Econ
The size of the dealer quoted spread depends primarily on three factors
the bid-offer spread in the interbank foreign exchange market for the two currencies involved, the size of the transaction (larger=larger spread) the relationship between the dealer and the client.
Carry Trade
Strategy involved taking long positions in high-yield currencies and short positions in low-yield currencies High-yield currencies, on average, have not depreciated, and low-yield currencies have not appreciated, to the levels predicted by interest rate differentials, therefore the carry trade is based on the supposition that uncovered interest rate parity does not hold.
What does uncovered interest rate parity assume about countries interest rates
Uncovered interest rate parity assumes that the country with the higher interest rate or money market yield will see its currency depreciate. The depreciation of the currency offsets the initial higher yield so that the (expected) all-in return on the two investment choices is the same. higher int rate=currency will dep
What happens when we have a weak dollar
Weak dollar= 1 USD buys less of foreign currency, US and worldwide consumers must pay more for imports and purchasing American-made items becomes less expensive than buying from other countries, American exports tend to increase and jobs may increase as well due to higher demand of our shit
Balance-of-payments (BOP)
accounting is a method used to keep track of transactions between a country and its international trading partners. It includes government transactions, consumer transactions, and business transactions. The BOP accounts reflect all payments and liabilities to foreigners as well as all payments and obligations received from foreigners.
capital deepening
an increase in the amount of capital per worker; capital-to-labor ratio = Capital (K) / Labor (L) increasing not a source of sustained growth Only when the economy is operating below the steady state and when the marginal product of capital exceeds its marginal cost can capital deepening raise per capital growth.
International Fisher Effect
difference in nominal int rates of two countries = difference in E(inflation) of two countiresThe international Fisher effect assumes that risk premia are the same throughout the world. • Real interest rate parity and Ex ante PPP are required to hold for int. fisher effect to be true Rnominal A - Rnominal B = E(inflationA) - E(inflationB)
What can Excessive Capital Inflows lead to?
leads to excessive appreciation of currency...leads to loss of competitiveness of exports can also lead to a currency crisis when such capital is eventually withdrawn from the country.
TFP
level of productivity or technology in the economy. Changes in total factor productivity generate proportional changes in output for any input combination. Sustained growth in per capita output requires progress in TFP. • scientific advances, applied research and development, improvements in management methods, and ways of organizing production that raise the productive capacity of factories and offices.
What happens when Actual GDP growth > potential growth rate
means economy is too HOT and with that comes... • Increase inflation, which • puts upward pressure on nominal interest rates and • bond prices. most likely will lead to restrictive monetary policy
Conditional convergence
means that convergence is conditional on the countries having the same • saving rate, • population • growth rate, • production function. If these conditions hold, the neoclassical model implies convergence to the same level of per capita output as well as the same steady state growth rate.
Does central bank internvention work for both DM and EM?
most studies conclude that the effect of Central Bank intervention in developed market economies is limited however there is some evidence to suggest that capital control works for emerging markets
Regulatory arbitrage
occurs when businesses shop for a country that allows a specific behavior rather than changing the behavior. Regulatory arbitrage also entails exploiting the difference between the economic substance and interpretation of a regulation. • To avoid regulatory arbitrage, cooperation at a global level to achieve a cohesive regulatory framework is necessary
Club convergence
only rich and middle-income countries that are members of the club are converging to the income level of the richest countries in the world. This means that the countries with the lowest per capita income IN THE CLUB grow at the fastest rate.
Cobb-Douglas formula for output per worker and capital-to-labor ratio
output per worker = output (Y)/Labor (L) capital-to-labor ratio = Capital (K) / Labor (L)
Relative version PPP
percentage change in the spot exchange rate (%ΔSf/d) will be completely determined by the difference between the foreign and domestic inflation rates examines the relative changes in price levels between two countries and maintains that exchange rates will change to compensate for inflation differentials. very similar to uncovered int rate parity
Net regulatory burden
private costs of regulation (-) the private benefits of regulation
Expansionary Monetary Policy
reduce the interest rate/increase money supply which would increase inv and consumption spending & also would reduce the inflow of capital investment in physical and financial assets. This decrease in financial inflows (deterioration of the financial account) reduces the demand for the domestic currency, resulting in depreciation of the domestic currency.
Dutch disease
refers to a situation where global demand for a country's natural resources drives up the country's currency values, making all exports more expensive and rendering other domestic industries uncompetitive in the global markets.
regulatory capture theory
regardless of the original purpose behind its establishment, a regulatory body will, at some point in time, be influenced or even possibly controlled by the industry that is being regulated.
Prudential Supervision
regulation and monitoring of the safety and soundness of financial institutions in order to promote financial stability, reduce system-wide risks, and protect customers of financial institutions. The objectives of securities commissions, per IOSCO, are protecting investors; ensuring that markets are fair, efficient, and transparent; and reducing systemic risk.
Regulating financial markets
regulations include regulation of securities markets and regulation of financial institutions. Regulation of financial markets is critical to prevent failures of the financial system. The objectives of securities regulations include three interrelated goals: protecting investors, creating confidence in the markets, and enhancing capital formation
regulatory competition
regulators compete to provide the most business-friendly regulatory environment
sunset clause
requires regulators to revisit the cost benefit analysis based on actual outcomes before renewing the regulation.
Ex ante version of PPP
the expected changes in the spot exchange rate are entirely driven by expected differences in national inflation rates. Ex ante PPP tells us that countries that are expected to run persistently high inflation rates should expect to see their currencies depreciate over time and vice versa
Neoclassical Model
the only way to sustain growth in potential GDP per capita is through technological change/growth in total factor productivity. • neoclassical model assumes that all countries have access to the same technology • growth comes from increases in TFP not related to the investment in capital within the model
Excessive emerging market capital inflows often plant the seeds of a crisis by contributing to...5 rhings
(1) an unwarranted appreciation of the emerging market currency, (2) a huge buildup in external indebtedness, by business or government (3) an asset bubble, (4) a consumption binge that contributes to explosive growth in domestic credit and/or the current account deficit, or (5) an overinvestment in risky projects and questionable activities.
How can policymakers reduce problems caused by excessive capital inflow? ie what are the objectives for capital controls?
(1) preventing currencies from appreciating too strongly, sell its own currency in the FX market (2) reducing the aggregate volume of capital inflows, and (3) enabling monetary authorities to pursue independent monetary policies without having to worry about whether changes in policy rates might attract too much capital from overseas.
Long Run relationship of Stock Market and GDP & Relationship between potential GDP growth and Credit Quality
The drivers of potential GDP are ultimately the drivers of stock market price performance in the LT (not ST or MT) Higher growth leads to higher quality—that is, an improvement in the likelihood of promised cash flows occurring.
Absolute Convergence
The idea that developing countries, regardless of their particular characteristics, will eventually catch up with the developed countries and match them in per capita output
Any correlation between equity market and exchange rates?
No current correlation between exchange rates and Equity market Such instability in the correlation between exchange rates and equity markets makes it difficult to form judgments on possible future currency moves based solely on expected equity market performance
Solow's Growth Accounting Equation
Remember Solows formula is essentially Cobbs production formula written in form of growth rates. IF any one of the factors (growth in TFP, L, K, are higher that's what is leading growth)
Fisher Relation
Rnom=Rreal+E(inflation)
Preconditions for Economic growth:
Savings and investment, financial markets and intermediaries, political stability, rule of law, and property rights, investment in human capital, tax and regulatory systems, free trade unrestricted capital flows
What are the 3 Channel through which current account trends influence exchange rates over time
Flow Supply/Demand Channel Portfolio Balance Channel Debt Sustainability? Channel
What are the 9 warning signs leading to a currency crisis?
1. capital markets have been liberalized to allow the free flow of capital. 2. There are large inflows of foreign capital (relative to GDP) in the period leading up to a crisis, with short-term funding denominated in a foreign currency being particularly problematic. Growth in the banking sector coupled with short-term funding denominated in foreign currency can lead to a currency crisis. 3. Currency crises are often happens before (and often coincide with) banking crises. 4. Countries with fixed or partially fixed exchange rates are more susceptible to currency crises than countries with floating exchange rates. 5. Foreign exchange reserves tend to decline 6. currency has risen substantially relative to its historical mean. 7. The ratio of exports to imports (known as "the terms of trade") often deteriorates 8. Broad money growth and the ratio of M2 (a measure of money supply) to bank reserves tend to rise 9. Inflation tends to be significantly higher in pre-crisis periods compared with tranquil periods.
Uncovered Interest Rate Parity
=not bounded by arbitrage/assumes investor is risk neutral (assumes unhedged by forward contract)and often holds in the long run = the expected return on an uncovered foreign currency investment should equal the return on a comparable domestic currency investment. = the expected change in the spot exchange rate should reflect the nominal interest rate spread between the two countries, ie...The expected appreciation/depreciation of the exchange rate will just offset the yield differential
Portfolio Balance Channel
Current account imbalances shift financial wealth from deficit nations to surplus nations. Countries with trade deficits will finance their trade with increased borrowing. This behavior may lead to shifts in global asset preferences, which in turn could influence the path of exchange rates. Risk premiums are more closely associated with the portfolio-balance approach For example, nations running large current account surpluses versus the United States might find that their holdings of US dollar-denominated assets exceed the amount they desire to hold in a portfolio context. Actions they might take to reduce their dollar holdings to desired levels could then have a profound, negative impact on the dollar's value.
What happens to fiscal budget during recession and expansion
Government budget deficit...increase during recessions(bad) and decrease during expansions. In examining fiscal policy, actual fiscal positions are often judged relative to structural or cyclically adjusted deficits—the budgetary balance that would exist if the economy were operating at potential GDP.
Regulating commerce
Government regulations provide an essential framework to facilitate business decision making. Examples of regulations covering commerce include company laws, tax laws, contract laws, competition laws, banking laws, bankruptcy laws, and dispute resolution systems.
PPP definition and example
Identical goods should trade at the same price across countries when valued in terms of a common currency cross-country comparisons of gross domestic product (GDP) should be based on purchasing power parity Not Bound by Arbitrage (Works LT not ST) if the price of good x in the euro area is EUR 100 and the nominal exchange rate stands at 1.40 USD/EUR, then the price of good x in the United States should equal USD 140. According to PPP, high-inflation countries should see their currencies depreciate (at least, over the longer term) in order to re-equilibrate real purchasing power between countries. ***If the Australian dollar is overvalued by 10% on a PPP basis, a depreciation of the JPY/AUD rate by 10% would move the Australian dollar back to equilibrium. Difference in nominal yields should explain difference in inflation if we want equilibrium
What happens when uncovered interest rate parity does not hold
If high-yield currencies do not depreciate in line with the path predicted by the uncovered interest rate parity condition, then high-yield currencies should exhibit a tendency to outperform low-yield currencies over time. If so, investors could adopt strategies that overweight high-yield currencies at the expense of low-yield currencies and generate attractive returns in the process. Such approaches are known as FX carry trade strategies.
Mark to Market Value
If you initially sold 1,000,000 usd forward you are going to have to mark to market by buying (using the ask price) Buying a forward means using the ASK price Selling a forward means using the bid price *bottom r = price in this formula*
Regulations are needed when it comes to (2 things)
Informational frictions.... occur when information is not equally available or distributed. A situation where some market participants have access to information unavailable to others is called information asymmetry. Regulations are put in place in an attempt to ensure that no participant is treated unfairly or is at a disadvantage. Externalities .... are costs or benefits that affect a party that did not choose to incur that cost or benefit. One externality issue commonly addressed by regulation is the provision of public goods. A public good is a resource, like parks or national defense, which can be enjoyed by a person without making it unavailable to others. Since people share in the consumption of public goods but don't necessarily bear a cost that is proportionate to consumption, regulations are necessary to ensure an optimal level of production of such public goods.
Labor force & Labor force participation
Labor force Everyone of working age (ages 16 to 64) that either is employed or is available for work but not working. labor force participation = labor force/working age population
The size of the bid-offer spread quoted in the interbank market depends on...
Liquidity in this market. Liquidity is influenced by several factors... 1. Currencies involved - similarly to stocks, high-volume currency pairs (USD/EUR, USD/JPY, and USD/GBP) command lower spreads than do lower-volume currency pairs (AUD/CAD). 2. Time of day - the time overlap during the trading day when both the NY and London currency markets are open is considered the most liquid time window; spreads are narrower during this period than at other times of the day. 3. Market volatility - Higher volatility leads to higher spreads to compensate market traders for the increased risk of holding those securities. Spreads change over time in response to volatility changes.
Portfolio Balance Approach
Looks at LT Fiscal Policy effects on currency value In the long run, governments that run large budget deficits on a sustained basis could eventually see their currencies decline in value.
The Mundell-Fleming Model Chart
Low Capital Mobility Only results if both the same High Capital Mobility Only results if both different Both do whatever Monetary policy implies!
neoclassical model
Objective: to determine the long-run steady state growth rate of output per capita and relate it to... (a) the savings/investment rate, An increase in savings (capital accumulation) will only temporarily raise economic growth (b) the rate of technological change Because of DIMINISHING marginal returns to capital, the ONLY way to sustain growth in potential GDP per capita is through technological change or growth in total factor productivity. (c) population growth Long-term sustainable growth cannot rely solely on capital deepening investment (capital deepening only shows ST growth) TFP progress is regarded as exogenous to the model.
Average value of stock market in terms of GDP and Earnings
P= Average value of Equities E/GDP= Earnings as a share of GDP
Three regulatory tools are available to regulators
Price mechanisms Restricting/requiring certain activities. Provision of public goods or financing of private projects.
Price mechanisms
Price mechanisms such as taxes and subsidies can be used to further specific regulatory objectives; for example, sin taxes are often used to deter consumption of alcohol. Conversely, subsidies such as those on green energy can encourage specific economic behavior.
What are the two main approaches to monetary models:
Pure monetary model, which assumes • An expansionary monetary policy leads to an increase in prices and a depreciation of domestic currency • PPP holds at any point in time and output is held constant (rarely ever true) Dornbusch overshooting model. assumes that prices are sticky in the short term and hence do not immediately reflect changes in monetary policy. And Expansionary monetary policy leads to a decrease in interest rates
Restricting/requiring certain activities
Regulators may ban certain activities (e.g., use of specific chemicals) or require that certain activities be performed (e.g., filing of 10-k reports by publicly listed companies) to further their objectives.
Provision of public goods or financing of private projects
Regulators may provide public goods (e.g., national defense) or fund private projects (e.g., small business loans) depending on their political priorities and objectives
Steady state growth rate
Related to Neoclassical Model (TFP/Labor share of GDP) +Labor force growth
Self-regulating organization (SRO)
Self-regulating organization Private, non-governmental organizations that both represent and regulate their members. Some self-regulating organizations are also independent regulators (independent SRO do not typically rely on government funding)
How would central bank fight inflation? using int rates and money supply
To LOWER inflation central bank will want to DECREASE money supply by SELLING DOMESTIC SECURITIES to the private sector and INCREASE RATES ***You want less/more expensive money out there (so you sell a few dom. bonds to the private sector) to lower inflation***
Debt Sustainability? Channel
When a country runs a large and persistent current account deficit over time, eventually it will experience an untenable rise in debt owed to foreign investors. If such investors believe that the deficit country's external debt is rising to unsustainable levels, they are likely to reason that a major depreciation of the deficit country's currency will be required at some point to ensure that the current account deficit narrows significantly, and that the external debt stabilizes at a level deemed sustainable.
When does a foreign currency trade at a forward premium
When the foreign currency is at a higher rate in the forward contract, relative to the spot rate,
Covered interest rate parity with formula
an investment in a foreign money market instrument that is completely hedged against exchange rate risk should yield exactly the same return as an otherwise identical domestic money market investment. a investor from X, in a fully hedged Y libor positions' return should be identical to X year libor ie Forward exchanger rate must equal the rate that gives these the 2 strategies (inv in dom. money market or in a fully currency-hedged foreign money market instrument) the same return. =specifies the forward exchange rate that must hold to prevent arbitrage given the spot exchange rate and the risk-free rates in both countries. f/d or p/b
Absolute PPP, and why it failed also law of one price
compares the average price of a representative basket of consumption goods between countries. Absolute PPP requires only that the law of one price be correct on average, that is, for like baskets of goods in each country. FALIURE= absolute version of PPP assumes that all goods and services are tradable and that the domestic and foreign price indexes include the same bundle of goods and services with the same exact weights in each country Law of one price two investments have the same or equivalent future cash flows regardless of what will happen in the future, then these two investments should have the same current price.
Regulatory burden
costs of regulation/compliance for the regulated entity; this cost is sometimes viewed as the private costs of regulation or government burden.
What are the 5 key international parity conditions
covered interest rate parity; uncovered interest rate parity; forward rate parity; purchasing power parity; and the international Fisher effect.
Flow Supply/Demand Channel and what 3 things is it dependent on
exchange rates will immediately correct the trade imbalance Current account deficits in a country increases the supply of that currency in the markets due to exporters to that country convert their revenues to their own local currency This puts downward pressure on the exchange value of that currency causing depreciation. Dependent on... The initial deficit gap between imports and exports The response of import and export prices to changes in the exchange rate The response of import and export demand to changes in import and export prices (Elasticity of goods)
Endogenous growth model ***growth from within***
explains technological progress within the model rather than treating it as exogenous. As a result, self-sustaining growth emerges as a natural consequence of the model and the economy does not converge to a steady state rate of growth that is independent of saving/investment decisions. Allows for the possibility of constant or even increasing returns to capital • no steady state growth rate, so that increased investment in R&D can permanently increase the rate of growth. • saving and investment decisions can generate self-sustaining growth at a permanently higher rate. This situation is in sharp contrast to the neoclassical model • direct government spending on R&D and/or providing tax breaks and subsidies for private production of knowledge capital.
Who are Regulations trying to protect
focused on protecting small (retail) investors, hence the relatively lax regulatory coverage of hedge funds and private equity funds that are marketed only to qualified investors
Forward Rate Parity
forward exchange rate will be an unbiased forecast of the future spot exchange rate if both covered and uncovered interest rate parity hold and vice versa
Coase Theorem
if private parties can costlessly bargain/trade over the allocation of resources, they can solve the externalities problem on their own
Expansionary Fiscal Policy
increased infrastructure spending/ LOWER TAXES lead to higher levels of government debt and interest rates, which will attract international capital flows. (In the long run, however, an excessive buildup in debt may eventually cause downward pressure on the domestic currency.)
Carry Trade Characteristics
• Carry trades= leverages trades which increases the volatility of ROE • One argument for the persistence of the success of the carry trade is that the yields in higher interest rate countries reflect a risk premium due to a more unstable economy, while low-yield currencies represent less risky markets. • During periods of low volatility, carry trades tend to generate positive returns, but they are prone to significant crash risk in turbulent times. • The "crash risk" of carry trades implies a fat-tailed distribution skewed toward a higher probability of large losses (distribution with fat tails and a negative skew and excess kurtosis) return= interest earned on investment - funding cost-currency depreciation
Cobbs-Douglas Production formula for OUTPUT
• Cobbs function exhibits Constant Return To Scale (all the inputs into the production process are increased by the same percentage, then output rises by that percentage) • Increase output but increasing tech or increasing capital deepening • Continued growth in per capita output is possible even in the steady state as long as there is ongoing technological progress (increases in TFP). • Also exhibits Diminishing Marginal Productivity (When each additional unit of an input, keeping the other inputs unchanged, increases output by a smaller increment) o at some point the extra output obtained from each additional unit of the input will decline o A value of α close to zero means diminishing marginal returns to capital are very significant and the extra output made possible by additional capital declines quickly as capital increases
When Exports > Imports
• Exports > Imports = (a current account surplus) 1. Countries that run persistent current account surpluses (net lenders) often see their currencies appreciate over time
When Imports > Exports
• Imports > Exports = (current Account deficit) countries with current account deficits must attract funds from abroad in order to pay for the imports (i.e., they must have a capital account surplus). 1. Countries that run persistent current account deficits (net borrowers) currencies depreciate because they finance their acquisition of imports through the continued use of debt.
Classical Model
• growth in real GDP per capita is not permanent, because when real GDP per capita rises above the subsistence level, a population explosion occurs, and it would revert the income per capita back to where it was • Pessimistic and Failed! cause... o The growth in GDP per capita increased rather than slowed as predicted o Growth in GDP per capita has been possible because tech progress has been rapid enough to offset the diminishing marginal returns
