l2 flash cards economics - ss 4

Study Session 4, Reading 15

Sources of Economic Growth

Factors affecting labor productivity growth are:1. Physical Capital2. Human Capital3. Technological advancement

Population growth increases aggregate hours and real GDP


Preconditions for Economic Growth

Incentive systemsMarketsClearly established property rights and their enforcementMonetary exchange


The 1/3 rule

Measure the contributions of an increase in capital per hour of labor and technological change to the growth of labor productivity.

Used to divide change in productivity growth in two components attributed to

1. Change in capital per labor hour2. Technological change


Three Sources of Faster Economic Growth

Saving and Investment in New CapitalInvestment in Human CapitalDiscovery of New Technologies


Main Sources of Achieving Faster Economic Growth

Stimulate savingsStimulate research and developmentHigh technology industry targetingEncouragement of international tradeImprovement in the quality of education


Classical Theory of Economic GrowthWhen real GDP rises above subsistence level, a population

explosion occursAdvancements in technology leads to increased investment in

new capital which increases labor productivity. Increase in real wage rate


Classical Theory of Economic Growth (cont.)


Neo Classical Theory of Economic GrowthWithout technological change, no long term growth in real GDP

will occur. Saving and investments are increased due to changes in

technology which leads to higher capital per labor hour. Economic growth will only decline if technology stops advancing. Population growth is independent of economic growth.People use a target rate of return as the benchmark when they

are making savings decisions. Growth in labor productivity


New Growth Theory of Economic GrowthBased on two properties of market economies, (1) discoveries

are the result of choices (2) discoveries lead to profits and competition eliminates profits.

Discoveries of new products and techniquesThe rate at which discoveries are madePublic capital goods and the law of diminishing return Describes the economy as “perpetual motion economy”


New Growth Theory of Economic Growth (cont.)


Economic RegulationRefers to regulations set by government for specific industries. To reduce the deadweight loss due to monopoly pricingTwo types of regulations of natural monopolies:1. cost of service regulation - the price a monopolist can charge is

restricted to marginal cost or average cost pricing. 2. rate of return regulation - regulators set the price so that a

competitive rate of return is earned by the monopolist company.


Social RegulationThe main objectives are to protect people from incompetent or

unscrupulous producers.Include regulations to protect consumers and to improve the

functioning of markets.


Effects of Social Regulation

Increased regulation mostly results in higher production costs.Higher level of regulationFirms may attempt to avoid the regulation or minimize the costs.


Merits and Demerits of Social RegulationsSafer products, cleaner environment and safer workplaces are

some benefits of social regulationCompanies can incur significant expenditures. Businesses may engage in activities intended to avoid the true

objective of regulationFirms subject to regulation and not conforming to the intent of

the regulation is referred as a creative response. Feedback effect is an example of a creative response to regulation

in which consumer’s behaviour is changed due to new regulation.


Capture Theory of Economic Growth Regulators will be selected from industry “experts”Industry participants are able to present more persuasive

argument to regulatorsOnly the interests of industry participants are of paramount

interest to the regulatory agency


Share-the-gain, share-the-pain Theoryof Economic Growth The assumption that regulators must worry about legislators and

consumers as well. Regulators consider the consequences of their decisions from a

viewpoint of all three Predicts a slower and more measured regulatory response

rather than a speedy and more favourable response to the firms.


Comparative Advantages and Benefits of International TradeThe lower opportunity cost to produce a product is referred to

as a comparative advantage and is the fundamental source of gains from trade.

As long as a country has a comparative advantage in producing some good, both countries can benefit from trade.

A country gains from when it exports the goods in which it has a comparative advantage and imports those in which it does not have advantage.


Merits of International TradeThe slope of each country’s production possibility frontier at its production point represents the opportunity cost of

producing one good in terms of another. This slope is the opportunity cost of production.

As long as the opportunity cost of production differs between two countries, both countries can benefit from

Comparative advantage explains the increase in international trade taking place over time.

The gain from specialization and trade is that both countries can consume outside their production possibility frontier


TariffsA tariff is a tax imposed on imported goodsTariffs benefit domestic producers because the level of imports

will be reduced due to an effective increase in the price of the good in the domestic market.

Tariffs provide revenue for the government. The benefits of free international trade is reduced when tariffs

are imposed.


QuotasA quota is a limitation on the quantity of goods that can be

importedUnder a quota, the supply of imported goods is reduced. The key difference between a quota and a tariff lies in who collects

the gap between the exporter’s supply price and the domestic price. When tariffs are imposed, it is collected by the government of the country importing the good. In the case of a quota, it goes to the importer.

The imposition of quotas reduces the competition from foreign producers which benefit local producers.


Voluntary Export RestraintsAgreements by exporting countries to limit the quantity of goods

they will export to an importing countryThe government of an exporting country has to establish

procedures for allocating the limited volume ofGains are received by firms in the exporting countries that have

export permits.


Primary Reasons for Trade Restrictions Governments receive tariff revenueDomestic producers may need protection from foreign

competition


Arguments in Support of Trade Restrictions with Some ValidityDeveloping (infant) industries should be protected until they

reach a globally competitive standard of quality and productivity.Exporters should be prohibited from selling goods at less then

their production cost in foreign countries. Trade restrictions should protect those industries which are

associated with national defence.


Arguments in Support of Trade Restrictions with Little ValidityTrade restrictions protect domestic jobsTrade restrictions create jobsAllow country to compete with cheap foreign laborBring diversity and stabilityTrade restrictions protect national cultureTrade restrictions prevent rich countries from exploiting

developing countries


Direct Quotations

Direct quotation of currency X is the value of one unit of currency X in units of the counter currency, currency Y.

The quotation 0.75 CAD: USD is an example of direct quote of the Canadian dollar to the US dollar.


Indirect Quotations

An indirect quote for currency X is the amount of currency X for one unit of currency Y.

The quotation 0.75 CAD:USD is an indirect quote of USD to the Canadian investor.


Converting an Indirect into a Direct Quote

An investor can simply reverse the units of quotations. The reciprocal of the indirect quotation is the direct quoted rate.

Continuing with our previous example, the indirectly quoted rate can be converted into direct quotation by:

USD: CAD = 1/0.75 = 1.333


Factors Affecting the Spread on a Foreign Currency Quotation

1. Market conditions2. Positions of bank and currency dealer 3. Trading volumes.

spread - the difference between the bid and ask price of a dealer


Market Conditions

Exchange rate uncertainty typically increases the spread between the bid and ask price of foreign currency.

Larger spreads between foreign currencies compensates dealers for the risk of dealing in currencies with higher exchange rate volatility.


Bank and Currency Dealer PositionsTo reflect trading objectives, dealers often adjust the spread up

or down. If a dealer has excess position in a currency, he lowers both the

bid and ask price.


Trading Volumes

Increase trading volumes in a currency causes the spread to be narrowed.

Currency pairs with more trading volumes like EUR: USD, EUR: JPY typically have narrower spreads compared to less actively traded currencies.


Calculating Currency Cross Ratescurrency cross rate - the exchange of two currencies with a common

third currency (reference currency).

Cross rates must be computed from the exchange rates between each of the two currencies to a third currency, usually EUR or USD.

The key to calculating cross rates is that the desired result of the cross rate between two currencies be calculated algebraically


Profit on Triangular Arbitrage OpportunitiesThree pairs of currencies with bid and ask quotes are present in

triangular arbitrage. For identify arbitrage opportunities (riskless profit), you go from

the starting point and convert currencies in either in a clock wise or anti clock wise direction until you reach the point from where you started and end up having more currency than originally.

Triangular arbitrage ensures consistency between exchange rates and cross rates


Calculating Profits from Triangular ArbitrageStart in the home currency and go both ways around the triangle

by exchanging the home currency for the first foreign currency, then exchanging the first foreign currency to the second foreign currency and then exchanging the second foreign currency back in the home currency. If the money at the end of triangle is more than at the start, there is an arbitrage opportunity.

Taking transaction costs into consideration, one should end up with having less money when completing the triangle.


Spot Exchange RateSpot foreign exchange markets refer to transactions which call

for immediate delivery of a currency.Spot exchange rates are quoted for immediate currency

transactions, although in practise the settlement takes place after 2 business days (T+2 settlement).

Spot transactions are used to settle commercial purchases of goods as well as for investment purposes.


Forward Contract for Currency ExchangeForward FX market transactions refer to the exchange of

currencies that will occur in the future.Forward exchange rates are commonly used by asset managers

and companies to manage their foreign currency positions.Both parties to the transaction in currency forward contract

agree to exchange one currency for another currency at a specific future date for a specific price that is fixed today.

For transactions 30, 60, 90, or 180 days in the future


Forward Discount (Premium)If in future an investor pays less (more) in their domestic

currency per unit of foreign currency, the foreign currency is at a forward discount (premium).

A currency is quoted at a forward discount (premium) relative to the second currency if the forward price (in units of secondary currency) is less (greater) than the spot price.


Calculating Discount (Premium)The forward discount, or premium, is calculated as an annualized

percentage deviation from the spot rate. The annualized forward premium (discount) of a currency is equal to:

The percentage premium (discount) is annualized by multiplying by 12 and dividing by the length of the forward contract in months.

%100.

12

forwardMonthsofNorateSpot

rateSpotrateForward


Interest Rate Parity

Interest rate parity implies that the discount interest rate differential is equal to the forward premium or discount.

Interest rate parity holds that the forward discount (premium) is equal to the interest rate differential between two currencies.


Covered Interest ArbitrageCovered Interest Arbitrage - a trading strategy that exploits mispricing

between spot and forward rates.

Process of simultaneously borrowing the domestic currency, transferring the domestic currency into foreign currency at the spot rate, lending it and buying a forward exchange rate contract to repatriate the foreign currency into domestic currency at the forward exchange rate. The net result of such a trading strategy should be zero. If not, a covered interest arbitrage opportunity exists.


Determining Strength of Currencyspot rate - the exchange rate for immediate transaction forward exchange rate - for a transaction at a specific future date A currency selling at a forward premium is considered “strong” relative to

the second currency and the currency is expected to appreciate.A currency selling at a forward discount is considered weak and is

expected to depreciate.The annual forward discount/ premium is calculated by using the

following formula:

%100.

12

forwardMonthsofNorateSpot

rateSpotrateForward


Flexible Exchange rate System

Exchange rates are determined by demand and supply in the foreign exchange markets.

Major currencies such as dollar, euro, Swiss franc, British pound trade in a flexible or floating exchange rate system.

The exchange rates of freely traded currencies belonging to a flexible exchange rate system are determined by their demand and supply.


Components of the Balance of Payment Account

The Balance of Payment includes government transactions, consumer transactions, and business transactions

In the balance of payment accounts, the Current Account includes the balance of goods and services, income received or paid on current investments, and current transfers. The Financial Account includes short and long term capital transactions.

The BOP equation is:

0 accountreserveofficialaccountfinancialaccountcurrent


Balance of Payment Account

Used to keep track of transactions between a country and its international trading partners.

Reflects all payments and liabilities to foreigners, and all payments and obligations received from foreigners.


Current Account

Covers all transactions that take place in the normal business of residents of a country.

The balance on the current account summarizes whether a country is selling more goods and services to the rest of the world than it is buying (current account surplus), or buying from the rest of the world is more than the sales to the rest of the world (a current account deficit).


Financial Capital Account Measures the flow of funds for debt and equity investment into

and out of the country.Covers a country’s residents investment abroad and non-

residents investment in the country.

Official Reserve Account Tracks all reserve transactions by monetary authorities.


Current Account deficit (surplus) and Financial Account Surplus (deficit)

Countries that run current account deficits tend to run financial account surpluses so that the current account deficit is offset by a financial account surplus.

As long as foreign investors are willing to finance the trade deficit by net capital flows to the country, the situation posses no economic problem. The depreciation pressures from current account deficits are balanced by the appreciation pressures from financial account surplus.

A current account surplus and financial account deficit is not an indication of financial strength


Factors Affecting Exchange RatesDifferences in income growthDifferences in inflation ratesDifferences in real interest ratesChanges in the investment climate


Factors Affecting Exchange Rates (cont.)Differences in income growth Nations with high income growth demand more imported goods.

Differences in inflation ratesIn a country with a high inflation rate, its currency will depreciate as the purchasing power will be eroded compared to a country with low inflation rates.

Differences in real interest ratesWill cause the flow of capital to countries with higher real interest rates.


Factors Affecting Exchange Rates (cont.)A positive change in the investment climate will decrease the

risk of country, which will cause an appreciation of the currency of that country.

Changes in Investment Climate include changes in investment risk


Monetary Policy

Expansionary monetary policy - increases economic growth and inflation rates, causing exports to decline and the current account to deteriorate, leading to an in decrease in demand for the domestic currency.


Fiscal Policy

Expansionary fiscal policy - increases government borrowing, causing the interest rate to increase, which will attract foreign investors, consequently increasing the demand for domestic currency.


Fixed Exchange Rate Systemfixed exchange rate system - the exchange rate of a currency is fixed against another currency

official parity - an exchange rate between two currencies remains fixed at the present level

Advantages: it removes exchange rate risk and brings discipline to government policies Disadvantages: that it deprives the country of any monetary independence and constrains the

country’s fiscal policy


Pegged Exchange Rate System

pegged exchange rate system - the target exchange rate is set against a major currency

Advantage: it stabilizes the exchange rate Disadvantage: that the more inflexible the exchange rate system, the more

speculators will try to take advantage of the lack of adjustment in the exchange rate


Purchasing Power Parity: Absolute vs Real

absolute purchasing power parity - price levels should be the same across all countries after adjustment are made for exchange rates

Relative purchasing power parity - exchange rates between countries will adjust to offset the differences in the inflation rates between two countries


Calculating the End of Period Exchange Rate through Purchasing Power Parity

Formula:

Where: = spot exchange rate today = expected spot exchange rate after t periods

tt

foreign

domestic

o SElation

lationS

inf1

inf1

oS

tSE


International Fisher Relation International Fisher Relation - the nominal rate of interest is approximately equal to

the sum of the real rate and the expected inflation rate.

Linear approximation:

International Fisher Relation can also be stated as: BABNOMINALANOMINAL INFLATIONEINFLATIONERR )()()(

)infaltion(1

)inflation(1

1

1

B

A

B nominal

Anominal

E

E

R

R


Uncovered Interest Rate ParityInterest rate parity - says that we expect foreign currency appreciation or depreciation should be equal to the interest

rate differential between two countries.

Uncovered Interest Rate Parity – a situation where currency risk cannot be covered with a forward currency exchange rate contract.

covered interest rate theory - arbitrage would force the forward contract exchange rate to a level consistent with the difference between the nominal rates of interest between two countries


Uncovered Interest Rate Parity (cont.)The exact relation of interest rate parity:

foreign

domestic

R1

R1

S

E[S1]

o


Forecasting Spot Rates with Uncovered Interest Rate Parity

Formula:

1 tat time ratespot Expected So x

R1

R1

foreign

domestic


Components of Measures of Economic Activity

Gross domestic Product (GDP) - the total of all economic activity in a country regardless of who owns the productive assets.

Gross National Income (GNI) - the total income earned by the residents of a country

Net National Income (NNI) - gross national income less depreciation


Conversion of Market Price to Factor Cost GDP

Formula:

GDP at factor cost = GDP at market price + Subsidies – Indirect taxes


Reporting of GDP Figures and the GDP Deflator

Output data - collected in both current and constant prices Expenditure data - collected at current prices Income data - collected at current prices and converted into constant prices GDP deflator or price deflator - the measure of the impact of overall inflation

The GDP deflator allows for change in the relative price of goods

l2 flash cards economics - ss 4

Business

economic regulation

independent of economic

labor productivity growth

growth of labor productivity

pain theory of economic

new regulation

long term growth

real gdpstudy session