CFA Level II - Econ
Describe warning signs of a currency crisis:
1) terms of trade deteriorate 2) official foreign exchange reserves dramatically decline 3) real exchange rate is substantially higher than the mean-reverting level 4) inflation increases 5) equity markets experience a boom-bust cycle 6) money supply relative to bank reserves increases 7) nominal private credit grows
The endogenous growth theory holds that productivity growth is a function of society's ability to discover new products and methods (i.e., the creation of knowledge capital), and real interest rates.
The endogenous growth model hypothesizes that expenditures on R&D and knowledge capital generate benefits to the economy as a whole, beyond the private benefit to the investing company. Under the endogenous growth model, the resulting increase in growth is likely to be enduring
covered interest rate parity
The word 'covered' in the context of covered interest parity means bound by arbitrage. Covered interest rate parity holds when any forward premium or discount exactly offsets differences in interest rates, so that an investor would earn the same return investing in either currency. If covered interest rate parity holds and euro interest rates are higher than dollar interest rates, depreciation of the euro relative to the dollar will just offset the higher euro interest rate
Risk Management in Carry Trades
There are two approaches to managing crash risk in a carry trade: 1.Volatility filter: Whenever implied volatility (implied by the market prices of options on currencies or equities) increases above a certain threshold, the carry trade positions are closed (i.e., reversed). 2. Valuation filter: A valuation band is established for each currency based on PPP or other models. If the value of a currency falls below (above) the band, the trader will overweight (underweight) that currency in the trader's carry trade portfolio.
Daniel Parthik has collected data that indicates that interest rates are expected to change for three countries as provided below: Country Real Interest rate Risk premium A 3% 0.5% B 3.5% 1.5% C 2.5% 1% Assuming that the exchange rates are currently at equilibrium, which country would see their real exchange rate appreciate?
country a The difference in real interest rate and risk premium drive short-term real appreciation/depreciation of a currency. For country A, the difference is 2.5% while it is 2% and 1.5% for countries B and C respectively
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
current account + financial account + official reserve account = 0
Labor Supply Factors
1. Demographics. A country's demographics strongly influence its potential economic growth. As a country's population ages and individuals live beyond working age, the labor force declines. Conversely, countries with younger populations have higher potential growth. Furthermore, fertility rates drive population growth and thereby affect potential future economic output. Countries with low or declining fertility rates will likely face growth challenges from labor force declines 2. Labor force participation = labor force / working age population 3. Immigration. Immigration poses a potential solution to a declining labor force. Countries with low population growth or adverse demographic shifts (older population) may find their growth constrained. Since developed countries tend to have lower fertility rates than less developed countries, immigration represents a potential source of continued economic growth in developed countries. 4. Average hours worked. For most countries, the general trend in average hours worked is downward. Possible explanations include legislation limiting the number of hours worked, the "wealth effect" which induces individuals to take more leisure time, high tax rates on labor income, and an increase in part-time and temporary workers.
Tools of Regulatory Intervention
1. 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. 2. 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. 3. 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.
Explain purposes in regulating commerce and financial markets
1. 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. Regulations may facilitate or hinder commerce. For example, protections of intellectual property facilitate long-term investments in research. Similarly, trade agreements promote commerce internationally .2. Regulating financial markets. Financial market 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.
Preconditions for GDP Growth
1. Savings and investment is positively correlated with economic development. For countries to grow, private and public sector investment must provide a sufficient level of capital per worker. If a country has insufficient domestic savings, it must attract foreign investment in order to grow. 2. Financial markets and intermediaries augment economic growth by efficiently allocating resources in several ways. First, financial markets determine which potential users of capital offer the best returns on a risk-adjusted basis. Second, financial instruments are created by intermediaries that provide investors with liquidity and opportunities for risk reduction. Finally, by pooling small amounts of savings from investors, intermediaries can finance projects on larger scales than would otherwise be possible. Some caution is in order, however. Financial sector intermediation may lead to declining credit standards and/or increases in leverage, increasing risk but not economic growth. 3.The political stability, rule of law, and property rights environment of a country also influence economic growth. Countries that have not developed a system of property rights for both physical and intellectual property will have difficulty attracting capital. Similarly, economic uncertainty caused by wars, corruption, and other disruptions poses unacceptable risk to many investors, reducing potential economic growth. 4. Investment in human capital, the investment in skills and well-being of workers, is thought to be complementary to growth in physical capital. Consequently, countries that invest in education and health care systems tend to have higher growth rates. Developed countries benefit the most from post-secondary education spending, which has been shown to foster innovation. Less-developed countries benefit the most from spending on primary and secondary education, which enables the workforce to apply the technology developed elsewhere. 5. Tax and regulatory systems need to be favorable for economies to develop. All else equal, the lower the tax and regulatory burdens, the higher the rate of economic growth. Lower levels of regulation foster entrepreneurial activity (startups), which have been shown to be positively related to the overall level of productivity. 6. Free trade and unrestricted capital flows are also positively related to economic growth. Free trade promotes growth by providing competition for domestic firms, thus increasing overall efficiency and reducing costs. Additionally, free trade opens up new markets for domestic producers. Unrestricted capital flows mitigate the problem of insufficient domestic savings as foreign capital can increase a country's capital, allowing for greater growth. Foreign capital can be invested directly in assets such as property, physical plant, and equipment (foreign direct investment), or invested indirectly in financial assets such as stocks and bonds.
Carry trade risk is most likely to be controlled by: buying the funding currency when its value drops below its PPP-implied value. buying the funding currency forward. selling the funding currency forward.
A The carry trade involves borrowing the funding currency, converting it into a higher-yielding currency, and investing that higher-yielding currency. If the funding currency falls below its PPP-implied value, the likelihood of its appreciation increases. At this point it becomes wise to exit the trade: buying the funding currency at this point and thus effectively closing out the position limits risk. Using forward contracts to buy the funding currency would also limit risk - but would eliminate any potential carry trade profits as well
Earlier, we stated that in the short term, real exchange rates fluctuate around the long-term equilibrium real exchange rates. The fluctuations around equilibrium real exchange rates can be explained as follows: real exchange rate (A/B) = equilibrium real exchange rate (A/B) + (real interest rateB - real interest rateA) - (risk premiumB - risk premiumA) where: risk premiumA = risk premium demanded by investors for investing in assets denominated in currency A
A couple of observations can be made based on the relationship identified above: •In the short term, the real value of a currency fluctuates around its long-term, equilibrium value. •The real value of a currency is positively related to its real interest rate and negatively related to the risk premium investors demand for investing in assets denominated in the currency.
A spot exchange rate is the currency exchange rate for immediate delivery, which for most currencies means the exchange of currencies takes place two days after the trade
A forward exchange rate is a currency exchange rate for an exchange to be done in the future. Forward rates are quoted for various future dates (e.g., 30 days, 60 days, 90 days, or one year). A forward contract is an agreement to exchange a specific amount of one currency for a specific amount of another currency on a future date specified in the forward agreement.
Cost Benefit Analysis of Regulation
A regulatory framework needs to be assessed in terms of the cost of the framework relative to the benefit it provides. U.S. federal regulatory agencies are required to conduct a cost-benefit analysis prior to issuing a regulation. The costs and benefits of regulations may be easy to view but difficult to quantify. The cost of regulation is not limited to the implementation cost (i.e., the cost of operating a government agency to provide monitoring and supervision); an analyst should also consider the cost of the regulation to the private sector. Regulatory burden (also known as government burden) refers to the cost of compliance for the regulated entity. Regulatory burden minus the private benefits of regulation is known as the net regulatory burden. Regulators should be aware of unintended consequences of regulations. For example, regulations mandating an increase in automobile fuel efficiency standards may encourage consumers to drive more, reducing the effectiveness of the regulation. Regulatory burden is generally difficult to measure as it includes the indirect costs related to changes in economic behavior. Regulatory costs are difficult to assess before a regulation is put in place. For this reason, many regulatory provisions include a ' sunset clause' that requires regulators to revisit the cost-benefit analysis based on actual outcomes before renewing the regulation.
Example: Forecasting spot rates with uncovered interest rate parity Suppose the spot exchange rate quote is ZAR/EUR = 8.385. The 1-year nominal rate in the eurozone is 10% and the 1-year nominal rate in South Africa is 8%. Calculate the expected percentage change in the exchange rate over the coming year using uncovered interest rate parity.
Answer: The rand interest rate is less than the euro interest rate, so uncovered interest rate parity predicts that the value of the rand will rise (it will take fewer rand to buy one euro) because of higher interest rates in the eurozone. The euro (the base currency) is expected to "appreciate" by approximately RZAR - REUR = 8% - 10% = -2%. (Note the negative 2% value.) Thus the euro is expected to depreciate by 2% relative to the rand, leading to a change in exchange rate from 8.385 ZAR/EUR to 8.217 ZAR/EUR over the coming year.
In a FX carry trade, an investor invests in a higher yielding currency using funds borrowed in a lower yielding currency. The lower yielding currency is called the funding currency.
As discussed earlier, the carry trade is profitable only if uncovered interest rate parity does not hold over the investment horizon. The risk is that the funding currency may appreciate significantly against the currency of the investment, which would reduce a trader's profit—or even lead to a loss. Furthermore, the return distribution of the carry trade is not normal; it is characterized by negative skewness and excess kurtosis (i.e., fat tails), meaning that the probability of a large loss is higher than the probability implied under a normal distribution. We call this high probability of a large loss the crash risk of the carry trade.
In steady state (i.e., equilibrium), the marginal product of capital (MPK = αY/K) and marginal cost of capital (i.e., the rental price of capital, r) are equal; hence: αY/K = r or α = rK/Y Professor's Note: In the previous equation, r is rate of return and K is amount of capital. rK measures the amount of return to providers of capital. The ratio of rK to output (Y) measures the amount of output that is allocated to providers of capital. This is precisely our definition of α.
As stated earlier, for developed countries, the capital per worker ratio is relatively high (e.g., level C1 in Figure 1), so those countries gain little from capital deepening and must rely on technological progress for growth in productivity. In contrast, developing nations often have low capital per worker ratios (e.g., C0 in Figure 1), so capital deepening can lead to at least a short-term increase in productivity.
Example: Estimating potential GDP growth rate
Azikland is an emerging market economy where labor cost accounts for 60% of total factor cost. The long-term trend of labor growth of 1.5% is expected to continue. Capital investment has been growing at 3%. The country has benefited greatly from borrowing the technology of more developed countries; total factor productivity is expected to increase by 2% annually. Compute the potential GDP growth rate for Azikland. Answer: Using the growth accounting equation: growth rate in potential GDP = 2% + (0.4)(3%) + (0.6)(1.5%) = 4.1%
Which of the following factors is most likely to contribute to a failure of the convergence hypothesis? Regulatory policies that encourage investment. Low rates of savings. Political stability.
B Low rates of savings is one factor that can cause a developing country to fail to converge. The convergence hypothesis suggest that developing countries should have higher rates of growth of productivity and GDP, which should lead to the per capita GDP, and the gap narrowing between developing and developed economies over time. Other reasons that countries may fail to converge include: low rates of investment, political instability, a lack of property rights, poor education and health, taxes and regulations that discourage working and investing, and restrictions on trade.
Which of the following statements regarding purchasing power parity (PPP) is least accurate? Absolute PPP is similar to the law of one price, except it concerns a basket of goods rather than a single good. Relative PPP states that prices for goods and services are the same whether it is for one good or for a basket of goods. Under absolute PPP the foreign price level expressed in domestic currency terms should be equal to the domestic country's price level.
B Relative PPP does not state that prices for goods and services are the same, only that the rate of change in the FX rate is a function of the inflation differentials between the two countries.
Compare classical growth theory, neoclassical growth theory, and endogenous growth theory
Classical Growth Theory Based on Malthusian economics, classical growth theory posits that, in the long-term, population growth increases whenever there are increases in per capita income above subsistence level due to an increase in capital or technological progress. Subsistence level is the minimum income needed to maintain life. Classical growth theory contends that growth in real GDP per capita is not permanent, because when real GDP per capita rises above the subsistence level, a population explosion occurs. Population growth leads to diminishing marginal returns to labor, which reduces productivity and drives GDP per capita back to the subsistence level. This mechanism would prevent long-term growth in per capita income. Classical growth theory is not supported by empirical evidence.
The interbank spread on a currency pair depends on:
Currencies involved. Similar to stocks, high-volume currency pairs (e.g., USD/EUR, USD/JPY, and USD/GBP) command lower spreads than do lower-volume currency pairs (e.g., AUD/CAD). •Time of day. The time overlap during the trading day when both the New York 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. •Market volatility. Spreads are directly related to the exchange rate volatility of the currencies involved. Higher volatility leads to higher spreads to compensate market traders for the increased risk of holding those currencies. Spreads change over time in response to volatility changes In addition to these factors, spreads in forward exchange rate quotes increase with maturity. The reasons for this are: longer maturity contracts tend to be less liquid, counterparty credit risk in forward contracts increases with maturity, and interest rate risk in forward contracts increases with maturity.
Economic Rationale for Regulation 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.
Economic Rationale for Regulation 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.
The objectives of capital controls or central bank intervention in FX markets are to: •Ensure that the domestic currency does not appreciate excessively. •Allow the pursuit of independent monetary policies without being hindered by their impact on currency values. For example, an emerging market central bank seeking to reduce inflation may pursue a restrictive monetary policy to do so, increasing interest rates. However, these higher rates may attract large inflows of foreign capital, pushing up the value of the domestic currency. •Reduce excessive inflow of foreign capital.
Effectiveness For developed market countries, the volume of trading in a country's currency is usually very large relative to the foreign exchange reserves of its central bank. Evidence has shown that for developed markets, central banks are relatively ineffective at intervening in the foreign exchange markets due to lack of sufficient resources. Evidence in the case of emerging markets is less clear. Central banks of emerging market countries may have accumulated sufficient foreign exchange reserves (relative to trading volume) to affect the supply and demand of their currencies in the foreign exchange markets. Empirical evidence suggests that the success of capital controls in emerging markets depends on persistence and size of capital flows: large and persistent capital flows are harder for central banks to mitigate than small and less persistent capital flows.
An additional hypothesis is club convergence. Under this hypothesis, countries may be part of a 'club' (i.e., countries with similar institutional features such as savings rates, financial markets, property rights, health and educational services, etc.). Under club convergence, poorer countries that are part of the club will grow rapidly to catch up with their richer peers. Countries can 'join' the club by making appropriate institutional changes. Those countries that are not part of the club may never achieve the higher standard of living.
Empirical evidence shows that developing economies often (but not always) reach the standard of living of more developed ones. Over the past half century, about two-thirds of economies with a lower standard of living than the United States grew at a faster pace than the United States. Though they have not converged to standard of living of the United States, their more rapid growth provides at least some support for the convergence hypothesis. The club convergence theory may explain why some countries that have not implemented appropriate economic or political reforms still lag behind.
Capital Account Influences Capital account flows are one of the major determinants of exchange rates. As capital flows into a country, demand for that country's currency increases, resulting in appreciation. Capital flows into a country may be needed to overcome a shortage of internal savings to fund investments needed for economic growth. However, capital flows in excess of needed investment capital poses several problems. This is especially problematic for emerging markets.
Excessive capital inflows into emerging markets create problems for those countries such as: •Excessive real appreciation of the domestic currency. •Financial asset and/or real estate bubbles. •Increases in external debt by businesses or government. •Excessive consumption in the domestic market fueled by credit.
An exchange rate is simply the price of one currency in terms of another.
For example, a quote of 1.4126 USD/EUR means that each euro costs $1.4126. In this example, euro is called the base currency and USD the price currency. Hence, a quote is the price of one unit of the base currency in terms of the price currency.
Earlier, we stated that a dealer will sell a currency at the ask price and purchase it at the bid price. We need to be a bit more specific. For example, imagine that you are given a USD/AUD bid and ask quote of 1.0508-1.0510. Investors can buy AUD (i.e., the base currency) from the dealer at the ask price of USD 1.0510. Similarly, investors can sell AUD to the dealer at the bid price of USD 1.0508. Remember, investors always take a loss due to spread. So the rule is buy the base currency at ask and sell the base currency at bid.
For transactions in the price currency, we do the opposite. If we need to buy USD (i.e., the price currency) using AUD (i.e., selling the base currency), we now use the dealer bid quote. Similarly, to sell the price currency, we use the dealer ask quote. So the rule is buy the price currency at bid and sell the price currency at ask.
Explain how investment in physical capital, human capital, and technological development affects economic growth.
Human capital. Human capital is knowledge and skills individuals possess. Unlike quantitative labor metrics, such as hours worked, human capital is a qualitative measure of the labor force. Increasing human capital through education or work experience increases productivity and economic growth. Furthermore, human capital may have external spillover effects as knowledgeable workers innovate. Innovations are then used by society in general creating greater efficiencies economy wide Physical capital. Physical capital is generally separated into infrastructure, computers, and telecommunications capital (ICT) and non-ICT capital (i.e., machinery, transportation, and non-residential construction). Empirical research has found a strong positive correlation between investment in physical capital and GDP growth rates. This result may seem inconsistent given our previous discussion about capital deepening and diminishing marginal returns to capital. Several explanations exist to explain why capital increases may still result in economic growth. First, many countries (e.g., developing economies) have relatively low capital to labor ratios, so increases in capital may still have significant impact on economic growth. Second, capital investment can take different forms. Some capital investment actually influences technological progress, thereby increasing TFP and economic growth. For example, acceleration of spending in the IT sector has created what are termed network externalities. Investment in IT networks may have multiplicative effects on productivity since IT network investment actually becomes more valuable as more people are connected to the network Technological development. Investment in technology includes investment in both physical and human capital. Technological innovation can manifest itself in processes, knowledge, information, machinery, and software, among other things. Researchers have examined proxies for investment in technology such as research and development (R&D) spending or number of patents issued. Developed countries tend to spend the most on R&D since they rely on technological progress for growth given their high existing capital stock and slower population growth. In contrast, less developed countries often copy the technological innovations of developed countries and thus invest less in R&D as a percentage of GDP. Ultimately, technological development should lead to increases in productivity as measured by GDP per worker. Developed countries tend to have very high levels of productivity by this measure while less developed countries tend to have greater potential for growth in productivity. Public infrastructure. Investments in public infrastructure such as the construction of public roads, bridges, and municipal facilities, provide additional benefits to private investment. For example, an investment in distribution facilities by a private company would do little good without an interstate highway grid. The highway system, therefore, enhances total productivity for the economy by complementing the private investment and increasing total factor productivity.
Endogenous Growth Theory
In contrast to the neoclassical model, endogenous growth theory contends that technological growth emerges as a result of investment in both physical and human capital (hence the name endogenous which means coming from within). Technological progress enhances productivity of both labor and capital. Unlike the neoclassical model, there is no steady state growth rate, so that increased investment can permanently increase the rate of growth. The driving force behind the endogenous growth theory result is the assumption that certain investments increase TFP (i.e., lead to technological progress) from a societal standpoint. Increasing R&D investments, for example, results in benefits that are also external to the firm making the R&D investments. Those benefits raise the level of growth for the entire economy. The endogenous growth model theorizes that returns to capital are constant. The key implication of constant returns to capital is the effect of an increase in savings: unlike the neoclassical model, the endogenous growth model implies that an increase in savings will permanently increase the growth rate.
None of the growth theories that we have discussed account for potential trade and capital flows between countries. Removing trade barriers and allowing for free flow of capital is likely to have the following benefits for countries: •Increased investment from foreign savings. •Allows focus on industries where the country has a comparative advantage. •Increased markets for domestic products, resulting in economies of scale. •Increased sharing of technology and higher total factor productivity growth. •Increased competition leading to failure of inefficient firms and reallocation of their assets to more efficient uses.
In terms of convergence, removing barriers on capital and trade flows may speed the convergence of standard of living of less developed countries to that of developed countries. Research has shown that as long as countries follow outward-oriented policies of integrating their industries with the world economy and increasing exports, their standard of living tends to converge to that of more developed countries. Countries following inward-oriented policies and protecting domestic industries, can expect slower GDP growth and convergence may not occur.
As indicated previously, growth in potential GDP represents the main driver of aggregate equity valuation. More generally, potential GDP also has implications for real interest rates. Positive growth in potential GDP indicates that future income will rise relative to current income. When consumers expect their incomes to rise, they increase current consumption and save less for future consumption (i.e., they are less likely to worry about funding their future consumption). To encourage consumers to delay consumption (i.e., to encourage savings), investments would have to offer a higher real rate of return. Therefore, higher potential GDP growth implies higher real interest rates and higher real asset returns in general.
In the short term, the relationship between actual GDP and potential GDP may provide insight to both equity and fixed-income investors as to the state of the economy. For example, since actual GDP in excess of potential GDP results in rising prices, the gap between the two can be used as a forecast of inflationary pressures—useful to all investors but of particular concern to fixed-income investors. Furthermore, central banks are likely to adopt monetary policies consistent with the gap between potential output and actual output. When actual GDP growth rate is higher (lower) than potential GDP growth rate, concerns about inflation increase (decrease) and the central bank is more likely to follow a restrictive (expansionary) monetary policy. In addition to predicting monetary policy, the relationship between actual and potential GDP can also be useful in analyzing fiscal policies. It is more likely for a government to run a fiscal deficit when actual GDP growth rate is lower than its potential growth rate. Finally, because of the credit risk assumed by fixed-income investors, growth in GDP may be used to gauge credit risk of both corporate and government debt. A higher potential GDP growth rate reduces expected credit risk and generally increases the credit quality of all debt issues.
absolute purchasing power parity (absolute PPP)
Instead of focusing on individual products, absolute purchasing power parity (absolute PPP) 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. S(A/B) = CPI(A) / CPI(B) In practice, even if the law of one price held for every good in two economies, absolute PPP might not hold because the weights (consumption patterns) of the various goods in the two economies may not be the same (e.g., people eat more potatoes in Russia and more rice in Japan).
Neoclassical growth theory's primary focus is on estimating the economy's long-term steady state growth rate (sustainable growth rate or equilibrium growth rate). The economy is at equilibrium when the output-to-capital ratio is constant. When the output-to-capital ratio is constant, the labor-to-capital ratio and output per capita also grow at the equilibrium growth rate, g*. Professor's Note: Steady state growth rate for the purpose of neoclassical growth theory does not assume a constant level of technology and hence differs from the definition of steady state discussed earlier.
Professor's Note: In the equations for sustainable growth (per capita or total), growth rate is not affected by capital (K). Hence, we say that capital deepening is occurring but it does not affect growth rate once steady state is achieved
Taylor Rule Central banks are usually charged with setting policy interest rates so as to (1) maintain price stability (inflation target) and (2) achieve the maximum sustainable level of employment. The Taylor rule links the central bank's policy rate to economic conditions (employment level and inflation) and can be used to forecast exchange rates: = (neutral real policy rate) + (current inflation rate) + α(current inflation gap) + β(current output gap)
R = rn + π + α(π - π*)+ β(y - y*) where: R = Central bank policy rate implied by the Taylor rule rn = Neutral real policy interest rate π = Current inflation rate π* = Central bank's target inflation rate y = log of current level of output y* = log of central bank's target (sustainable) output. α,β = policy response coefficients (>0, Taylor suggested a value of 0.5 for both). Subtracting inflation from both sides of the equation above, we get: Real interest rate = r = (R - π) = rn + α(π - π*) + β(y - y*) Hence, the real value of a currency is positively related to its neutral real interest rate, inflation gap, and output gap, and is negatively related to the risk premium investors demand for investing in that currency.
regulatory capture theory
Regulation does not always conflict with the interests of the regulated. The regulatory capture theory is based upon the assumption that, 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. The rationale behind the theory is that regulators often have experience in the industry, and this affects the regulators' ability to render impartial decisions. Regulatory capture is often cited as a concern with the commercialization of financial exchanges.
Regulations have important implications on businesses and the overall economy. Regulations can be classified as statutes (laws made by legislative bodies), administrative regulations (rules issued by government agencies or other bodies authorized by the government), or judicial law (findings of the court).
Regulators can be government agencies or independent regulators. Figure 1 shows the different types of regulators. Independent regulators are given recognition by government agencies and have power to make rules and enforce them. However, independent regulators are usually not funded by the government and hence are politically independent. Some independent regulators are self-regulating organizations (SROs) that regulate as well as represent their members. Not all SROs are independent regulators (i.e., have government recognition). Also, not all independent regulators are SROs. Some independent regulators such as the Public Company Accounting Oversight Board (PCAOB) are not SROs.
Cobb-Douglas function
The Cobb-Douglas function essentially states that output (GDP) is a function of labor and capital inputs and their productivity. It exhibits constant returns to scale; increasing all inputs by a fixed percentage leads to the same percentage increase in output. Dividing both sides by L in the Cobb-Douglas production function, we can obtain the output per worker (labor productivity). output per worker = Y/L = T(K/L)α Labor productivity is similar to GDP per capita, a standard of living measure. The previous equation has important implications about the effect of capital investment on the standard of living. Assuming the number of workers and α remain constant, increases in output can be gained by increasing capital per worker ( capital deepening) or by improving technology (increasing TFP). However, since α is less than one, additional capital has a diminishing effect on productivity: the lower the value of α, the lower the benefit of capital deepening. Developed markets typically have a high capital to labor ratio and a lower α compared to developing markets, and therefore developed markets stand to gain less in increased productivity from capital deepening. Professor's Note: We need to distinguish between marginal product of capital and marginal productivity of capital. Marginal product of capital is the additional output for one additional unit of capital. Marginal productivity of capital is the increase in output per worker for one additional unit of capital per labor (i.e., increasing capital while keeping labor constant). The Cobb-Douglas function exhibits constant marginal product of capital but diminishing marginal productivity of capital.
The absolute convergence hypothesis states that less developed countries will achieve equal living standards over time. The neoclassical model assumes that every country has access to the same technology. This leads to countries having the same growth rates but not the same per capita income.
The conditional convergence hypothesis states that convergence in living standards will only occur for countries with the same savings rates, population growth rates, and production functions. Under the conditional convergence hypothesis, the growth rate will be higher for less developed countries until they catch up. Under the neoclassical model, once a developing country's standard of living converges with that of developed countries, the growth rate will then stabilize to the same steady state growth rate as that of developed countries.
Example of Ex-Ante Version of PPP
The current spot rate is USD/AUD = 1.00. You expect the annualized Australian inflation rate to be 5%, and the annualized U.S. inflation rate to be 2%. According to ex-ante version of PPP, what is the expected change in the spot rate over the coming year? Answer: Since the AUD has the higher expected inflation rate, we expect that the AUD will depreciate relative to the USD. To keep the cost of goods and services the same across borders, countries with higher rates of inflation should see their currencies depreciate. The expected change in the spot rate over the coming year is inflation(USD) - inflation(AUD) = 2% - 5% = -3%. This predicts a new USD/AUD exchange rate of approximately 0.97 USD/AUD. Because there is no true arbitrage available to force relative PPP to hold, violations of relative PPP in the short run are common. However, because the evidence suggests that the relative form of PPP holds approximately in the long run, it remains a useful method for estimating the relationship between exchange rates and inflation rates.
Dealer quotes often include both bid and offer (ask) rates. For example, the euro could be quoted as $1.4124 - 1.4128. The bid price ($1.4124) is the price at which the dealer will buy euros, and the offer price ($1.4128) is the price at which the dealer will sell euros.
The difference between the offer and bid price is called the spread. Spreads are often stated as 'pips'. When the spot quote has four decimal places, one pip is 1/10,000. In the above example, the spread is $0.0004 (4 pips) reflecting the dealer's profit. Dealers manage their foreign currency inventories by transacting in the interbank market (think of this as a wholesale market for currency). Spreads are narrower in the interbank market.
Relative purchasing power parity (relative PPP) states that changes in exchange rates should exactly offset the price effects of any inflation differential between the two countries. Simply put, if (over a 1-year period) Country A has a 6% inflation rate and Country B has a 4% inflation rate, then Country A's currency should depreciate by approximately 2% relative to Country B's currency over the period.
The equation for relative PPP is as follows: %ΔS(A/B) = Inflation(A) - Inflation(B) where: %ΔS(A/B) = change in spot price (A/B) Relative PPP is based on the idea that even if absolute PPP does not hold, there may still be a relationship between changes in the exchange rate and differences between the inflation rates of the two countries.
Ex-Ante Version of PPP
The ex-ante version of purchasing power parity is the same as relative purchasing power parity except that it uses expected inflation instead of actual inflation.
The current account measures the exchange of goods, the exchange of services, the exchange of investment income, and unilateral transfers (gifts to and from other nations). The current account balance summarizes whether we are selling more goods and services to the rest of the world than we are buying from them (a current account surplus) or buying more from the rest of the world than we are selling to them (a current account deficit).
The financial account (also known as the capital account) measures the flow of funds for debt and equity investment into and out of the country.
The spread quoted by the dealer depends on:
The spread in the interbank market for the same currency pair. Dealer spreads vary directly with spreads quoted in the interbank market. •The size of the transaction. Larger, liquidity-demanding transactions generally get quoted a larger spread. •The relationship between the dealer and client. Sometimes dealers will give favorable rates to preferred clients based on other ongoing business relationships.
If the forward contract price is consistent with covered interest rate parity (discussed later), the value of the contract at initiation is zero to both parties. After initiation, the value of the forward contract will change as forward quotes for the currency pair change in the market.
The value of a forward contract (to the party buying the base currency) at maturity (time T) is: VT = (FPT - FP)(contract size) where: VT = value of the forward contract at time T, denominated in price currency T = maturity of the forward contract FP = forward price locked in at inception to buy the base currency (and with a maturity of T) FPT = forward price to sell the base currency at time T contract size = number of units of currency covered by the agreement
If the forward rate is equal to the expected future spot rate, we say that the forward rate is an unbiased predictor of the future spot rate. In such an instance, F = E(S1). In this special case, if covered interest parity holds (and it will; by arbitrage) uncovered interest parity would also hold (and vice versa). Stated differently, if uncovered interest rate parity holds, the forward rate is an unbiased predictor of expected future spot rates.
There is no reason that uncovered interest rate parity must hold in the short run, and indeed it typically does not. There is evidence that it does generally hold in the long run, so longer-term expected future spot rates based on uncovered interest rate parity are often used as forecasts of future exchange rates.
Fixed Exchange Rate Regimes Under a fixed exchange rate regime, the government fixes the rate of exchange of its currency relative to one of the major currencies. An expansionary (restrictive) monetary policy would lead to depreciation (appreciation) of domestic currency as stated above. Under a fixed rate regime, the government would then have to purchase (sell) its own currency in the foreign exchange market. This action essentially reverses the expansionary (restrictive) stance.
This explains why in a world with mobility of capital, governments cannot both manage exchange rates as well as pursue independent monetary policy. If the government wants to manage monetary policy, it must either let exchange rates float freely or restrict capital movements to keep them stable. Expansionary (restrictive) fiscal policy leads to appreciation (depreciation) of domestic currency. Under a fixed exchange rate regime, the government would then sell (buy) its own domestic currency to keep exchange rates stable—reinforcing the impact of its fiscal policy on aggregate demand.
Absolute PPP is based on a number of unrealistic assumptions that limits its real-world usefulness. These assumptions are: that all goods and services can be transported among countries at no cost; all countries use the same basket of goods and services to measure their price levels; and all countries measure their rates of inflation the same way. PPP is based on the idea that a given basket of goods should cost the same in different countries after taking into account the changes in exchange rates. PPP does not hold due to transportation costs and other factors. Under absolute PPP the foreign price level expressed in domestic currency terms should be equal to the domestic country's price level.
UIRP rests on the idea of equal real interest rates across international borders. Real interest rate differentials would result in capital flows to the higher real interest rate country, equalizing the rates over time. Another way to say this is that differences in interest rates are equal to differences in expected changes in exchange rates. UIRP means that interest rates and exchange rates will adjust so the risk adjusted return on assets between any two countries and their associated currencies will be the same
Monetary Approach to Exchange Rate Determination
Under monetary models, we assume that output is fixed, so that monetary policy primarily affects inflation, which in turn affects exchange rates. There are two main approaches to monetary models: 1. Pure monetary model. Under a pure monetary model, the PPP holds at any point in time and output is held constant. An expansionary (restrictive) monetary or fiscal policy leads to an increase (decrease) in prices and a decrease (increase) in the value of the domestic currency. The pure monetary approach does not take into account expectations about future monetary expansion or contraction. 2. Dornbusch overshooting model. This model assumes that prices are sticky (inflexible) in the short term and, hence, do not immediately reflect changes in monetary policy. In the case of an expansionary monetary policy, prices increase over time. This leads to a decrease in real interest rates—and depreciation of the domestic currency due to capital outflows. Additionally, according to the model, in the short term, exchange rates overshoot the long-run PPP implied values. In other words, under an expansionary monetary policy, in the short term, the depreciation of currency is greater than the depreciation implied by PPP. In the long term, exchange rates gradually increase toward their PPP implied values. Similarly, a restrictive monetary policy leads to excessive appreciation of the domestic currency in the short term and then a slow depreciation toward the long-term PPP value.
real interest rate parity
Under real interest rate parity, real interest rates are assumed to converge across different markets. Taking the Fisher relation and real interest rate parity together gives us the international Fisher effect: Rnominal A - Rnominal B = E(inflationA) - E(inflationB) This tells us that the difference between two countries' nominal interest rates should be equal to the difference between their expected inflation rates. The argument for the equality of real interest rates across countries is based on the idea that with free capital flows, funds will move to the country with a higher real rate until real rates are equalized.
Comparing covered and uncovered interest parity, we see that covered interest rate parity derives the no-arbitrage forward rate, while uncovered interest rate parity derives the expected future spot rate (which is not market traded). Covered interest parity is assumed by arbitrage, but this is not the case for uncovered interest rate parity.
Under uncovered interest rate parity, if the foreign interest rate is higher by 2%, the foreign currency is expected to depreciate by 2%, so the investor should be indifferent between investing in the foreign currency or in their own domestic currency. An investor that chooses to invest in the foreign currency without any additional return (the interest rate differential is offset by currency value changes) is not demanding a risk premium for the foreign currency risk. Hence, uncovered interest rate parity assumes that the investor is risk-neutral.
Portfolio Balance (Asset Market) Approach to Exchange Rate Determination The Mundell-Fleming approach focuses on the short-term implications of fiscal policy and, as such, is inadequate. The portfolio balance model focuses on the long-term implications of sustained fiscal policy (deficit or surplus) on currency values.
When the government runs a fiscal deficit, it borrows money from investors. Under the portfolio balance approach, investors evaluate the debt based on expected risk and return. A sovereign debt investor would earn a return based on both the debt's yield and its currency return. When a government pursues a long-term stance of expansionary fiscal policy, an investor should evaluate the implications of such a policy on expected risk and return (typically the yield should increase due to a higher risk premium). If investors perceive that the yield and/or currency return is sufficient, they will continue to purchase the bonds. However, continued increases in fiscal deficits are unsustainable and investors may refuse to fund the deficits—leading to currency depreciation. Combining the Mundell-Fleming and portfolio balance approaches, we find that in the short term, with free capital flows, an expansionary fiscal policy leads to domestic currency appreciation (via high real interest rates). In the long term, the government has to reverse course (through tighter budgetary policy) leading to depreciation of the domestic currency. If the government does not reverse course, it will have to monetize its debt (i.e., print money), which would also lead to depreciation of the domestic currency.
low capital mobility with flexible regime- Low Capital Mobility Our discussion so far has assumed free flow of capital, which is a valid assumption with respect to developed markets. In emerging markets, however, capital flows may be restricted. In that case, the impact of trade imbalance on exchange rates (goods flow effect) is greater than the impact of interest rates (financial flows effect). In such a case, expansionary fiscal or monetary policy leads to increases in net imports, leading to depreciation of the domestic currency. Similarly, restrictive monetary or fiscal policy leads to an appreciation of domestic currency
effect on exchange rates
Mundell-Fleming model
evaluates the impact of monetary and fiscal policies on interest rates—and consequently on exchange rates. Changes in inflation rates due to changes in monetary or fiscal policy are not explicitly modeled by the Mundell-Fleming model. WE ASSUME THAT INFLATION/PRICE LEVELS PLAY NO ROLE IN EXCHANGE RATE DETERMINATION
A currency is quoted at a forward premium relative to a second currency if the forward price (in units of the second currency) is greater than the spot price. A currency is quoted at a forward discount relative to a second currency if the forward price (in units of the second currency) is less than the spot price. The premium or discount is for the base currency (i.e., the currency at the bottom of the quote). For example, if the spot price is 1.20$/€ and forward price is 1.25$/€ we say that the euro is trading at a forward premium.
forward premium (discount) = F - S0 Given a quote of A/B, if the above equation results in a positive value, we say that currency B (i.e., the base currency) is trading at a premium in the forward market.
Another approach to forecasting potential GDP growth is the labor productivity growth accounting equation, which focuses on changes in labor as follows
growth rate in potential GDP = long-term growth rate of labor force + long-term growth rate in labor productivity The long-term growth rate in labor productivity reflects both capital deepening and technological progress.
high capital mobility with flexible regime- Expansionary monetary policy and expansionary fiscal policy are likely to have opposite effects on exchange rates. Expansionary monetary policy will reduce the interest rate and, consequently, 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. Restrictive monetary policy should have the opposite effect, increasing interest rates and leading to an appreciation in the value of the domestic currency
high capital mobility with flexible regime - Expansionary fiscal policy (an increased deficit from lower taxes or higher government spending) will increase government borrowing and, consequently, real interest rates. An increase in real interest rates will attract foreign investment, improve the financial account, and consequently, increase the demand for the domestic currency.
Current Account Influences Current account deficits lead to a depreciation of domestic currency via a variety of mechanisms:
• Flow mechanism. Current account deficits in a country increase the supply of that currency in the markets (as exporters to that country convert their revenues to their own local currency). This puts downward pressure on the exchange value of that currency. The decrease in the value of the currency may restore the current account deficit to a balance—depending on the following factors: •The initial deficit. The larger the initial deficit, the larger the depreciation of domestic currency needed to restore current account balance. •The influence of exchange rates on domestic import and export prices. As a country's currency depreciates, the cost of imported goods increases. However, some of the increase in cost may not be passed on to consumers. •Price elasticity of demand of the traded goods. If the most important imports are relatively price inelastic, the quantity imported will not change.
Using the Cobb-Douglas production function, the growth in potential GDP can be expressed using the growth accounting relation as:
∆Y/Y = ∆A/A + α × (∆K/K) + (1−α) × (∆L/L) where: Y = output A = technology K = capital L = labor α = elasticity of output with respect to capital = share of income paid to capital (1 - α) = elasticity of output with respect to labor = share of income paid to labor or: growth rate in potential GDP = long-term growth rate of technology + α (long-term growth rate of capital) + (1 - α) (long-term growth rate of labor)
