of all goods excluding food and energy
Limitations of inflation measures
CPI is widely belived to overstate the true rate of inflation:
* Consumers substitution of lower priced products for higher priced products
* New goods replace older, lower priced products
* Price increases due to quality improvements
Laspeyres index
uses basket weights from base period
Paasche index
uses basket weights from current period
Chained price index
reduces bias from substitution (Fisher index geo-mean of Lasp and Pasche)
NAIRU
lowest possible unemployment rate that will not induce wage-push inflation; also called natural rate of unemployment.
functions of money
- Medium of exchange
- Unit of account
- Store of value
Fractional reserve banking system
a bank is required to hold a fraction of its depostis in reserve; this fraction is the required reserve ratio
Transactions demand (money)
increases with GDP
Precautionary demand (money)
money held for unforeseen future needs, increases with GDP
Speculative demand (money)
Money held to take advantage of future investment opportunities, smaller when current returns are high, greater when risk is perceived to be high
Fisher effect
nominal interest rate is simply the sum of the real interest rate and expected inflation.
Roles of central banks
- Issue currency
- Banker to banks and government
- Regulate banking and payment systems
- Lender of last resort
- Hold gold and foreign currency reserves
- Conduct monetary policy
effects of expected inflation
increases cost of holding money, adds cost of frequently changing advertised prices
effects if unexpected inflation
- Shifts wealth from lenders to borrowers
- Less reliable supply/demand information in price changes
- Incorrect production decisions by firms
- Less stable business cycle
effective central bank
- Independent (operational / target independence)
- Credible
- Transparent
Neutral interest rate
trend growth rate of GDP + target inflation rate
Limitations of Monetary policy
- Long-term rates may move oppositely to short-term rates because inflation expectations change
- If monetary tightening is extreme, expectations of recession may make long-term more attractive, decreasing long-term rates
- If demand for money is very elastic, people will hold currency even as money supply increases, referred to as a Liquidity trap
- Banks may desire to increase capital and not increase lending in response to expansionary monetary policy
- Short-term rates cannot be below zero – limits a central bank’s ability to act against inflation
Ricardian Equivalence
- If a tax decrease causes taxpayers to anticipate higher future taxes, the resulting decrease in spending will reduce the expansionary impact of a tax cut
- If the increase in savings (decrease in consumption) just offsets the tax decrease, it is termed Ricardian equivalnce
- An increase in spending funded by issuing debt will have not impact on aggregate demand
Fiscal policy limitations
Recognition lag
Action lag
Impact lag
Geopolitics
study of how geography affects international relations. Interactions of governments, individuals, companies and organisations wit respect to economic, financial, and political activities
Autarky
(non-cooperation and nationalism) refers to a goal of national self-reliance, including producing most or all necessary goods and services domestically. Autarky is often associated with a state-dominated society in general, with attributes such as government control of industry and media.
Hegemony
(non-cooperation and globalization) refers to countries that are open to globalization but have the size and scale to influence other countries without necessarily cooperating.
Bilateralism
(cooperation and nationalism) refers to cooperation between two countries. A country that engages in bilateralism may have many such relationships with other countries while tending not to involve itself in multi-country arrangements.
Multilateralism
(cooperation and globalization) refers to countries that engage extensively in international trade and other forms of cooperation with many other countries. Some countries may exhibit regionalism, cooperating multilaterally with nearby countries but less so with the world at large.
Tools of geopolitics
National Security Tools
Economic Tools
Financial Toos
Geopolitical risks
- Event risk – outcome of an event at a known date
- Exogenous risk – unanticipated risk
- Thematic risk – risks that tend to grow over time
Velocity of geopolitical risk
high = short term, low = long-term
Black Swan
low likelihood with large short term impact
GNP
Value of goods and services produced by a country’s citizens and their capital.
Ricardian model
labour is the only factor of production; comparative advantage depends on relative labour productivity for different goods
Heckscher-Ohlin model
two factors of production: capital and labour; comparative advantage depends on relative amount of each factor possessed by a country
Free Trade Areas
o All barriers to import and export of goods and services among member countries are removed.
Customs Union
o All barriers to import and export of goods and services among member countries are removed.
* All countries adopt a common set of trade restrictions with non-members.
Common Market
o All barriers to import and export of goods and services among member countries are removed.
* All countries adopt a common set of trade restrictions with non-members.
* All barriers to the movement of labor and capital goods among member countries are removed.
Economic Union
o All barriers to import and export of goods and services among member countries are removed.
* All countries adopt a common set of trade restrictions with non-members.
* All barriers to the movement of labor and capital goods among member countries are removed.
* Member countries establish common institutions and economic policy for the union.
Monetary Union
o All barriers to import and export of goods and services among member countries are removed.
* All countries adopt a common set of trade restrictions with non-members.
* All barriers to the movement of labor and capital goods among member countries are removed.
* Member countries establish common institutions and economic policy for the union.
* Member countries adopt a single currency.
common objectives of capital restrictions imposed by governments
- Reduce volatility of domestic asset prices due to large inflows and outflows of capital
- Maintain exchange rate target while using monetary and fiscal policy for domestic goals
- Keep domestic interest rates low by restricting outflows of capital to higher-yeilding foreign investments
- Protect strategic industries (defence) from foreign ownership
Balance of Payments (BOP) Accounts
Current Account – merchandise/services purchases, foreign dividends and interest, unilateral transfers (income statement)
Capital account – sales/purchases of physical assets, natural resources, intangible assets, debt forgiveness, death duties and taxes (balance sheet)
Financial account – domestic-owned financial assets abroad (official reserve, government, private) and foreign owned domestic financial assets
International Monetary Fund (IMF)
- Monetary cooperation
- Growth of trade
- Exchange stability
- Multilateral systems of payments
- Overcome temporary BOP difficulties
World Bank
- Fight poverty
- Development and assistance
World Trade Organisation (WTO)
- Enforce global rules of trade
- Ensure trade flows smoothly and freely
- Dispute settlement process
- Multilateral trading system – agreements
Countries without sovereign currency
- Formal dollarisation – uses other countries currency
- Monetary Union – several countries use a common currency
Countries with sovereign currency:
- Currency board – commits to a fixed rate of exchange of domestic for a foreign currency
- Conventional fixed peg – maintain at pegged rate (+- 1%) via direct intervention in the FX market or indirectly via monetary policy changes
- Target zone – gives flexibility to maintain the exchange rate within a wider range (e.g. +- 2%)
- Crawling peg – allows exchange rate to move slowly with changes in fundamentals (active = announced and implemented) (passive – managed but market driven)
- Managed floating – no target exchange rate; managed through direct intervention or monetary policy
- Independently floating – market determined
Generalised Marshall-Lerner condition
depreciation of domestic currency will decrease trade deficit
J - curve
in the short-run, due to existing contracts, export and import demand are relatively inelastic. Currency depreciation initially leads to a larger trade deficit. In the long run elasticities increase, currency depreciation leads to a reduction in the trade deficit
Absorption approach
includes the effect of currency depreciation on capital flows, as well as trade flows.
(X – M) = National income – expenditures
For depreciation to improve the balance of trade:
* National income must increase relative to expenditures
* National savings (private + government) must increase relative to domestic investment in physical capital
Roy Safety First Criterion
(Expected return - min return) / standard deviation
Larger RSF = better
