Volume 1 - Economics

Question 1

Firms and Market Structures

Answer 1

determine and interpret breakeven and shutdown points of production, as well as how economies and diseconomies of scale affect costs under perfect and imperfect competition

describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly

explain supply and demand relationships under monopolistic competition, including the optimal price and output for firms as well as pricing strategy

explain supply and demand relationships under oligopoly, including the optimal price and output for firms as well as pricing strategy

identify the type of market structure within which a firm operates and describe the use and limitations of concentration measure

Question 2

Firms that operated in perfectly competitive markets are price takers, meaning that they have no pricing power and must accept the market price for any units they produce. A firm’s marginal revenue (MR) is equal to the market price (P) for each unit produced. As a result, the demand curve is horizontal and total revenue (TR) increases linearly as a function of the number of units sold.

Question 3

Firms in imperfectly competitive industries have at least some pricing power, which creates a downward-sloping demand curve. Firms can choose to sell for a lower price, which will increase the number of units they sell. In this environment, the total revenue curve takes the shape of an arch because the benefits of selling at a lower price disappear beyond a certain point

Answer 3

By contrast, the price in an imperfectly competitive market (e.g., monopoly) is equal to a firm’s average revenue (AR) with the marginal revenue from each incremental unit produced plotting on a separate but also downward-sloping curve.

Question 4

Profit-Maximization :

The short-term marginal cost (SMC), average variable cost (AVC). and average total cost (ATC) start out high and then fall before rising again as output increases. This is true whether a firm operates under perfect competition or some form of imperfect competition. The difference is that, under perfect competition, the demand curve is flat with the market price representing the firm’s marginal revenue at all levels of production. By contrast, the price in an imperfectly competitive market (e.g., monopoly) is equal to a firm’s average revenue (AR) with the marginal revenue from each incremental unit produced plotting on a separate but also downward-sloping curve.

Question 5

a firm will maximize its profit by setting its production quantity ( Q* ) at the point where marginal revenue equals the short-term marginal cost (MR = SMC), assuming that SMC is rising.

Question 6

Breakeven Analysis :

To earn an economic profit, a firm’s revenue must be greater than the sum of its explicit accounting costs and its implicit costs, such as the opportunity cost of capital (i.e., the rate of return required by investors).

Answer 6

Market price > ATC

Question 7

Impossible to earn economic profits over the long-run under perfect competition because the lack of barriers to entry will allow new competitors to enter the market.

Answer 7

On the long-run, in perfect competition, firms earn just enough revenue to cover their economic costs (accounting + implicit costs, such as the opportunity cost of capital (i.e., the rate of return required by investors).

Question 8

The short run is defined as a period during which at least one factor of production is fixed, such as plant size, physical capital, and/or technology.

Answer 8

Firms are continually operating in the short-run while simultaneously planning for the long-run.

Question 9

Short- and Long-Run Cost Curves :

• The short-run average total cost (SATC) curve defines the per-unit cost in the short-run. Dependent on the choice of technology, physical capital, and plant size.
• The long-run average total cost (LRAC) curve is derived from the SATCs available to the firm (formed by fitting a curve tangent to the SATCs).

Question 10

• A firm can gain economies of scale by growing provided the output increases faster than the inputs.
• Diseconomies of scale emerge if the increase in output is slower than the increase in input.

Answer 10

Q3 is where a firm must operate to minimize its per unit cost. This low point on the LRAC is called the minimum efficient scale (MES). In the short run, maximum profit (or minimal loss) is determined where marginal cost equals marginal revenue.

Long run in perfect competition: MES point maximize profit

Question 11

Economies of scale can come from factors such as:

• Increasing returns to scale (increases in output are proportionately larger than increases in inputs)
• Specialization in functions
• Purchasing more expensive but more efficient equipment
• Reducing waste
• Better use of market information
• Obtaining discounted prices on inputs from bulk purchases

Question 12

Diseconomies of scale can come from factors such as:

• Decreasing returns to scale (increases in output are proportionately smaller than increases in inputs)
• Cumbersome management
• Duplication of business functions
• Higher resource prices due to supply constraints

Answer 12

Companies experience diseconomies of scale if they grow too large to be managed efficiently.

Question 13

Economic profit = Accounting Profit - total implicit opportunity costs (required rate of return)

Question 14

Normal profit = Economic profit = 0

Answer 14

ROE = RRR

Question 15

Abnormal profit : Economic profit > 0

Answer 15

ROE > RRR

Result of : technology, efficiency, cost advantage

Question 16

Effect on equity of economic profit :

Answer 16

> 0 ; positive effect
= 0 ; no effect
< 0 ; negative effect

Question 17

In perfect competition, firms are price takers, all face horizontal demand curves.

Answer 17

P = Marginal Revenu (MR) = Average Revenue (AR) = Demand curve (D)

Question 18

In imperfect competition:
- Individual firms can influence price
- Smaller number of firms in the market (only one = monopoly)
- Firms face downward sloping demande curves

Answer 18

Total Revenue (TR) maximized at the peak MR = 0

Question 19

If Average Variable Cost (AVC) are decreasing, Marginal Cost (MC) < AVC

If AVC are increasing, MC > AVC

MC intersects both AVC and ATC at their minimum

Question 20

Short Run Cost : At least one of the factors of production are fixed

Answer 20

Long run Cost : All factors are variable

Question 21

Until Long Run Average Cost touches the minimum Short Run Average Cost
curve ; Economies of scale

Question 22

Diseconomies of scale :
- Poor management control / oversight
- Overlap/Duplication
- Greater stress on local supply
- Big targets — Unions, antitrust legislation, litigation

Question 23

Economic Profit (MC > SRATC) : Encourages market entry since ROE > RRR –> Downward pressure on Price

Economic Loss (MC < SRATC) : Encourages market exit since ROE < RRR –> Upward pressure on Price

Answer 23

The minimum point of LRATC ; Settle a price –> Economic profit = 0

Question 24

Oligoply market demand characteristics on pricing (With the assumption of no collusion/cartel between the firms )

Answer 24

1 - Pricing Interdependence : If you up prices, competition will not act and the demande will become elastic. Lowering price –> Price war and nobody wins

2- Cournot Assumption: Firms set output simultaneously and let the market determine price. Assumption ; each firm chooses its profit maximizing output assuming the output of the other firms will not change. Making the peace with competition by finding the best price.
(Ex: In order words, looking last year of other firms and only thinking in our output.)

3- Nash Equilibrium: No firm can obtain a higher payoff, holding all other firms strategies constant, by choosing a different strategy.

Question 25

In Oligoply ; The followers firms, follow the price and their quantity of demande is set by that price.

Question 26

Concentration Ratio: Market Share of N largest firms
0% - Perfect competition
100% - Oligopoly/Monopoly

Answer 26

Quantifies size, but not market power
May be unaffected by M&A among top N firms

Question 27

Herfindahl - Hirschman Index (HHI):
Market Share of N largest firms **2

1–> Monopoly

1/M –> M firms with equal market share

Answer 27

Does not take possibility of entry into account

Does not consider elasticity of demand

Question 28

The Ricardian and Heckesher-Ohlin models focus on countries developing specialization based on absolute and comparative advantages.

Question 29

4 Phases of the Business Cycle:
1- Recovery
2- Expansion
3- Slowdown
4- Contraction

Question 30

Fiscal Policy (Gouvernement –. Economy) : Taxation and Spending

Question 31

Monetary Policy (Central Banks –> Banking) :
- Activities related to the levels of money supply and credit (interest rates)

• Typically act idenpendtly of gouvt.

Question 32

The Fiscal and Monetary policies are used to regulate/influence economic activity over time - to accelerate or slown down the economy

Answer 32

Goal:
- Create an economic environment where growth is stable and positive and inflation is low and stable (Prices stability, Full employement).

• Attempt to avoid boom/bust scenarios in the economy

Question 33

Keynesians: Fiscal policy can have a significant effect on Aggregate Demand (AD), Y (GDP), and Employement WHEN there is an output gap

Answer 33

In recession: Increase spending to raise employement and Y
Rev < Exp –> Budget deficit –> issue debt

In expansions: Lower spending, raise taxes
Rev > Exp –> Budget surplus–> pay down debt

Question 34

Monetarist: Fiscal changes have only a temporary effect on AD.

No long lasting effect

Question 35

Surplus = Contractionary

Deficit = Expansionary

Question 36

The gouvernment policy tools for outflows; Transfer payment (B): Welfare, pensions, housing benefit, tax credits, child benefits, unemployement, etc –> are not considered spending by G so they are included in the GDP by C.

Question 37

Desirable attributes of a tax policy:
1- Simplicity

2- Efficiency :
Taxes should interfere as little as possible in choices
Should discoruage work and investment as little as possible
Often Broken (alchool, tabacco)

3- Fairness :
Horizontal equity -> ppoeple in similar situations should pay the same tax
Vertical equity-those who earn more should pay more

4- Revenue sufficiency : May conflict with other attributes

Answer 37

Issues:
May reduce incentives to work/save, including people who would leave the country (Capital flight)

Fairness is subjective -> Depends on your position

Tax reform vs Spending reform : If the gouv. always run for taxes for revenue, maybe they have a spending problem and not revenue problem.

Question 38

GDP (y) = C + I + G + (X-N)

Question 39

G ( Gouv Spending) - T (revenue) + B (transfer payement) = Budget deficit

Question 40

YD (Disposable income) = Y - NT (taxes less transfer PMT -> net taxes) = ( I- t (tax rate)) Y

Question 41

Fiscal multiplier : How much output changes for a change in taxation or spending.

1 / 1- Marginal propensity to consume (MPC)(1-t)

Answer 41

1 / 1- MPC : Without tax

Question 42

Automatic Stabilizers:
-Affect deficit/surplus unrelated to fiscal policy
-What may then appear to be expansionary/contractionary policy may only be the result of non-discretuonary reactions

Answer 42

Therefore: The level of surplus/deficit may not be a good indicator of fiscal policy stance

Question 43

rpoblem originates –> Reconition lag –> Problem Detected –> Action lag –> Action implemented –> Impact lag –> Effect on the economy

Answer 43

Action will often:
Target employement or/and inflation

Question 44

Central Bank:
Bnaker to the Gouv
Banker’s bank –> lender of last resort to the banks in its jurisdiction
Regulator/Supervisor of the payment system
Banking system supervisor
Manage the country’s foreign currency reserves and gold reserves
Conduct Monetary policy

Answer 44

Objectives;
Maintain the stability of the financial system
Promote full employement
Promote price stability (most common mandate)

Tools:
1- Open market Operations: Purchase/Sale of gouv bonds from/to commercial banks and designated market makers (secured loans -> REPO and Reverse REPO)

2- Policy Rate: Federal funds rate –> US
Upper Bound - Rate willing to lend at (banks)
Lower Bound - Rate willing to borrow at

Hike in policy rate meant to increase lending rates and constrict credit growth

3- Reserve Requirements; How much each banks deposits have to be held at the central bank

Question 45

A market is a group of buyers and sellers that agree on a price to exchange goods and services.

Question 46

Analysis of Market Structures :

1- Perfect Competition :
Markets with perfect competition have homogeneous (i.e., identical) products with no producer large enough to influence the price. Profits are driven to the minimum required to raise capital.

2- Monopolistic Competition:
This type of market also has a large number of firms, but the products are differentiated. Soft drinks and cosmetics fall into this category.

3- Oligopoly:
The oligopoly market structure has only a few firms supplying the market. Retaliatory strategies must be considered when changing prices or production levels. The airline industry is an oligopoly.

4- Monopoly:
Least competitive market structure. There is a single seller and no substitutes for the product. The seller has much control over the prices, but often regulated by governments. Local utility companies often fall into this category.

Question 47

5 forces of Porter :

1- Threat of substitutes
2- Threat of entry
3- Intensity of competition among incumbents
4- Bargaining power of customers
5- Bargaining power of suppliers

Question 48

Firms that operate under monopolistic competition typically direct considerable resources to advertising and branding in order to maintain or increase their pricing power.

Question 49

Demand, Supply, and Optimal Output for monopolistic competition :

Firms operating under monopolistic competition face a downward-sloping demand curve, meaning that they can increase the demand for their product by charging a lower price. Demand for products in monopolistically competitive markets is more elastic at higher price levels. In the short-run, firms maximize their profits by producing at the point where marginal revenue equals marginal cost.

Question 50

Long-Run Equilibrium for monopolistic competition :

Because barriers to entry are relatively low, economic profits will fall to zero in a monopolistically competitive market over the long-run as economic profits attract new competitors. This will put downward pressure on prices and, in the long-run, total cost (including opportunity cost) will match total revenue (C = P)

Answer 50

In the long-run, production in a monopolistically competitive market will be set at the point where marginal revenue intersects with long-run marginal cost.

Question 51

In a perfectly competitive market, the long-run equilibrium is reached at the point where MR intersects with both LRMC and long-run average cost.

Answer 51

Level of production in a monopolistically competitive market is lower than it would be under perfect competition

Question 52

Demand Analysis and Pricing Strategies for Oligopoly :

With price collusion, the aggregate demand curve is divided up among the individual participants. Individual demand curves are present for non-colluding markets, which are dependent upon the pricing strategies adopted by the firms.

Answer 52

There are three pricing strategies.

1- Pricing Interdependence : This situation exists in any market with price wars. A common example is airlines that serve the same cities. It is common to assume competitors will match price reductions and ignore price increases. This means market share will increase when competitors increase their prices. This implies the elasticity is greater for price increases than decreases. Two demand functions are applicable – one for a price increase and one for a price decrease. The two demand curves will intersect at the current price. This kink in the demand curve also causes a discontinuous marginal revenue structure. Multiple cost structures are consistent with the current price.

2- Cournot Assumption : Under the Cournot assumption, each firm determines its profit-maximizing production level assuming all the other firms will not change their output. In the long run, the equilibrium output and price are stable.

3- Game Theory/Nash Equilibrium : Under a Nash equilibrium, the pricing strategy is set when no firm has an incentive to change. Each firm does the best it can given the reaction of its rivals. This approach assumes each firm is acting in their own best interest without price collusion. The resulting market equilibrium may not maximize the total profits for all firms.

Question 53

Open collusive agreements are called cartels and more likely to be successful under the following conditions:

• There are just a few firms or one of the firms is dominant.
• Firms should not all have similar market shares. Otherwise, the competitive forces would overshadow the benefits of collusion.
• Products are homogeneous.
• Firms have similar cost structures.
• Order sizes are small and deliveries are frequent.
• There is a threat of severe retaliation from competitors for breaking a collusive agreement.
• Collusion among incumbent firms is likely to be a barrier to new entrants.

Question 54

A cartel is less likely to successfully execute a collusion strategy if, as in this example, the firms have similar market shares. In such circumstances, the incentive to compete is greater than would be the case if one firm’s market share was significantly larger than the market shares of other firms in the industry.

Question 55

The Stackelberg model is another potential strategy based on game theory. This theory assumes moves are made sequentially, whereas Cournot assumes they are made simultaneously. Under the Stackelberg model, the leader firm has a distinct advantage.

Question 56

Optimal Price, Output, and Long-Run Equilibrium for Oligopoly :

Dependent on the demand conditions and the competitor’s strategies. Profit is still maximized when marginal revenue equals marginal cost.

Answer 56

The dominant (or leader) firm generally is the price maker. Typically, the dominant firm has a lower cost structure, which makes it unlikely other firms will start a price war. The total market demand curve will have a steeper slope than for the leader because the leading firm will capture a larger percentage of the total market at lower prices.

Question 57

There is no single optimum price and output analysis for all oligopoly markets. It is most clear when one firm is dominant.

Question 58

Factors Affecting Long-Run Equilibrium :

Over time, the market share of the dominant firm typically declines as other firms become more efficient. Pricing wars should be avoided because they only lead to temporary market share gains.

Answer 58

Innovation is key for dominant position

Question 59

Market structures are generally inefficient for consumers if firms have an incentive to reduce output in order to increase prices.

Question 60

Elasticity could be used to measure market concentration. Highly elastic demand implies good competition, while inelastic demand could indicate too much market concentration.

Question 61

Simpler Measures :

The concentration ratio is the sum of the market shares of the N largest firms. The result will be a number between 0 and 1. However, a high concentration ratio does not necessarily imply market power. Just the threat of new entrants could force a firm to act in a competitive manner. Also, the ratio is not affected by the mergers of the top players in the market.

Answer 61

The Herfindahl-Hirschman index (HHI) attempts to fix some of the issues with the concentration ratio. The HHI is the sum of the squared market shares of the N largest firms. The HHI still does not take into account the possibility of new entrants. So only take the TOP firms !!!

Question 62

Understanding Business Cycles

Answer 62

describe the business cycle and its phases

describe credit cycles

describe how resource use, consumer and business activity, housing sector activity, and external trade sector activity vary over the business cycle and describe their measurement using economic indicators

Question 63

The classical cycle refers to fluctuations in the level of economic activity, which can be measured by GDP in volume terms. Usually, the contraction phases are short and the expansion phases are long.

Answer 63

Rarely used because it does not allow the breakdown of movements between short-term fluctuations and long-run trends.

Question 64

The growth cycle refers to fluctuations in economic activity around the long-term potential or trend growth level. The peak of the growth cycle corresponds to the largest positive gap between actual GDP and the trend GDP. Compared to the classical cycle, the peaks of the growth cycle generally happen earlier and troughs later in time. The growth cycle is most commonly used by economists because it captures both the changes driven by long-run trends and changes due to short-term fluctuations.

Question 65

The growth rate cycle refers to fluctuations in the growth rate of economic activity. The peaks and troughs of a growth rate cycle typically occur earlier than those of a classical cycle and a growth cycle.

Question 66

Market Conditions and Investor Behavior :

1- Recovery Phase
When an expansion is expected, risky assets will be repriced upward as the markets start incorporating higher profit expectations into the prices. Equity values typically bottom out three to six months before the overall economy reaches its trough.

2- Expansion Phase
The later part of an economic expansion is called the boom phase, during which the economy is operating at above full capacity and prices of risky asset are rising. Companies compete for qualified workers by raising wages and continue to expand capacity through strong cash flows and borrowing. Central banks may raise interest rates to reduce the inflationary pressure caused by an overheating economy.

3- Slowdown Phase
As the economy begins to slow after the boom phase, prices of risky assets come down from their peak levels. Investors focus on relatively safe assets, such as government bonds and high-quality corporate bonds. Concern over higher inflation drives higher nominal yields.

4- Contraction phase
Investors turn to safer assets and shares of companies with steady positive cash flows, such as producers of staple goods. The marginal utility of a safe income stream increases when employment is falling.

Question 67

When the spread between 10-year US Treasury yields and the federal funds rate narrows and at the same time the prime rate stays unchanged, this mix of indicators most likely forecasts future economic:

A
growth.

B
decline.

C
stability.

Answer 67

A weakening economy and activity measures that are below potential signal the beginning of the contraction phase of the business cycle. After achieving its fastest rate of growth during the slowdown phase, inflation eventually begins to decelerate during the contraction phase, but with a lag

The prime rate is the interest rate that commercial banks charge their most creditworthy customers, typically large corporations. It is often used as a reference or base rate for many types of loans, including personal loans, home equity lines of credit, and credit cards.

Question 68

During an economic expansion, lenders are more willing to extend credit, usually on favorable terms. When the economy is weak or weakening, lenders “tighten” credit by making it less available and more expensive. This often leads to decline in real estate values and higher default rates, which further weakens the economy.

Question 70

Applications of Credit Cycles :

It is now widely accepted that the credit cycle is closely linked to the business cycle, although they are not always synchronized with each other.

Answer 70

Key observations include:

• Loose private sector often leads to bubbles in asset prices and real estate valuation that eventually burst due to capital withdrawals prompted by weaking economic conditions.
• A recession is likely to be deeper and last longer if it accompanied by collapses in real estate and equity valuations.
• Conversely, economic recoveries tend to be stronger when they are combined with rapid growth in credit to support a rising real estate market.
• Compared to business cycles, credit cycles are usually longer, deeper, and sharper.
• A typical credit cycle reaches its peak just before the overall economy moves into a recessionary phase.

Question 71

Consequences for Policy :

• Understanding developments in the housing and construction markets
• Assessing the extent of business cycle expansions and contractions
• Anticipating policy changes

Answer 71

Unlike monetary and fiscal policies, which are designed to minimize the volatility of business cycles, macro-prudential stabilization policies aim to dampen financial booms.

Question 72

The Workforce and Company Costs :

Companies are reluctant to fire employees during temporary economic downturns because they may need them back soon and there is some implicit loyalty. If the downturn continues, companies will try to cut all non-essential costs (consultants and advertising). Companies will try to liquidate inventories. Banks will reduce lending as bankruptcy risks are perceived to be higher.

Answer 72

The decreases in prices and interest rates will make goods cheaper and borrowing less expensive, so businesses and individuals will begin to spend more. This is the turning point of the business cycle, where aggregate demand starts to increase and economic activity increases.

Question 73

Business and credit cycles are closely linked, but not perfectly synchronized. Compared to a business cycle, a typical credit cycle lasts longer, peaks sooner, and follows a steeper path as it moves between its peak and its trough.

Question 74

Fluctuations in Capital Spending :

1- Recovery:
- Low but increasing, with a focus on efficiency rather than capacity
- Light producer equipment and equipment with a high rate of obsolescence are reinstated first

2- Expansion:
- Focused on capacity expansion
- New types of equipment needed to meet demand
- Purchase of heavy and complex equipment
- Companies expand warehouse space to new locations

3- Slowdown:
- New orders continue to be placed as companies operate at or near capacity

4- Contraction:
- Existing orders are canceled and companies stop placing new orders
- Technology and light equipment with short lead times get cut first, then cutbacks in heavy equipment and construction follow
- Scale back on maintenance

Question 75

Types of Indicator :

1- Leading indicators are useful for predicting the future state of the economy.

2- Coincident indicators help identify the current economic state.

3- Lagging indicators help identify past economic conditions.

Question 76

Fluctuations in Inventory Levels :

Inventories can be used as a gauge for the position of the economy in a business cycle because they go up and down quickly and frequently. The inventory-sales ratio is a key indicator. Sales slow faster than production when the economy is in the slowdown phase, causing a spike in inventory-sales ratio.

Question 77

Economic indicators provide information on the state of the overall economy. Help understand the position of an economy in a cycle predict the future performance of the market.

Question 78

Composite indicators include several different variables that tend to move together. For example, a composite indicator may measure the financial stability of a company using variables such as its total asset value, debt ratio, and other important metrics.

Question 79

An analyst may use lagging and coincident indicators to determine the current cycle phase, then seek confirmation using leading indicators. If all indicators produce the same result, the analyst can design an investment strategy based on this conclusion.

Question 80

Other Composite Leading Indicators :

The Organisation for Economic Co-operation and Development (OECD) publishes the OECD Composite Leading Indicator (CLI) to allow comparison of the business cycle across different countries.

Answer 80

• Economic sentiment index
• Residential building permits
• Capital goods orders
• Euro Stoxx Equity Index
• M2 money supply
• An interest rate spread
• EurozoneEuro area Manufacturing Purchasing Managers Index (PMI)
• EurozoneEuro area Service Sector Future Business Activity Expectations Index

Question 81

Don’t forget surveys

Question 82

Nowcasting is the process of estimating the current state (think “now” + “forecasting”), and the produced estimate is known as a nowcast. This is important because certain data are subject to publications delays.

While different nowcasts are produced by different institutions, the Atlanta Fed publishes a running estimate of real GDP growth for the current quarter known as GDPNow. GDPNow is useful because the current GDP data is usually not available until the end of the quarter.

Answer 82

Commonly used to estimate the current GDP growth, inflation rate, and unemployment rate.

Question 83

In the US, the diffusion index consists of different leading, coincident, and lagging indicators. This index shows the components that are moving consistently with the overall index.

Answer 83

A higher diffusion index value signifies a broader movement in the economy.

Question 84

The indicator indexes are constantly updated for their composition and methodology based on the accumulation of empirical knowledge, and they can certainly include more than just leading indicators.

Question 85

Aggregate real personal income and industrial output are coincident indicators, whereas the S&P 500 is a leading indicator. An increase in aggregate personal income and industrial output signals that an expansion is occurring, whereas an increase in the S&P 500 signals that an expansion will occur or is expected to continue. Taken together, these statistics indicate that a cyclical upturn is occurring.

Question 86

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.

Answer 86

B is correct. Physical capital adjustments to downturns come through aging of equipment plus lack of maintenance.

Question 87

Fiscal Policy

Answer 87

compare monetary and fiscal policy

describe roles and objectives of fiscal policy as well as arguments as to whether the size of a national debt relative to GDP matters

describe tools of fiscal policy, including their advantages and disadvantages

explain the implementation of fiscal policy and difficulties of implementation as well as whether a fiscal policy is expansionary or contractionary

Question 88

Monetary policy is used by the central bank to influence the quantity of money and credit. Fiscal policy relates to the government’s taxation and spending.

Question 89

Keynesians believe fiscal policy can greatly affect aggregate demand, output, and employment. Monetarists represent a different school of thought, believing that fiscal policy has only a temporary impact on aggregate demand and that monetary policy is the most effective means of addressing inflationary pressures.

Question 90

Governments can increase spending (expansionary policy) to boost the economy or cut back on spending (contractionary policy) to slow it down.

Answer 90

Expansionnary : cutting personal income, sales, or corporate tax.

Question 91

Automatic stabilizers adapt to changing economic conditions without requiring any policy interventions. For example, unemployment benefit payments increase automatically during economic downturns.

Question 92

Deficits and the National Debt:

Government deficits are the difference between government revenues and expenditures over a time period. The national debt is the accumulation of deficits.

Question 93

General concerns about a country’s national debt include:

• The higher taxes needed to repay debt obligations may discourage economic activity.
• Using loose monetary policy to service debt obligations can result in spiralling inflation.
• Government borrowing can crowd out private sector borrowing.

Answer 93

Arguments against excessive concern over national debt are:

• Obligations to domestic lenders are less concerning than foreign debts.
• Debt can be used to finance important capital projects.
• Higher levels of debt can lead to the adoption of more effective tax laws.
• The private sector could increase saving to finance public borrowing.
• Deficit spending may be necessary to increase employment.

Question 94

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.

Answer 94

C is correct. Ensuring stable purchasing power is a goal of monetary rather than fiscal policy.

Question 95

Government spending :
Transfer payments are made through the social security system for things such as state pensions, income support for low-income families, and unemployment benefits. They allow the government to redistribute income. They are not a part of GDP or government spending on goods and services.

Question 96

Direct taxes come from income, wealth, and corporate profits. This could include property tax and inheritance tax. Indirect taxes include excise duties on fuel, alcohol, tobacco, and other items.

Answer 96

There are four desirable attributes of tax policy:

1- Simplicity (not easily manipulated)

2- Efficiency (should not discourage work or investment or interfere with personal choices)

3- Fairness (this is subjective, but most want the rich to pay more)

4- Revenue sufficiency

Question 97

Advantages and Disadvantages of Different Fiscal Policy Tools :

Indirect taxes can have immediate impact and discourage unwanted behavior. Direct taxes take longer to change. Capital spending takes a long time to formulate and plan.

Question 98

The Fiscal Multiplier :

The fiscal multiplier helps determine how much the output will change for a given change in government spending or taxes.

1 / 1-c * (1-t)

Where c is the marginal propensity to consume.

Answer 98

A government contributes to aggregate demand through spending and transfer payments, while taxation reduces demand. Running a fiscal deficit has a net positive impact on aggregate demand, while the net impact of a fiscal surplus is negative.

Question 99

This behavior, theorized by economist David Ricardo, is called Ricardian equivalence. According to this view, deficit spending will only stimulate aggregate demand if individuals fail to anticipate the need for future tax increases correctly.

Answer 99

fiscal deficits will have no net impact if individuals view this as a delayed tax increase and respond by increasing their savings in order to pay future taxes rather than increasing their current consumption.

Question 100

There are difficulties in executing fiscal policy :
1- A recognition lag occurs because it takes time for data to indicate the economy is slowing.

2- It then takes time to implement the policy changes, which is the action lag.

3- The impact lag measures how long the actions take to impact the economy.

Question 101

The deficit can change for reasons unrelated to fiscal policy (e.g., automatic stabilizers), so its size does not necessarily indicate expansionary or contractionary policy. Economists focus on a country’s structural budget deficit (a.k.a. cyclically adjusted budget deficits), which is the deficit that would occur if the economy was at full employment. At lower unemployment, tax revenues would be greater and social transfers lower.

Question 102

Fiscal policy does not work well when combating unemployment and inflation. High budget deficits may preclude more deficit spending to provide a stimulus.

Answer 102

Fiscal policy will not work if there are supply resource shortages.

Question 103

Cyclically adjusted budget deficits are appropriate indicators of fiscal policy. These are defined as the deficit that would exist if the economy was at full employment (or full potential output).

Question 104

Monetary Policy

Answer 104

describe the roles and objectives of central banks

describe tools used to implement monetary policy tools and the monetary transmission mechanism, and explain the relationships between monetary policy and economic growth, inflation, interest, and exchange rates

describe qualities of effective central banks; contrast their use of inflation, interest rate, and exchange rate targeting in expansionary or contractionary monetary policy; and describe the limitations of monetary policy

explain the interaction of monetary and fiscal policy

Question 105

Role of Central Banks :

1- Supplier of Currency

2- Banker to Government and Bankers’ Bank : A central bank’s clients typically include the government and major commercial banks. They get the gouv money deposited and fund commercial banks with short-term loans.

3- Lender of Last Resort : Provide liquidity to commercial banks facing crises that have the potential to cause significant damage throughout the financial system (reinforcing investor confidence in the domestic financial system).

4- Regulator of Payments System

5- Conductor of Monetary Policy : Determine the quantity of money and credit in the economy.

6- Supervisor of Banking System : Another model is to have the central bank perform this role jointly with another organization.

7- Maintain Foreign Currency Reserves and Gold Reserves : Accumulate reserves of foreign currencies as a result of international transactions.

Question 106

The Objectives of Monetary Policy :
Depends on the country

The United States Federal Reserve has three explicit objectives:

• Stable prices
• Maximum employment
• Moderate long-term interest rates

Answer 106

It is important to note that these goals are not necessarily consistent with each other. For example, in order to maintain price stability, it may be necessary for a central bank to take actions that are inconsistent with maintaining full employment. Because of this, some banks make primary and secondary objectives.

Question 107

Monetary Policy Tools :

1- Open Market Operations : Involve the purchase and sale of government bonds from commercial banks. The money supply increases when a central bank buys bonds from commercial banks because funds have been transferred to the private sector and are available to be provided as loans (Sell = reduce money circulating).

2- Central Bank’s Official Policy Rate : Rate that it charges on the short-term loans that it makes to commercial banks. Increasing the rate will reduce the money supply because commercial banks will respond to this increase in their borrowing rate by increasing the rates on the loans that they offer to individuals and businesses (Lower rates = lower lending rates and increase the money supply).

3- Reserve Requirements : Ability to regulate the minimum balance that commercial banks are required to maintain in their accounts. Increasing the reserve requirement has the effect of reducing the money supply (and vice versa).

Answer 107

3- Some countries have chosen to abandon reserve requirements because commercial banks find it disruptive to their lending practices (often emerging markets).

Question 108

The Transmission Mechanism :

The key channels for monetary transmission are short-term market interest rates, asset prices, investor confidence/expectations, and foreign exchange rates. Changes in the official policy rate impact each of these and they impact domestic demand, which influences inflation.

Question 109

Inflation Targeting :

Success of an inflation targeting policy depends on three key factors:

1- Central Bank Independence : Must have the operational independence to make monetary policy decisions independently of political interference. Central banks may also be target independent if they are granted the ability to set the target rate of inflation.

2- Credibility : Credible if the public believes that the central bank is committed to achieving its target. If economic agents are sufficiently convinced of the central bank’s credibility, they will adopt the target rate when setting their inflation expectations.

3- Transparency : Making decisions in a transparent manner. By issuing regular reports on the economic indicators that influence their decisions.

Answer 109

1- Impossible as central bankers are appointed by governments and remain accountable to politicians.

2- If the country is very indebt, inflation reduce the real value of debt, therefore, the gouv loses credibility in trying to fight inflation because it helps them with debt.

Question 110

The basis for contractionary/expansionary interest rates is the neutral interest rate, which is the sum of the real trend rate of economic growth and the target rate of inflation.

Question 111

Two central banks that do not have explicit inflation targets are the Bank of Japan (BoJ) and the U.S. Federal Reserve System. The possibility of deflation has been a persistent concern for the Japanese economy since the 1990s. Given the BoJ’s inability to achieve consistent positive inflation, households and businesses would likely be highly skeptical of its ability to implement inflation targeting policy successfully.

Answer 111

The U.S. Federal Reserve has a mandate to promote maximum employment, stable prices, and moderate long-term interest rates. But the 2% is an implicit objective.

Question 112

Monetary Policy in Developing Countries :

• No liquid government bond market
• Rapidly changing economy
• Rapid financial innovation
• Low credibility
• Lack of central bank independence

Question 113

Monetary policy is described as contractionary if the policy rate is set above the neutral rate. This encourages individuals and business to save rather than spend, which should reduce inflationary pressures. By contrast, setting the policy rate below the neutral rate is expansionary monetary policy designed to increase the rate of growth in the money supply and the real economy.

Question 114

Source of the Shock :

When developing a monetary response to rising inflation, central banks should consider the source of the shock that has put upward pressure on prices. For example, contractionary monetary policy (i.e., increasing the policy rate above the neutral rate) is generally appropriate when dealing with inflation that is driven by a demand shock, such as rapidly rising consumer confidence and business investment.

Answer 114

By contrast, a typical contractionary monetary policy response is unlikely to be an effective response to inflation that is caused by a supply shock, such as a spike in oil prices.

Question 115

Limitations of Monetary Policy :

1- Problems in the Monetary Transmission Mechanism : Bond market vigilantes are private market participants with sufficient resources to counteract a central bank’s policy objectives. For example, a central bank can increase its short-term policy rate to confront rising inflationary pressures but interest rates at the long end of the curve could fall if the market interprets this action as an indication of a coming recession.

2- Interest Rate Adjustment in a Deflationary Environment and Quantitative Easing : Because interest rates cannot fall below zero, central banks have limited tools at their disposal in a deflationary environment, which increases the value of debt obligations in real terms. One policy option is quantitative easing (QE), which is when central banks effectively print money through large-scale open bond purchases.

Answer 115

1- Monetary policy is also ineffective in situations when demand for money becomes infinitely elastic, meaning that individuals are willing to hold additional cash balances without any change in interest rates. In this extreme scenario, known as a liquidity trap, increasing the money supply will neither reduce interest rates nor have any impact on real economic activity.

2- Ultimately, monetary policy is limited because it cannot control how much households deposit at the bank and how much banks are willing to lend.

Question 116

A liquidity trap can happen when the demand for money is completely elastic. Graphically, this situation is captured by a horizontal demand curve. In such circumstances, an increase in the money supply will not reduce interest rates or increase real economic activity.

Question 117

Factors Influencing the Mix of Fiscal and Monetary Policy :

Governments seek to maintain aggregate demand at close to full employment while also increasing the level of potential output. Fiscal policy is relatively difficult to adjust due to political concerns. It is easier for politicians to loosen fiscal policy than tighten the budget. In many cases, fiscal tightening is attributable to automatic stabilizers (e.g., fewer unemployment benefits during an economic expansion) rather than a deliberate policy choice. By contrast, monetary policymakers can act with far less concern for political considerations.

Question 118

Social transfers are more effective if targeted at lower-income earners rather than distributed evenly to all citizens. The fiscal multiplier effect is greater when government spending and social transfers are coupled with monetary accommodation.

Answer 118

Government spending increases have a much larger impact on GDP than social transfer increases

Question 119

Quantitative Easing and Policy Interaction :

Central banks implement QE by purchasing securities from individuals, institutions, and banks.

The objective of QE is to lower interest rates and stimulate economic activity with direct cash transfers. However, economists note that by making large-scale purchases of government bonds, central banks are effectively printing money to fund the budget deficit and abandoning their commitment to independent monetary policy.

Question 120

A perceived lack of commitment results in higher real interest rates and a permanent decrease in GDP.

Question 121

Under which combination of monetary and fiscal policy is public sector spending most likely to increase as a proportion of the economy?

A
Easy monetary policy and easy fiscal policy

B
Tight monetary policy and easy fiscal policy

C
Easy monetary policy and tight fiscal policy

Answer 121

B)
Aggregate economic output will increase due to the additional public spending from an expansionary fiscal policy. However, the impact of tight monetary policy will be lower private sector demand. The net effect will be an increase in government spending as a proportion of GDP.

Question 122

Introduction to Geopolitics

Answer 122

describe geopolitics from a cooperation versus competition perspective

describe geopolitics and its relationship with globalization

describe functions and objectives of the international organizations that facilitate trade, including the World Bank, the International Monetary Fund, and the World Trade Organization

describe geopolitical risk

describe tools of geopolitics and their impact on regions and economies

describe the impact of geopolitical risk on investment

Question 123

Geopolitics is the study of how political decisions and international relations are influenced by geography. Choices made by actors such as governments, companies, and individuals are affected by geopolitical considerations.

Answer 123

Geopolitical risk is the potential for events such as policy changes, natural disasters, or terrorism to disrupt the normal and peaceful course of international relations.

Question 124

National Governments and Political Cooperation :

Decisions about managing exposure to geopolitical risk can be made by two types of actors :

1- State actors possess the authority to deploy a country’s national security resources (presidents and prime ministers or institutions).

2- Non-state actors include companies, non-governmental organizations (NGOs), and influential individuals who participate in global political, economic, or financial affairs.

Question 125

A cooperative country engages with others, seeking reciprocal relationships based on transparent, standardized rules and norms. This relationship dynamic increases trust over time, allowing for greater mobility of capital, goods, services, and technology.

Answer 125

Non-cooperative countries are characterized by inconsistent, arbitrary rules and retaliation. This dynamic leads to mistrust and limitations on trade, migration, capital flows, and technological exchanges.

Question 126

Motivations for Cooperation :

1- National Security or Military Interest: Coalitions with allies are often used to achieve mutual protection against common external threats. Countries with geographic limitations, may be more motivated to cooperate while countries with geographic advantages may seek to leverage these.

2- Economic Interest : Ability to access resources such as energy, food, and water.

Question 127

A country’s geophysical resource endowment includes the geographic features that are needed for sustainable growth. Relatively few countries are endowed with sufficient resources to sustainably increase living standards without some degree of cooperation with the rest of the world.

Answer 127

Governments and non-state actors are motivated to work toward standardization because these efforts are often essential to overcoming challenges that limit cross-border economic and financial activity.

Question 128

Governments seek to exert non-coercive influence through soft power initiatives, such as cultural and educational exchanges, travel grants, and advertising.

Question 129

Institutions are broadly defined as established organizations or practices within a society.

Answer 129

Countries generally benefit from having strong institutions, particularly those that promote government accountability, property rights, and the rule of law.

Question 130

Hierarchy of Interests and Costs of Cooperation :

Governments are regularly required to make choices that prioritize their interests. For example, a country may choose to join an international trade agreement in pursuit of economic objectives even if this requires giving up some of its ability to act independently of other countries. Similarly, military objectives may be given a higher priority than economic development.

Question 131

A geophysical resource endowment is a country’s access to food, water, energy, and other resources that are necessary for sustainable growth. Beyond tradable commodities, a geophysical resource endowment also includes factors such as a livable climate.

Geophysical resource endowments shape the dynamics of engagement between countries they are so unequally distributed.

Question 132

Globalization is broadly defined as countries opening their economies to increase their integration with the global economy. The degree of integration is tracked by the World Bank Openness Index, which measures global trade as a share of GDP.

Question 133

At the other end of the spectrum is anti-globalization (or nationalism), which seeks to limit these flows based on national borders. Nationalist policies are driven by a desire to promote a country’s economic interests by limiting the ability of other countries to advance their own.

Question 134

Globalization can advance even in the absence of government support or harmonized rules because this process is primarily driven by non-state actors, such as companies, individuals, and NGOs.

Question 135

Motivations for Globalization :

1- Increasing profits : Expanding into new markets can help companies in capital-intensive industries reduce their average unit costs by spreading fixed expenses over higher levels of production ( integration into the global supply chain).

2- Access to resources and markets: Foreign direct investment (FDI), the acquisition of physical productive assets, involves a longer-term commitment. Cross-border investing is supported by specialist service providers such as foreign exchange dealers and accountants.

3- Intrinsic gain: Increased understanding and empathy between actors and individual growth that comes from broadening one’s horizons and gaining exposure to new ideas.

Question 136

Costs of Globalization and Threats of Rollback :

1- Unequal Accrual of Economic and Financial Gains : Generate gains for certain individuals and countries and losses for others.

2- Lower Environmental, Social, and Governance Standards

3- Political Consequences : The perceptions that the gains of globalization are perceived to be inequitably distributed and that domestic standards have been lowered to attract foreign companies can lead to a popular backlash against globalization.

4- Interdependence : Countries can become dependent on others for certain critical products. They may come to regret the loss of domestic production capacity during times of crisis (Ex: Covid-19 and masks productions).

Question 137

Re-globalizing production: The COVID-19 pandemic has also demonstrated the global supply chain’s vulnerability to disruptions in one or more countries. While companies will continue to source inputs from foreign markets, they have begun to diversify their supply chains, even duplicating certain elements of them. This helps to mitigate exposure to production disruptions, rising labor costs, and political risk.

Question 138

Reshoring the essentials : Many companies have sought to reduce their exposure to manufacturing and procurement risk by returning production of certain essential items back to their domestic market.

Answer 138

Doubling down on key markets: While the costs and risks of operating in markets such as China have increased, productivity has also increased. Relocating foreign operations would require significant investments of time and capital that few companies are willing or even able to undertake.

Question 139

While globalization can be facilitated and accelerated by political cooperation, it is an independent process that can be driven even without government support or harmonized rules. Non-state actors can advance the process of globalization through exchanges.

Question 140

1944: United Nations Monetary and Financial Conference in Bretton Woods, New Hampshire. This conference resulted in the creation of the World Bank and led to the establishment of the International Monetary Fund (IMF), which formally came into existence in 1945.

Answer 140

The World Bank’s initial purpose was to fund and facilitate post-war reconstruction and development efforts, while the IMF was focused on stabilizing exchange rates and the global payments system.

Question 141

The IMF has a mandate to:

• Provide a forum for cooperation on international monetary problems.
• Facilitate international trade.
• Promote employment, economic growth, and poverty reduction.
• Support exchange rate stability.
• Lend to members temporarily under adequate safeguards. This was enhanced following the 2007-2009 financial crisis.
• Monitor global, regional, and country economies.
• Help resolve global economic imbalances.
• Assess financial sector vulnerabilities.

Question 142

The World Bank helps countries fight poverty and enhance economic growth. It seeks to assist developing countries with the following activities:

• Strengthening government institutions and educating government officials.
• Implementing legal and judicial systems that encourage business.
• Protecting individual rights and honoring contracts.
• Developing robust financial systems.
• Combating corruption.

Question 143

The role of the International Development Association (IDA) is most accurately described as: lending to countries with developing economies.

Question 144

Within the parameters of this framework, we can develop four models that actors can adopt:

Autarky: Nationalism and Non-Cooperation

Hegemony: Globalization and Non-Cooperation

Multilateralism: Globalization and Cooperation

Bilateralism: Nationalism and Cooperation

Question 145

Autarky:

An autarkic regime exerts strong centralized influence or control over technology, goods, services, and media.

Answer 145

This model has been cited as a part of a stepping stone approach that countries such as China have used to transition toward more open economies and societies.

Question 146

Hegemony:

The hegemonic model is typically adopted by regional (or global) leaders seeking to leverage their influence to exert control over resources. Key export industries are often dominated by state-owned enterprises.

Answer 146

United States and Russia.

Question 147

Multilateralism :

The multilateralism model involves engaging in mutually beneficial trading relationships with extensive harmonization of rules. Singapore, a prime example of this model, has little choice but to trade with the rest of the world due to that country’s limited geography and natural resources.

Question 148

Bilateralism :

Bilateralism is similar to multilateralism, but this model calls for countries to engage with other countries on a one-at-a-time basis.

Question 149

In practice, countries commonly adopt an approach called regionalism, which falls between bilateralism and multilateralism on the spectrum and involves cooperating with countries within a regional bloc.

Question 150

Under the autarky model, state-owned enterprises are typically granted control of strategically important domestic industries.

Hegemonic countries tend to allow state-owned enterprises to control key export sectors.

Question 151

The tools used by state and non-state actors in pursuit of their geopolitical objectives can be classified into three categories:

National security tools
Economic tools
Financial tools

Answer 151

1- National security tools are used by governments with the intention of coercing another country to take certain actions. The clearest example of a national security tool is the active use of military force.

2- Economic tools typically take the form of multilateral trade agreements. They include broad-based agreements on tariff harmonization among World Trade Organization (WTO) members, as well as agreements that are limited to countries within the same region.

3- Involves cooperation between countries. Sanctions, capital controls, and restrictions on currency trading are examples of non-cooperative financial tools.

Question 152

The GATT was the only multilateral body governing international trade from 1948 to 1995. It operated for almost half a century as a quasi-institutionalized, provisional system of multilateral treaties and included several rounds of negotiations.

Question 153

Non-cooperative economic tools include the nationalization of industries that are deemed to be strategically critical (e.g., energy). Voluntary export restraints and domestic content requirements are other examples of economic tools that countries can deploy unilaterally.

Question 154

Cabotage is the right to transport passengers or goods within a country by a foreign firm. Many countries—including those with multilateral trade agreements—impose restrictions on cabotage across transportation subsectors, meaning that shippers, airlines, and truck drivers are not allowed to transport goods and services within another country’s borders. Allowing cabotage requires coordination on areas like physical security and economic coordination, a highly multilateral (multi-tool) process.

Answer 154

geopolitical multi-tool for furthering national interests

Question 155

Through specialization, a country can develop economies of scale in the production of certain resources that can be exchanged for others in which it lacks a comparative advantage over other countries. According to this perspective, specialization and exchange lead to greater competition, increased consumer choice, and more efficient allocations of resources.

Question 156

Types of Geopolitical Risk :

1- Event risk: refers to uncertainty surrounding date-specific milestones (e.g., elections, new legislation) that can be known in advance.

2- Exogenous risk is the possibility of sudden, unanticipated developments that impact a country’s cooperative stance and/or the ability of non-state actors to participate in globalization. These are also known as black swan risks because they relate to events that are extremely rare and highly unpredictable.

3- Thematic risks are known, but they expand and evolve over time. Climate change and the ascent of populist political movements are examples of thematic risks.

Question 157

When assessing any particular geopolitical risk, investors must consider the following factors:

1- The likelihood of occurrence : Measuring the probability of geopolitical risks can be challenging due to their nature. Events and outcomes are dependent on interactions between many complex and dynamic factors.

2- The velocity (speed) of impact : The term high velocity is used to describe a risk that has the potential to affect the short-term performance of an investor’s portfolio. Black swan risks tend to exhibit high velocity, causing investors to make short-term tactical adjustments (such as a temporary “flight to quality”) but rarely resulting in changes to long-term strategic asset allocations.

3- The size and nature of impact : The nature of a risk’s impact can be classified as discrete or broad. Discrete impact risks relate to specific companies or sectors. By contrast, broad impact risks have the potential to affect investment performance on a national or even international scale.

Question 158

A signpost is an indicator that a particular risk is becoming more or less of a possibility. For example, if the yield on a government’s 10-year treasury notes is used as a signpost, 3% may be interpreted as a sign of low risk, but an increase to 3.5% may indicate that the likelihood of adverse events has reached a critical level, prompting an investor to implement a previously prepared action plan.

Question 159

2019: US Federal Reserve created the Geopolitical Risk Index (GPR) as a metric of real-time geopolitical risk perception among journalists, investors, policymakers, and the general public. The index’s creators noted three key observations:

1- High levels of political risk reduce US investment.

2- The negative impact on investment is greater in response to idiosyncratic geopolitical risk events.

3- Threats of adverse events had a greater impact than adverse events themselves.

Question 160

International Trade

Answer 160

describe the benefits and costs of international trade

compare types of trade restrictions, such as tariffs, quotas, and export subsidies, and their economic implications

explain motivations for and advantages of trading blocs, common markets, and economic unions

Question 161

Foreign direct investment (FDI) and foreign portfolio investment (FPI) :

1-FDI is an investment by companies in physical productive assets in foreign countries.

2- FPI involves holding securities such as stocks or bonds issued by foreign companies or governments.

Answer 161

FDI tends to be longer-term in nature than FPI.

Question 162

Economies that are more integrated with the rest of the world are more exposed to crises that originate beyond their borders. However, greater openness to international trade also allows countries to recover more quickly from economic downturns.

Question 163

Benefits and Costs of International Trade :

Benefits of International Trade:

1- Gains from exchange as countries receive higher prices for exports and pay less for imports.

2- Greater economies of scale and lower average production costs as companies gain access to larger markets.

3- Greater product variety for households and firms that gain access to goods and services from beyond their domestic markets.

4- Increased competition from abroad forces domestic firms to operate more efficiently. Consumers also benefit from the reduction in pricing power for domestic firms compared to what they would enjoy in the absence of foreign competition.

5- More efficient allocation of resources toward sectors and firms that offer the products and services that are most valued by global consumers. Countries are not required to focus only on sectors in which they have an absolute advantage of being able to produce at a lower cost than all of their trading partners.

Answer 163

Costs of International Trade : Opponents of free trade point to greater income inequality and job losses in developed countries due to competition from countries with lower-cost operations. Labor-intensive industries will tend to shift production to low-wage countries and/or invest heavily in automation, which reduces the need for human workers. Domestic firms operating in industries in which the country does not enjoy a comparative advantage may be forced to shut down in the face of international competition. Resources and capital will flow into industries that can compete internationally.

Question 164

Countries engage in intra-industry trade even when they are able to meet domestic demand. For example, while both Japan and Germany have leading auto manufacturing industries that are capable of supplying their respective domestic markets, Japan imports German cars (and vice versa) because consumers in both countries value the ability to choose from a greater variety of cars.

Question 165

Opening an economy to international trade can lead to higher unemployment, at least in the short-term, and workers may need to be retrained for jobs in growth industries. Individuals and firms that benefit from trade could, in theory, compensate those who have incurred losses and still experience a net gain.

Question 166

Trade restrictions are measures that limit the free exchange of goods and services between countries. They include tariffs, import quotas, voluntary export restraints, subsidies, embargoes, and domestic content requirements. They may be implemented for several reasons, ranging from increasing government revenues to national security concerns.

Question 167

Tariffs :

Tariffs are taxes levied on foreign goods, often to protect domestic industries. According to the infant industries argument, tariffs can be used to shield companies in emerging sectors until they can compete with larger international firms.

Answer 167

Large countries : Price maker
Small countries : Price taker

If a large country imposes tariffs on imported goods and services, small country exporters will reduce their prices to retain their share of the large country’s market.

Question 168

In theory, imposing tariffs can improve a large country’s terms of trade and welfare by reducing the cost of imports. On the following assumptions:

1- Other countries do not retaliate.

2- The deadweight loss imposed by the tariff is less than the benefit from better terms of trade.

Answer 168

Tariffs will reduce the net global welfare, regardless of how the losses are distributed among trading partners.

Question 169

Quotas :

A quota restricts the quantity of a good that can be imported. The quantity is specified with an import license. Foreigners can often raise the prices of their goods since the supply is limited. This will give them extra profits called quota rents.

Answer 169

A voluntary export restraint (VER) is a self-imposed limit on the quantity of exports to other counties. VERs allow the exporting country to capture quota rents and impose welfare losses on the importing country.

Question 170

Export Subsidies :

Such subsidies distort trade by encouraging companies to shift their sales to foreign markets. In a small country, domestic consumers pay a price that incorporates both a good’s international market price and the subsidy.

Answer 170

In both large and small countries, export subsidies have a net negative effect on national welfare. However, the impact is proportionally greater for large countries because the reduction in the global price effectively transfers part of the subsidy to foreign consumers. Additionally, trading partners may respond to export subsidies by imposing countervailing duties.

Question 171

Which of the following trade restrictions is likely to result in the greatest welfare loss for the importing country?

A
A tariff.

B
An import quota.

C
A voluntary export restraint.

Answer 171

C is correct. With a voluntary export restraint, the price increase induced by restricting the quantity of imports (= quota rent for equivalent quota = tariff revenue for equivalent tariff) accrues to foreign exporters and/or the foreign government.

Question 172

Which of the following statements is most accurate?

A
A country cannot improve its welfare by imposing tariffs

B
A country will improve its welfare by imposing tariffs as long as other countries do not retaliate

C
A country’s welfare may decrease when it imposes tariffs on goods even if it is large enough to influence the global prices of those goods

Answer 172

C) A country that is large enough to influence the price of a good can improve its terms of trade by imposing tariffs if exporters reduce their prices to maintain their share of the large country’s market.

However, even in large countries, tariffs create deadweight losses due to inefficient allocation of resources. A large country can only improve its welfare by imposing tariffs if none of its trading partners retaliate and the deadweight losses are less than the benefits from improved terms of trade.

Question 173

Extopia, a large, developed country, is world’s largest producer of cotton. In order to stimulate the country’s export sector, Extopia’s government will be implementing an export subsidy of $0.20 per pound of cotton. If the current global market price of cotton is $1.40 per pound, the most likely outcome after the implementation of this export subsidy is that:

A
the global market price of cotton will decrease below $1.40 per pound.

B
the domestic price of cotton will increase to $1.60 per pound in Extopia.

C
Extopia will increase its share of the global cotton trade at the current market price of $1.40 per pound.

Answer 173

A

Question 174

Types of Trading Blocs :

A regional trading bloc is a group of countries that attempts to reduce or eliminate trade barriers. Regional trading blocs include the North American Free Trade Agreement (NAFTA) and the European Union (EU).

• Free trade areas eliminate all barriers among member groups. Each country in the group can determine its own policies against non-members. NAFTA is an example.
• A customs union extends the free trade area by having common policies against non-members.
• The common market takes the integration further by allowing free movement of production factors among the members.
• An economic union also coordinates economic policies among the members. The EU is an example.
• A monetary union is an economic union with a common currency. The Eurozone (which consists of most of the EU member countries) is an example.

Question 175

Trade Creation and Diversion

Regional integration (e.g., customs unions) results in trade creation and trade diversion. Trade creation replaces higher-cost domestic production with lower-cost imports from member countries. Trade diversion substitutes lower-cost imports from non-member countries with higher-cost imports from member countries.

Question 176

The creation of regional trading blocs generally leads to a convergence of living standards among member countries due to, for example, knowledge spillovers as economies become more integrated. Also, enjoy greater bargaining power when dealing with non-member countries than they would on their own.

Answer 176

The disadvantages of regional integration include losses for certain sectors or categories of workers. Governments may need to help retrain employees whose jobs have been displaced due to competition with countries that hold a comparative advantage. For older workers, it may not be possible to find comparable opportunities.

Question 177

Challenges to Deeper Integration :

Concerns about cultural differences and sovereignty can complicate the process of integration.

Question 178

Regional trading agreements are politically less contentious and quicker to establish than multilateral trade negotiations (for example, under the World Trade Organization). Policy coordination and harmonization is easier among a smaller group of countries.

Answer 178

Quicker and easier policy coordination.

Question 179

Capital Flows and the FX Market

Answer 179

describe the foreign exchange market, including its functions and participants, distinguish between nominal and real exchange rates, and calculate and interpret the percentage change in a currency relative to another currency

describe exchange rate regimes and explain the effects of exchange rates on countries’ international trade and capital flows

describe common objectives of capital restrictions imposed by governments

Question 180

For exam purposes, exchange rates will be quoted in price/base terms. The numerator is the amount of the price currency required to purchase one unit of the base currency. For example, an EUR/GBP exchange rate of 1.25 means that it will cost 1.25 euros to purchase one UK pound.

Question 181

FX quotes represent nominal exchange rates. By contrast, real exchange rates are used by economists to compare currencies in terms of their purchasing power. Purchasing power parity (PPP) asserts nominal exchange rates will adjust, so identical baskets of goods have the same real price in different countries.

Question 182

Market Participants :

The sell-side consists of large FX trading banks.

Answer 182

The buy-side can be broken down into several categories:

• Corporate accounts – purchases and sales of goods and services; investment flows
• Real money accounts – investment funds managed by entities like insurance companies and mutual funds; restricted in the use of leverage
• Leveraged accounts – entities like hedge funds and commodity trading advisers that engage in active trading for profit
• Retail accounts – includes exchanging currency at the airport kiosk and small electronic trading accounts
• Governments – could be transactional or following policy goals
• Central banks – sometimes intervene to protect the domestic exchange rate
• Sovereign wealth funds (SWFs) – used by countries with large current account surpluses to hold capital flows rather than reserves managed by central banks

Question 183

Exchange Rate Quotations :

The “A/B” quoting convention for exchange rates represents how many units of currency A are required to purchase one unit of currency B. Currency A is the price currency, and currency B is the base currency.

Question 184

A direct quote uses the domestic country for the price currency and the foreign country for the base currency. An indirect quote is simply the reciprocal of the direct quote. For example, from the perspective of an investor in the eurozone, the direct and indirect quotes for UK pounds (GBP) are:

Direct quote: EUR/GBP = 1.25 (1 pound costs 1.25 euros).
Indirect quote: GBP/EUR = 1/1.25 = 0.80 (1 euro costs 0.80 pounds).

Question 185

Banks that are active in FX markets quote two-sided prices for the base currency. The bid represents the price at which the bank will buy the base currency and the offer represents the price at which the bank will sell. These banks profit by buying at the bid price and selling at the offer price. Bid/offer spreads have narrowed as FX markets have adopted electronic trading.

Question 186

An increase in the exchange rate will represent an appreciation for the base currency and depreciation for the price currency.

Answer 186

For example, an increase in the EUR/GBP rate from 1.25 to 1.30 represents a 4% increase. This means a 4% appreciation in the British pound against the euro. In GBP/EUR terms, the rate has fallen from 0.80 to 0.7692, which is a decrease of just 3.85%. This means a 3.85% depreciation in the euro against the British pound.

Question 187

A country’s exchange rate regime is the policy framework adopted by its central bank. The ideal currency regime would have the following properties:

1- Exchange rates between currency pairs are credibly fixed.

2- All currencies would be fully convertible (i.e., unrestricted capital flows).

3- Each country undertakes an independent monetary policy for domestic objectives.

Answer 187

However, these three properties are inconsistent with each other. If the first two were true, different currencies would be interchangeable like coins and bills of the same currency. It is not possible to achieve the ideal currency regime.

Question 188

If we allow for floating (rather than fixed) exchange rates, a decrease in the domestic interest rate makes the domestic currency less attractive. This would increase the demand for domestic goods, which reinforces the expansionary monetary policy.

Question 189

In 1944, major economies adopted the Bretton Woods system of fixed exchange rates that were periodically adjusted.

In 1973, the Smithsonian Agreements put an end to the Bretton Woods system, and the world moved to a system of flexible exchange rates. In response to unexpectedly high exchange rate volatility following this liberalization, European countries created an Exchange Rate Mechanism (ERM) that allowed for currency values to fluctuate within a narrow band.

Question 190

Countries that adopt the euro give up their ability to manage exchange rates and practice independent monetary policy.

Question 191

A Taxonomy of Currency Regimes :

The International Monetary Fund (IMF) has classified actual exchange rate regimes into eight categories

1- Arrangements with No Separate Legal Tender : Dollarization and monetary union are two examples of countries abandoning their domestic currency (The country inherits currency credibility. Dollarization imposes fiscal discipline by stopping the central bank from monetizing government debt through purchasing government bonds).

2- Currency Board System: A currency board system (CBS) is a legislative commitment to fix the exchange rate with a specified foreign currency. The foreign currency is held as a reserve to back the entire monetary base. Hong Kong is an example of a CBS backed by US dollar reserves. Unlike dollarization, a currency board system allows the monetary authority to earn a profit (called seigniorage) on the spread between the interest earned on assets (reserves) and the minimal interest paid on its liabilities (the monetary base).

3- Fixed Parity : Fixed parity differs from CBS in two ways. First, there is no legislative commitment to maintain a fixed exchange rate. Second, the foreign exchange reserves’ target level is discretionary rather than linked to the domestic money supply. The exchange rate can be pegged to a single currency or index of multiple currencies.

4- Target Zone: Target zone regimes are fixed-rate parity regimes with wider bands (up to ± 2%).

5- Active and Passive Crawling Pegs: Under this regime, exchange rates are adjusted frequently to keep pace with inflation. The approach is active if the adjustment is announced in advance.

6- Fixed Parity with Crawling Bands : This regime allows a country to wean off a fixed parity system gradually (e.g., starts from ± 1%, then ± 2%, then ± 3%, and so on).

7- Managed Float : In this approach, a country bases its exchange rate policy on internal or external policy targets.

8-Independently Floating Rates: This regime allows the market to determine the exchange rate and the monetary authority to carry out an independent monetary policy. Most major currencies use this approach, although some government intervention is still present.

Answer 191

Many countries adopt regimes somewhere between fixed and flexible exchange rates. Fixed approaches are better for countries that lack credibility.

Question 192

A fixed exchange rate regime in which the monetary authority is legally required to hold foreign exchange reserves backing 100% of its domestic currency issuance is best described as:

A
dollarization.

B
a currency board.

C
a monetary union.

Answer 192

B is correct. With a currency board, the monetary authority is legally required to exchange domestic currency for a specified foreign currency at a fixed exchange rate. It cannot issue domestic currency without receiving foreign currency in exchange, and it must hold that foreign currency as a 100% reserve against the domestic currency issued. Thus, the country’s monetary base (bank reserves plus notes and coins in circulation) is fully backed by foreign exchange reserves.

Question 193

A country that imports more than it exports will record a trade deficit, which must be offset by a capital account surplus (i.e., borrowing from foreigners). As a corollary, a country that has a trade surplus will have a matching capital account deficit (i.e., lending to foreigners).

Question 194

Over the short-to-intermediate term, changes in international capital flows are primarily determined by fluctuations in exchange rates and asset prices.

Question 195

Governments often restrict the ability of foreigners to invest in domestic industries that have been deemed strategically important, such as defense, telecommunications, and natural resources. Foreign investors may also be subject to restriction when attempting to repatriate their capital, interest, and profits. In countries with relatively low foreign exchange reserves, domestic investors may be limited in their ability to invest abroad and there may be deadlines for the repatriation of income earn on foreign investments.

Question 196

Governments have used capital controls such as prohibitions on the purchase of foreign assets and loans to foreigners to achieve the following objectives:

• Keeping capital within the domestic economy
• Increasing tax revenues on wealth and interest income
• Reducing the cost of government debt
• Allocating credit within the domestic economy

Question 197

Restrictions :

1- Price controls include taxes on international investment, taxes on certain types of transactions, and mandatory reserve requirements.

2- Quantity restrictions on capital controls may take the form of ceilings on borrowing from foreign creditors or special authorization requirements for new or existing borrowing from foreign creditors.

3- Administrative controls typically take the form of requiring approvals for transactions involving certain types of assets.

Question 198

Empirical evidence suggests that capital restrictions can be costly to administer and have a mixed record in terms of helping governments achieve their objectives.

Question 199

A trade deficit must be exactly matched by an offsetting capital account surplus to fund the deficit. A capital account surplus reflects borrowing from foreigners (an increase in domestic liabilities) and/or selling assets to foreigners (a decrease in domestic assets). A capital account surplus is often referred to as a “capital inflow” because the net effect is foreign investment in the domestic economy.

Question 200

A country with a persistent trade surplus is being pressured to let its currency appreciate. Which of the following best describes the adjustment that must occur if currency appreciation is to be effective in reducing the trade surplus?

A
Domestic investment must decline relative to saving.

B
Foreigners must increase investment relative to saving.

C
Global capital flows must shift toward the domestic market

Answer 200

C is correct. The trade surplus cannot decline unless the capital account deficit also declines. Regardless of the mix of assets bought and sold, foreigners must buy more assets from (or sell fewer assets to) domestic issuers/investors.

Question 201

Exchange Rate Calculations

Answer 201

calculate and interpret currency cross-rates

explain the arbitrage relationship between spot and forward exchange rates and interest rates, calculate a forward rate using points or in percentage terms, and interpret a forward discount or premium

Question 202

Quotations for currency pairs are given in terms of a price currency per unit of a base currency.

Answer 202

For example, a grocery store in the United States selling apples for 20 cents per unit would quote a price of $0.20/apple. In this case, the “base” is one apple and the “price” is USD 0.20.

Question 203

For example, if the one US dollar can be exchanged for 18.56 South African rand (ZAR) and one Swiss franc (CHF) can purchase USD 1.09, then the cross-rate calculation to find the ZAR/CHF exchange rate is: 18.56 * 1.09 = 20.23

Answer 203

Cross-rate calculations can be used to determine the presence of triangular arbitrage opportunities. In the above example, a Swiss investor who is quoted a ZAR/CHF rate of 20.00 would earn an arbitrage profit by taking the following steps:

Convert CHF 100 into USD 109 ( 100 * 109)
Convert USD 109 into ZAR 2,023 (109 * 18.56)
Convert ZAR 2,023 into CHF 101.15 (2023 * 1/ 20.00)

Question 204

Forward exchange rates are typically quoted in points (or “pips”). The points represent the difference between the forward rate quote and the spot rate quote. The points will be positive when the forward rate is greater than the spot rate, which is described as a forward premium for the base currency.

Question 205

For example, if the spot rate was 1.2863 and the forward points were 24.7, the forward rate would be:

1.2863 + 24.7 / 10,000 = 1.2887

Answer 205

One point equals 0.0001. Certain FX rates, often those that have the Japanese yen as the price currency, are only quoted to two decimal places. For those rates, one point equals 0.01.

Question 206

The absolute number of points usually increases with maturity because the points are related to the yield differential between the countries. An investor can either invest risk-free in the domestic currency or risk-free in a foreign currency using spot and forward exchanges. The two investment strategies must be equal to avoid arbitrage.

Question 207

It is appealing to think of forward rates as expected future spot rates. However, historical data shows forward rates are inaccurate, though unbiased, predictors of spot rates. FX markets are affected by many factors other than interest rates.

Answer 207

Empirical evidence indicates that forward exchange rates are not biased predictors of future spot rates, meaning that there is no systematic over- or under-estimation. However, the margin of error is so large that this information is of little value in making such predictions.

Question 208

forward premium indicates, the interest rate is higher in the price currency than in the base currency.

Question 209

A Japanese company seeking to hedge the exchange rate risk attributable to a large USD-denominated payment expected from an American customer in six months would most likely : buy JPY in the forward market.

Answer 209

Because the Japanese company is expecting a payment denominated in USD, it has long USD exposure. If the company does not hedge this exposure, it will suffer in the event that the USD depreciates relative to the JPY over the next six months. This exposure can be hedged by entering a forward contract to sell USD and buy JPY.