Economics - Cfa Level Ii

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Sources of Economic Growth

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aggregate hours

labor productivity

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aggregate hours

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total number of hours worked by all employed people

components of growth in aggregate hours:

i. Working-age population growth
ii. Changes in the employment-to-population ratio
iii. Changes in average hours per worker

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labor productivity

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the quantity of real GDP produced by an hour of labor

components of growth in labor productivity:

i. Physical capital growth
ii. Human capital growth – accumulated skill and knowledge of humans
iii. Technological advances – discovery and application of new technologies and new goods

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preconditions for economic growth

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i. Markets – enable buyers and sellers to get information and do business with each other, and market prices send signals to buyers and sells that create incentives to increase or decrease the quantities demanded and supplied
ii. Property Rights – social arrangements that govern the ownership, use, and disposal of factors of production and goods and services
iii. Monetary Exchange – facilitates transactions of all kinds

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one-third rule

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On average, with no change in technology, a 1% increase in capital per hour of labor brings 1/3rd percent increase in labor productivity

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How faster economic growth can be achieved through increasing growth in physical capital, technological advances, and investment in human capital

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a. Stimulate saving for capital accumulation
b. Stimulate research and development for future technology advances
c. Target high-technology industries to be the first to exploit new technology, earning above average returns
d. Encourage international trade to extract gains from trade – export and import
e. Improve the quality of education to assure skills and potentially class mobility

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Classical Growth Theory

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the view that growth of real GDP per person is temporary and that when it rises above subsistence level, a population explosion eventually brings it back to subsistence level

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Neoclassical Growth Theory

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: the view that real GDP per person grows because technological change induces a level of saving and investment that makes capital per hour of labor grow (GDP growth is not dependent on population growth, but is dependent on technological advances)

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New Growth Theory

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holds that real GDP per person grows because of the choices people make in the pursuit of profit and that growth can persist indefinitely

i. Discoveries result from choices
ii. Discoveries bring profit, and competition destroys profit
iii. Discoveries are a public capital good
iv. Knowledge is capital that is not subject to the law of diminishing returns

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Rationale for economic regulation of Natural Monopolies

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Economic regulation of the price and sometimes quality of services – initial aim to control prices in industries with natural monopolies, which has evolved into seeking influence over the characteristics of products and processes of firms – all to prevent such industries from earning monopoly profits

Regulation may impose average cost pricing at a “fair rate of return” – based on a set price or a determined rate of return

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Rationale for social regulation of non-monopolistic industries

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Social regulation includes occupational, health and safety rules that the federal and state governments impose on most businesses and all industries – aim is to achieve a better quality of life through improved products, a less polluted environment, and better working conditions.

Main objectives to protect people from incompetent or unscrupulous producers, but at a cost to the firm and taxpayers

* protection of the end consumer; environment, etc.

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Creative response

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conforming to the letter of the law, but undermining its spirit

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Feedback Effect

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when behaviors may change after a regulation has been put into effect

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Capture Hypothesis

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claims that regardless of why a regulatory agency was originally established, eventually special interests of the industry it regulates will capture it – because agencies want experts in the field to be involved, but those expert’s allegiances often come internally

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Share-the-gains, Share-the-pains theory

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proposes that the regulator’s main objective is simply to keep his or her job as a regulator by attempting to obtain approval of both the legislators who originally established and continue to oversee the regulatory agency and the regulated industry

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Comparative Advantage

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when a country can produce a good at a lower opportunity cost than any other country

beneficial in international trade - as one country may find that it is cheaper to buy than produce certain products – net gains may be realized between imports and exports

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Tariffs

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a tax that is imposed by the importing country when an imported good crosses its international boundary

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Non-tariff barriers

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any action other than a tariff that restricts international trade (i.e. quantitative restrictions and licensing regulations limiting imports)

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Quotas

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a quantitative restriction on the import of a particular good, which specifies the maximum amount of the good that may be imported in a given period of time

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Difference between a Quota and a Tariff

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who collects the gap between the exporter’s supply price and the domestic price?

With a tariff the government of the importing country receives the gap

With a quota, the gap goes to the importer

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Voluntary export restraints (VER)

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an agreement between two governments in which the government of the exporting country agrees to restrain the volume of its own exports

Is similar to a quota, but allocated to each exporter, and the gap is captured by the foreign exporter, and requires procedures for allocating restrictions

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Old arguments + evaluation for trade restrictions:

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a. The national security argument – often only applicable during times of war, but during times of war all industries contribute to national defense

b. The infant-industry argument – it is necessary to protect a new industry to enable it to grow into a mature industry that can compete in the world markets (valid to some degree, but often more efficient to create a subsidy financed out of taxes)

c. The dumping argument: dumping occurs when a foreign firm sells its exports at a lower price than its cost of production – a tool that may be used to a gain a global monopoly – but it is virtually impossible to detect dumping (how do you know what a firm’s costs are?), natural global monopolies don’t really exist, and the best way of dealing with a natural monopoly would be with regulation

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New arguments for trade restriction

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saves jobs
allows us to compete with cheap foreign labor
brings diversity and stability
penalizes lax environmental standards
protects national culture
prevents rich countries from exploiting development countries

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Rent seeking

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lobbying and other political activity that seek to capture the gains from trade – is often why international trade is restricted

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Why (despite arguments against it) is international trade restricted?

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tariff revenue

rent seeking

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Direct FX method

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if in a:b, ‘a’ is the foreign currency and ‘b’ the domestic currency

the price of the foreign currency in which we are interested

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Indirect FX method

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the amount of foreign currency that one unit of the domestic currency will purchase

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Bid Price

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the exchange rate at which the dealer is willing to buy a currency

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Ask (or offer) price

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is the exchange rate at which the dealer is willing to sell a currency

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Bid-ask spread

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the difference between the bid and ask prices

The size of the spread varies with exchange rate uncertainty or volatility and lack of liquidity because of bank/dealer risk aversion

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Cross Rates

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the exchange rate between two currencies inferred from each country’s exchange rate with a third currency

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(a:b) x (b:c) = a:c and (a:b) / (a:c) = c:b

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Spot Exchange Rates

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quoted for immediate currency transactions

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Forward Exchange Rates

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are quoted today but with delivery and settlement in the future

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Why spreads on forward foreign currency quotations can differ as a result of market conditions, bank/dealer positions, trading volume, and maturity/length of contract

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a. Forward exchange rates are commonly used by asset managers to manage their foreign current positions – hedging fx risks

b. Liquidity decreases with the increasing maturity of the forward contract

c. Typically a bank will do three transactions: a spot fx transaction, coupled with borrowing and lending in the two currencies

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Interest rate parity (IRP)

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a relationship linking spot exchange rates, forward exchange rates, and interest rates – the relationship is that the forward discount/premium equals the discounted interest rate differential between the two currencies

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Covered interest arbitrage (riskless)

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the process of simultaneously borrowing the domestic currency, transferring it into foreign currency at the spot exchange rate, lending it, and buying a forward exchange rate contract to repatriate the foreign currency into domestic currency at a known forward exchange rate – the net result of such an arbitrage should be nil

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A currency is "strong" when...

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when its forward rate trades at a premium to its spot rate, the DENOMINATOR currency is considered STRONG

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A currency is "weak" when...

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when its forward rate trades at a discount to its spot rate, the DENOMINATOR currency is considered WEAK

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Determining Flex/floating exchange rates

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Flex/floating exchange rates are determined by supply and demand, as their exchange rate is freely exchanged in the foreign exchange market

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Balance of payments

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tracks all financial flows crossing a country’s borders during a specified time period – exports create a financial inflow, while imports are a financial inflow; purchase of a foreign financial security is an outflow, while a loan made by a foreigner domestically is an inflow

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Current Account

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covers all current transactions that take place in the normal business of residents: imports/exports, services, income from investments (interest, dividends, and investment income from cross-border investments), and current transfers (gifts and other flows that do not require something in return)

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Financial Account

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covers a country’s residents’ investments abroad and nonresidents’ investments – direct investment made by companies, portfolio investments in equity & bonds, other investments and liabilities (deposits or borrowing with foreign banks)

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Impact of Current Account deficit

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a. Should not be confused with an overall balance deficit – has to be offset by a financial account surplus (official reserve offset is only a temporary solution)
b. A current account deficit is often the cause of a trade deficit – may be that the country is growing faster than its trading partners, needing to import more than export in order to sustain output growth
c. Social implications may be that countries with trade deficits may face political pressure against free trade, while those with surpluses may see an influx in tariffs

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Factors that may cause a country's currency to fluctuate - appreciate or depreciate

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a. An increase in the country’s real interest rate leads to an appreciation of its currency, while a decrease will lead to a depreciation of its currency – relative to another currency
b. But if the real interest rate movement is matched by another country – no change
c. Capital flows are dictated by expected returns – if an improvement in a country’s investment climate leads to an increase in financial inflows, the currency will appreciate (and vice versa)

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Impact from Expansionary Monetary Policy

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will temporarily cause a drop in interest rates, upward pressure on the domestic price level, and inflation with accelerate – both reactions would lead to a depreciation of the domestic currency, and may induce a short-term boost in economic growth which would pressure the current account (imports > exports)

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Impact from Restrictive Monetary Policy

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would lead to an appreciation of the domestic currency

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Impact from Expansionary Fiscal Policy

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– means that a government reduces taxes while increasing the budget deficit: will induce a higher domestic real interest rate, which should lead to an appreciation of the currency, but this should also induce a rise in output and inflationary pressures, resulting in the depreciation of the currency

Common view is that interest rate “factor” dominates = appreciation

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Impact from Restrictive Fiscal Policy

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government increases the share of taxes and reduces the share of borrowing to finance government spending; should reduce interest rates and result in the depreciation of the domestic currency, and should also slow down economic activity and inflation, which should lead to an appreciation of the domestic currency

Common view is that interest rate “factor” dominates = depreciation

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Fixed exchange rate

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where the exchange rate between two currencies remains fixed at a preset level, known as official parity – exchange rate is expected to remain at its fixed parity forever

Positive in that it eliminates exchange rate risk (in the short run)

Negative in that it deprives the country of any monetary independence and lacks long term credibility

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Pegged exchange rate

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a compromise between a flexible and fixed exchange rate – pegging the domestic currency to another major currency within a small band around its target with the ability to adjust the target rate overtime

Positive in that it reduces exchange rate volatility(in the short run)

Negative in that it can induce destabilizing speculation

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Purchasing power parity

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states that the spot exchange rate adjusts perfectly to inflation differentials between two countries

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Absolute purchasing power parity

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law of one price – that the real price of a good must be the same in all countries after adjusting for Fx

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Relative purchasing power parity

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focuses on the general, across the board inflation rates in two countries and claims that the exchange rate movements should exactly offset any inflation differential between the two countries

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International Fisher relation

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a. States that the interest rate differential between two countries should be equal to the expected inflation rate differential over the term of the interest rate

b. In practice, what we lose by having a higher domestic inflation rate, we can expect to gain on the nominal interest rate differential, resulting in the same real rate of return regardless of whether we invest domestically or in the foreign country

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Theory of uncovered interest rate parity

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a. Implies that the expected currency depreciation should offset interest differential between the two countries over the term of the interest rate
b. Expect the foreign currency movement to be equal to the interest differential between the two countries

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GDP definition

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the total of all economic activity in one country, regardless of who owns the productive assets

Not included in GDP: transfer payments, gifts, unpaid and domestic activities, barter, second-hand and intermediate transactions, leisure, depletion of resources, environmental costs, allowance for non-profit making and inefficient activities, allowance for changes in quality

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GNI (or gross national product)

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total of incomes earned by residents of a country, regardless of where the assets are located

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NNI (net national income)

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Adjusts for depreciation - most comprehensive measure of economic activity but is of little practical value due to problems accounting for depreciation

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Current and/vs Constant prices

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output data is collected in both, but...

constant price figures are determined by valuing current output in the prices applicable in a given base year

Expenditures and income are often collected in current prices and converted to constant

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GDP deflator or Implicit Price Deflator

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a handy measure of economy-wide inflation trends, but is affected by changes in the composition of GDP

is calculated from expenditure data at factor cost in also known as the implicit price deflator