L2 flash cards economics - SS 4

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

Preconditions for Economic Growth
Incentive systems
Markets
Clearly established property rights and their enforcement
Monetary 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 hour
2. Technological change


Three Sources of Faster
Economic Growth
Saving and Investment in New Capital
Investment in Human Capital
Discovery of New Technologies


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


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


Classical Theory of Economic Growth (cont.)


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

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”


New Growth Theory
of Economic Growth (cont.)


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.


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.


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.


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.

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


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.


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.


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

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.


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.

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.


Primary Reasons for Trade Restrictions
Governments receive tariff revenue
Domestic producers may need protection from foreign

competition


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.


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


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 conditions
2. 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 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.


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 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


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


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.


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.


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


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:
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.

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 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.


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





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:
current account + financial account + official reserve account = 0

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 nonresidents 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 Rates
Differences in income growth
Differences in inflation rates
Differences in real interest rates
Changes 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 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.

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 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

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:

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

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 



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

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

E[S1] 1 + R domestic
=
So
1 + R foreign


Forecasting Spot Rates with Uncovered
Interest Rate Parity
Formula:
 1 + R domestic 

 x So = Expected spot rate at time t = 1
 1+ R

foreign 



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

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L2 flash cards economics - SS 4