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L2 flash cards economics - SS 4


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L2 flash cards economics - SS 4

  1. 1. Sources of Economic Growth Factors affecting labor productivity growth are: 1. Physical Capital 2. Human Capital 3. Technological advancement Population growth increases aggregate hours and real GDP Study Session 4, Reading 15
  2. 2. Preconditions for Economic Growth Incentive systems Markets Clearly established property rights and their enforcement Monetary exchange Study Session 4, Reading 15
  3. 3. 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 hour 2. Technological change Study Session 4, Reading 15
  4. 4. Three Sources of Faster Economic Growth Saving and Investment in New Capital Investment in Human Capital Discovery of New Technologies Study Session 4, Reading 15
  5. 5. Main Sources of Achieving Faster Economic Growth Stimulate savings Stimulate research and development High technology industry targeting Encouragement of international trade Improvement in the quality of education Study Session 4, Reading 15
  6. 6. Classical Theory of Economic Growth When real GDP rises above subsistence level, a population explosion occurs Advancements in technology leads to increased investment in new capital which increases labor productivity. Increase in real wage rate Study Session 4, Reading 15
  7. 7. Classical Theory of Economic Growth (cont.) Study Session 4, Reading 15
  8. 8. Neo Classical Theory of Economic Growth Without 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 Study Session 4, Reading 15
  9. 9. New Growth Theory of Economic Growth Based 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 techniques The rate at which discoveries are made Public capital goods and the law of diminishing return Describes the economy as “perpetual motion economy” Study Session 4, Reading 15
  10. 10. New Growth Theory of Economic Growth (cont.) Study Session 4, Reading 15
  11. 11. Economic Regulation Refers to regulations set by government for specific industries. To reduce the deadweight loss due to monopoly pricing Two 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. Study Session 4, Reading 15
  12. 12. Social Regulation The main objectives are to protect people from incompetent or unscrupulous producers. Include regulations to protect consumers and to improve the functioning of markets. Study Session 4, Reading 15
  13. 13. Effects of Social Regulation Increased regulation mostly results in higher production costs. Higher level of regulation Firms may attempt to avoid the regulation or minimize the costs. Study Session 4, Reading 16
  14. 14. Merits and Demerits of Social Regulations Safer products, cleaner environment and safer workplaces are some benefits of social regulation Companies can incur significant expenditures. Businesses may engage in activities intended to avoid the true objective of regulation Firms 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. Study Session 4, Reading 16
  15. 15. Capture Theory of Economic Growth Regulators will be selected from industry “experts” Industry participants are able to present more persuasive argument to regulators Only the interests of industry participants are of paramount interest to the regulatory agency Study Session 4, Reading 16
  16. 16. Share-the-gain, share-the-pain Theory of 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. Study Session 4, Reading 16
  17. 17. Comparative Advantages and Benefits of International Trade The 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. Study Session 4, Reading 16
  18. 18. Merits of International Trade The 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 Study Session 4, Reading 16
  19. 19. Tariffs A tariff is a tax imposed on imported goods Tariffs 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. Study Session 4, Reading 16
  20. 20. Quotas A quota is a limitation on the quantity of goods that can be imported Under 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. Study Session 4, Reading 16
  21. 21. Voluntary Export Restraints Agreements by exporting countries to limit the quantity of goods they will export to an importing country The government of an exporting country has to establish procedures for allocating the limited volume of Gains are received by firms in the exporting countries that have export permits. Study Session 4, Reading 16
  22. 22. Primary Reasons for Trade Restrictions Governments receive tariff revenue Domestic producers may need protection from foreign competition Study Session 4, Reading 16
  23. 23. Arguments in Support of Trade Restrictions with Some Validity Developing (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. Study Session 4, Reading 16
  24. 24. Arguments in Support of Trade Restrictions with Little Validity Trade restrictions protect domestic jobs Trade restrictions create jobs Allow country to compete with cheap foreign labor Bring diversity and stability Trade restrictions protect national culture Trade restrictions prevent rich countries from exploiting developing countries Study Session 4, Reading 16
  25. 25. 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. Study Session 4, Reading 17
  26. 26. 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. Study Session 4, Reading 17
  27. 27. 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 Study Session 4, Reading 17
  28. 28. Factors Affecting the Spread on a Foreign Currency Quotation 1. Market conditions 2. Positions of bank and currency dealer 3. Trading volumes. spread - the difference between the bid and ask price of a dealer Study Session 4, Reading 14
  29. 29. 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. Study Session 4, Reading 14
  30. 30. Bank and Currency Dealer Positions To 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. Study Session 4, Reading 14
  31. 31. 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. Study Session 4, Reading 14
  32. 32. Calculating Currency Cross Rates currency 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 Study Session 4, Reading 14
  33. 33. Profit on Triangular Arbitrage Opportunities Three 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 Study Session 4, Reading 14
  34. 34. Calculating Profits from Triangular Arbitrage Start 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. Study Session 4, Reading 14
  35. 35. Spot Exchange Rate Spot 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. Study Session 4, Reading 14
  36. 36. Forward Contract for Currency Exchange Forward 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 Study Session 4, Reading 14
  37. 37. 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. Study Session 4, Reading 14
  38. 38. 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: 12  Forward rate − Spot rate          No. of Months forward 100% Spot rate    The percentage premium (discount) is annualized by multiplying by 12 and dividing by the length of the forward contract in months. Study Session 4, Reading 14
  39. 39. 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. Study Session 4, Reading 14
  40. 40. Covered Interest Arbitrage Covered 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. Study Session 4, Reading 14
  41. 41. Determining Strength of Currency spot 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: 12  Forward rate − Spot rate          No. of Months forward 100% Spot rate    Study Session 4, Reading 14
  42. 42. 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. Study Session 4, Reading 14
  43. 43. 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: current account + financial account + official reserve account = 0 Study Session 4, Reading 14
  44. 44. 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. Study Session 4, Reading 14
  45. 45. 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). Study Session 4, Reading 14
  46. 46. 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 nonresidents investment in the country. Official Reserve Account Tracks all reserve transactions by monetary authorities. Study Session 4, Reading 14
  47. 47. 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 Study Session 4, Reading 14
  48. 48. Factors Affecting Exchange Rates Differences in income growth Differences in inflation rates Differences in real interest rates Changes in the investment climate Study Session 4, Reading 14
  49. 49. Factors Affecting Exchange Rates (cont.) Differences in income growth Nations with high income growth demand more imported goods. Differences in inflation rates In 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 rates Will cause the flow of capital to countries with higher real interest rates. Study Session 4, Reading 14
  50. 50. 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 Study Session 4, Reading 14
  51. 51. 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. Study Session 4, Reading 18
  52. 52. 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. Study Session 4, Reading 18
  53. 53. Fixed Exchange Rate System fixed 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 Study Session 4, Reading 18
  54. 54. 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 Study Session 4, Reading 18
  55. 55. 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 Study Session 4, Reading 18
  56. 56. Calculating the End of Period Exchange Rate through Purchasing Power Parity Formula: t 1 + inf lation domestic   = E( St ) So  1 + inf lation  foreign   Where: So = spot exchange rate today E ( S t )= expected spot exchange rate after t periods Study Session 4, Reading 14
  57. 57. 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: R NOMINAL ( A) − R NOMINAL ( B ) = E ( INFLATION A ) − E ( INFLATION B ) International Fisher Relation can also be stated as: 1 + Rnominal A  1 + E (inflation A )   =  1 + E (infaltion )  1 + R  B   nominal B   Study Session 4, Reading 14
  58. 58. Uncovered Interest Rate Parity Interest 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 Study Session 4, Reading 14
  59. 59. Uncovered Interest Rate Parity (cont.) The exact relation of interest rate parity: E[S1] 1 + R domestic = So 1 + R foreign Study Session 4, Reading 14
  60. 60. Forecasting Spot Rates with Uncovered Interest Rate Parity Formula:  1 + R domestic    x So = Expected spot rate at time t = 1  1+ R  foreign   Study Session 4, Reading 14
  61. 61. 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 Study Session 4, Reading 14
  62. 62. Conversion of Market Price to Factor Cost GDP Formula: GDP at factor cost = GDP at market price + Subsidies – Indirect taxes Study Session 4, Reading 14
  63. 63. 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 Study Session 4, Reading 14