CFA Level 2: Econ Exam 115 Questions with Answers
This econ topic regards the relationship between exchange rates and interest rates - CORRECT ANSWER .....
When is interbank FX market for most currency pairs typi
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CFA Level 2: Econ Exam 115 Questions with Answers
This econ topic regards the relationship between exchange rates and interest rates - CORRECT ANSWER .....
When is interbank FX market for most currency pairs typically most liquid? - CORRECT ANSWER 8am-11am New York Time
^because the London and New York (two largest FX trading centers) overlap during these times making it the most liquid during these hours.
Arbitrage Constraints on Spot Exchange Rate Quotes - CORRECT ANSWER 1. the bid shown by a dealer in the interbank market cannot be higher than the current interbank offer, and the offer shown by a dealer cannot be lower than the current interbank bid.
*Example:
Assume interbank JPY/CAD bid-offer is 85.76/85.80
and,
Dealers JPY/CAD bid-offer is 85.74/85.81 ..........
Then,
The arbitrage relationship is not violated because,
-The dealer's bid (offer) is not above (below) the interbank market's offer (bid). The implied interbank cross rate for JPY/CAD is 85.76/85.80 (the solution to Question 2).
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*For example, suppose that the current spot USD/EUR price in the interbank market is 1.3649/1.3651. If a dealer showed a misaligned price quote of 1.3652/1.3654, then other market participants would pay the offer in the interbank market, buying EUR at a price of USD 1.3651, and then sell the EUR to the dealer by hitting the dealer's bid at USD 1.3652—thereby making a riskless profit of one pip on the trade
2. the cross-rate bids (offers) posted by a dealer must be lower (higher) than the implied cross-rate offers (bids) available in the interbank market.
*For A/C, A/B and C/B - how to trade currency A against currency C:
^If the exchange rates are not consistent, the arbitrageur will buy currency C from a dealer if it is undervalued (relative to the cross rate) and sell currency A. If currency C is overvalued by a dealer (relative to the cross rate), it will be sold and currency A will be bought.
Triangular arbitrage.. - CORRECT ANSWER is among three currencies, suppose that the interbank market bid-offer in USD/EUR is 1.3649/1.3651 and that the bid-offer in JPY/USD is 76.64/76.66. We need to use these two interbank bid-offer quotes to calculate the market-implied bid-offer quote on the JPY/EUR cross rate.
Begin by considering the transactions required to sell JPY and buy EUR, going through the JPY/USD and USD/EUR currency pairs. We can view this process intuitively as follows:
Sell JPY & Buy EUR =
Sell JPY & Buy USD
then,
Sell USD & Buy EUR
Note that the "Buy USD" and "Sell USD" in the expressions on the right-hand side of the equal sign will cancel out to give the JPY/EUR cross rate. In equation form, we can represent this relationship as follows: JPY/EUR = (JPY/USD)*(USD/EUR),
so USD cancels out of equation
Now, let's incorporate the bid-offer rates in order to do the JPY/EUR calculation. A rule of thumb is that when we speak of a bid or offer exchange rate, we are referring to the bid or offer for the currency in the denominator (the base currency).
i. The left-hand side of the above equal sign is "Sell JPY, Buy EUR." In the JPY/EUR price quote, the EUR is in the denominator (it is the base currency). Because we want to buy the currency in the denominator, we need an exchange rate that is an offer rate. Thus, we will be calculating the OFFER rate for JPY/EUR.
ii. The first term on the right-hand side of the equal sign is "Sell JPY, Buy USD." Because we want to buy the currency in the denominator of the quote, we need an exchange rate that is an offer rate. Thus, we need the offer rate for JPY/USD.
iii. The second term on the right-hand side of the equal sign is "Sell USD, Buy EUR." Because we want to buy the currency in the denominator of the quote, we need an exchange rate that is an offer rate. Thus, we need the offer rate for USD/EUR.
Combining all of this together conceptually and putting in the relevant offer rates leads to a JPY/EUR offer rate of
(JPY/EUR)offer=(JPY/USD)offer(USD/EUR)offer=76.66×1.3651=104.65
Perhaps not surprisingly, calculating the implied JPY/EUR bid rate uses the same process as above, but with "Buy JPY, Sell EUR" for the left-hand side of the equation, which leads to
(JPYEUR)bid=(JPY/USD)bid(USD/EUR)bid= 76.64×1.3649=104.61
Bid-Offer Rates Examples on pg. 522 - CORRECT ANSWER see page 522, do all blue box questions
Forward Market - CORRECT ANSWER Check page 524 for FORMULAS
Covered interest rate parity - CORRECT ANSWER The relationship among the spot exchange rate, the forward exchange rate, and the interest rates in two currencies that ensures that the return on a hedged (i.e., covered) foreign risk-free investment is the same as the return on a domestic risk-free investment. Also called interest rate parity.
*When will the domestic currency trade at a forward premium?*
(memorize this) - CORRECT ANSWER if, and only if, the foreign risk-free interest rate exceeds the domestic risk-free interest rate: i(f) > i(d)
*this also means the foreign currency will trade at a lower rate in the forward contract(relative to the spot rate) and we would say the foreign currency trades at a forward discount
Calculating the Forward Premium (Discount) - CORRECT ANSWER see pg.526 - Do blue box questions
Calculating Mark-to-Market Value of a Forward Contract - CORRECT ANSWER see pg 528 - do blue box questions
*understand question 3 vs 4
International Parity Conditions (5): - CORRECT ANSWER 1. Covered Interest Rate Parity
2. Uncovered Interest Rate Parity
3. Forward Rate Parity
4. Purchasing Power Parity
5. International Fisher Effect
Covered Interest Rate Parity - CORRECT ANSWER Under this parity condition, 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
*For covered interest rate parity to hold exactly, it must be assumed that there are zero transaction costs and that the underlying domestic and foreign money market instruments being compared are identical in terms of liquidity, maturity, and default risk.
Uncovered Interest Rate Parity - CORRECT ANSWER The proposition that the expected return on an uncovered (i.e., unhedged) foreign currency (risk-free) investment should equal the return on a comparable domestic currency investment.
investor return = i(f) - %ΔS(f/d)
where,
i(f) = foreign interest rate
Uncovered interest Rate Parity Example
Assume that the return on the one-year foreign money market instrument is 10% while the return on the one-year domestic money market instrument is 4%.
Now, consider the 3 cases below:
1. The S(f/d) rate is expected to remain unchanged.
2.The domestic currency is expected to appreciate by 10%.
3.The domestic currency is expected to appreciate by 6%. - CORRECT ANSWER 1st case: the investor would prefer the foreign-currency-denominated money market investment because it offers a 10% (= 10% - 0%) expected return, while the comparable domestic investment offers only 4%.
2nd case: the investor would prefer the domestic investment because the expected return on the foreign-currency-denominated investment is 0% (= 10% - 10%).
3rd case: uncovered interest rate parity holds because both investments offer a 4% (for the foreign investment, 10% - 6%) expected return. In this case, the risk-neutral investor is assumed to be indifferent between the alternatives.
Assuming Uncovered Interest Rate Parity Holds, what is the formula for the expected change in spot exchange rate over the investment horizon ? - CORRECT ANSWER %ΔS^e(f/d) = i(f) − i(d)
where,
i(f) = foreign interest rate
i(d) = domestic interest rate
uncovered interest rate parity says the expected change in the spot exchange rate over the investment horizon should be reflected in the interest rate differential
*In our example, if the yield spread between the foreign and domestic investments is 6% (i(f) - i(d) = 6%), then this spread implicitly reflects the expectation that the domestic currency will strengthen versus the foreign currency by 6%.
CFA Econ Questoin #9 contradicts "if uncovered interest rate parity holds"
Use this but remember the other formula just in case - CORRECT ANSWER If uncovered interest rate parity holds, the expected spot rate one-year forward is equal to the one-year forward exchange rate. The forward exchange rate is calculated using the formula:
S(e)=F(f/d)=S(f/d)*(((1+i(f))/(1+i(d)))
Forward Rate Parity - CORRECT ANSWER The proposition that the forward exchange rate is an unbiased predictore of the future spot exchange rate
*since uncovered interest rate parity is often violated, forward exchange rates are typically poor predictors of future spot exchange rates in the short run. Over the longer term, uncovered interest rate parity and forward rate parity have more empirical support.
Covered and Uncovered Interest Rate Parity: Predictors of Future Spot Rates questions.... - CORRECT ANSWER see page 537
Random Walk related to spot exchange rates - CORRECT ANSWER Assuming that the current spot exchange rate is the best predictor of future spot rates assumes that exchange rate movements follow a random walk
Moving to new topic: relationship between exchange rates and inflation - CORRECT ANSWER ......
Purchasing Power Parity (PPP) - CORRECT ANSWER The idea that exchange rates move to equalize the purchasing power of different currencies.
Law of One Price
(based on a single good) - CORRECT ANSWER A principle that states that if 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.
or
identical goods should trade at the same price across countries when valued in terms of a common currency.
*For example, for a EUR-based consumer, 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.
Absolute version of PPP - CORRECT ANSWER An extension of the law of one price whereby the prices of goods and services will not differ internationally once exchange rates are considered.
- extends the law of one price to the broad range of goods and services that are consumed in different countries
-The 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.
Absolute Version of PPP formula - CORRECT ANSWER P(f) = (S(f/d))*P(d)
can be rearranged to find nominal exchange rate, as seen below:
S(f/d)= P(f)/P(d)
- The absolute version of PPP asserts that the equilibrium exchange rate between two countries is *determined entirely by the ratio of their national price levels.*
Relative version of PPP
(based on actual changes in exchange rates driven by actual differences in national inflation rates) - CORRECT ANSWER The hypothesis that changes in (nominal) exchange rates over time are equal to national inflation rate differentials.
in other words,
the percentage change in the spot exchange rate (%ΔS(f/d)) will be completely determined by the difference between the foreign and domestic inflation rates π(f) - π(d)
%ΔS(f/d)≅π(f)−π(d)
For example, if the foreign inflation rate is assumed to be 9% while the domestic inflation rate is assumed to be 5%, then the Sf/d exchange rate must rise by 4% (%ΔSf/d = 9% - 5% = 4%) in order to maintain the relative competitiveness of the two regions: The currency of the high-inflation country should depreciate relative to the currency of the low-inflation country
Ex ante version of PPP
(based on expected) - CORRECT ANSWER The hypothesis that expected changes in the spot exchange rate are equal to expected differences in national inflation rates. An extension of relative purchasing power parity to expected future changes in the exchange rate.
- 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, while countries that are expected to run relatively low inflation rates on a sustainable basis should expect to see their currencies appreciate over time. Ex ante PPP can be expressed as
Ex Ante Formula - CORRECT ANSWER %ΔS^e(f/d)=π^e(f)−π^e(d)
in this formula,
e = expected
Do nominal exchange rate movements happen rapidly? - CORRECT ANSWER No. Over longer time horizons nominal exchange rates tend to gravitate toward their long-run PPP equilibrium values.
Fisher Equation - CORRECT ANSWER i(f)−i(d)=π^ε(f)−π^ε(d)
where,
i(d) = nominal domestic int rate
π^ε(d)= expected domestic inflation rate
r(d)= risk free domestic rate
The nominal interest rate spread is equal to the difference in expected inflation rates. We can therefore conclude that if uncovered interest rate parity and ex ante PPP hold, the real yield spread between the domestic and foreign countries, r(f)-r(d)=0. In other words, the level of real interest rates in the domestic country will be identical to the level of real interest rates in the foreign country.
Real Interest Rate Parity - CORRECT ANSWER The proposition that real interest rates will converge to the same level across different markets.
International fisher affect - CORRECT ANSWER The proposition that nominal interest rate differentials across currencies are determined by expected inflation differentials
^(because theory assumes real interest rates are equal across markets)
-The international Fisher effect and, by extension, real interest rate parity assume that currency risk is the same throughout the world. However, not all currencies carry the same risk.
^for example, emerging markets have HIGHER real interest rate due to a required risk premium to investors included in nominal rate for elevated level of currency risk
According to covered interest rate parity.... - CORRECT ANSWER arbitrage ensures that nominal interest rate spreads equal the percentage forward premium (or discount).
According to uncovered interest rate parity.... - CORRECT ANSWER the expected percentage change of the spot exchange rate should, on average, be reflected in the nominal interest rate spread.
According to uncovered interest rate parity, high-yield currencies are expected to depreciate in value, while low-yield currencies are expected to appreciate in value. If uncovered interest rate parity held at all times, investors would not be able to profit from a strategy that undertook long positions in high-yield currencies and short positions in low-yield currencies
-does not hold over short and medium time periods
-Studies have generally found that high-yield currencies, on average, have not depreciated, and low-yield currencies have not appreciated, to the levels predicted by interest rate differentials
If both covered and uncovered interest rate parity hold—that is the nominal yield spread equals both the forward premium (or discount) and the expected percentage change in the spot exchange rate—then... - CORRECT ANSWER the forward exchange rate will be an unbiased predictor of the future spot exchange rate.
According to the ex ante PPP approach to exchange rate determination.... - CORRECT ANSWER the expected change in the spot exchange rate should equal the expected difference between domestic and foreign inflation rates.
Assuming the Fisher effect holds in all markets—that is, the nominal interest rate in each market equals the real interest rate plus the expected inflation rate—and also assuming that real interest rates are broadly the same across all markets (real interest rate parity), then.... - CORRECT ANSWER the nominal yield spread between domestic and foreign markets will equal the domestic-foreign expected inflation differential, which is the international Fisher effect.
If ex ante PPP and the Fisher effect hold, then... - CORRECT ANSWER expected inflation differentials should equal both the expected change in the exchange rate and the nominal interest rate differential. This relationship implies that the expected change in the exchange rate equals the nominal interest rate differential, which is uncovered interest rate parity.
What would happen if all parity conditions held? - CORRECT ANSWER if all these parity conditions held, it would be impossible for a global investor to earn consistent profits on currency movements.
-If forward exchange rates accurately predicted the future path of spot exchange rates, there would be no way to make money in forward exchange speculation
Forward rates are unbiased predictors of future spot rates if two parity conditions hold. Which of the following is not one of these conditions?
A. Real interest rate parity
B.Covered interest rate parity
C.Uncovered interest rate parity - CORRECT ANSWER A. Real Interest Rate Parity
Both covered and uncovered interest rate parity must hold for the forward rate to be an unbiased predictor of the future spot rate. Real interest rate is not required.
The international Fisher effect requires all but which of the following to hold?
A.Ex ante PPP
B.Absolute PPP
C.Real interest rate parity - CORRECT ANSWER B. Absolute PPP
The international Fisher effect is based on real interest rate parity and ex ante PPP (not absolute PPP).
Go back and review blue box questions on pg 548 - CORRECT ANSWER .....
FX carry trade - CORRECT ANSWER An investment strategy that involves taking long positions in high-yield currencies and short positions in low-yield currencies.
The evidence suggests that uncovered interest rate parity does not hold over short and medium time periods.
^Studies have generally found that high-yield currencies, on average, have not depreciated, and low-yield currencies have not appreciated, to the levels predicted by interest rate differentials.
See Carry Trade Question in CFA qbank #11 & 18 - CORRECT ANSWER make sure you understand kid... do till this becomes easy
Forward Premium question in CFA qbank #12 - CORRECT ANSWER make sure you understand kiid
Triangular arbitrage question in CFA qbank #27 - CORRECT ANSWER make sure you understand kiiid
Findings on what theory underscore the potential profitability of FX carry trade? - CORRECT ANSWER Evidence suggested that uncovered interest rate parity does not hold over short and medium time periods.
As a simplified example of the carry trade, assume a trader can borrow Canadian dollars at 1% and earn 9% on an investment in Brazilian reals for one year. To execute the trade to earn 8% from the interest rate differential, the trader will do the following:
1. Borrow Canadian dollars at t = 0
2. Sell the dollars and buy Brazilian reals at the spot rate at t = 0
3. Invest in a real-denominated investment at t = 0
4. Liquidate the Brazilian investment at t = 1
5. Sell the reals and buy dollars at the spot rate at t = 1
6. Pay back the dollar loan - CORRECT ANSWER -If the real appreciates, the trader's profits will be greater than 8% because the stronger real will buy more dollars in one year.
-If the real depreciates, the trader's profits will be less than 8% because the weaker real will buy fewer dollars in the future.
-If the real falls in value by more than 8%, the trader will experience losses.
*During periods of low volatility, carry trades tend to generate positive returns, but they are prone to significant crash risk in turbulent times.
-Although carry trades have generated positive returns on average in the past, the negative skew and fat tails in the non-normal distribution of returns for all carry trades (developed and emerging markets) indicate that carry trades have tended to have more frequent and larger losses than would have been experienced had the return distribution been normal.
The volatility of the fund's returns relative to its equity base is best explained by:
A. leverage.
B. low deposit rates in the funding currency.
C. the yield spread between the high- and low-yielding currencies. - CORRECT ANSWER A is correct.
Carry trades are leveraged trades (borrow in the funding currency, invest in the high-yield currency), and leverage increases the volatility in the investor's return on equity.
What does a country's balance of payments consist of? (2 general categories) - CORRECT ANSWER 1. Current account: trade flows in the real economy referring to actual production of goods and services
2. Capital/Financial account: investment/financing flows
What does balance of payments mean? - CORRECT ANSWER A country current account balance must be matched with equal and opposite balance in the capital account
- Thus, 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). A country described above is called a "net borrower" (vs. net lender)
^typically see their currency depreciate through continued use of debt
Do investment/financing decisions or trade decisions have a dominant factor in determining exchange rate movements in the short-intermediate term? - CORRECT ANSWER Investment/financing decisions, because prices of real goods and services adjust more slowly than exchange rates while investment/financing decisions are virtually instantaneous
The Flow Supply/Demand Channel - CORRECT ANSWER The flow supply/demand channel is based on a fairly simple model that focuses on the fact that purchases and sales of internationally traded goods and services require the exchange of domestic and foreign currencies in order to arrange payment for those goods and services. For example, if a country sold more goods and services than it purchased (i.e., the country was running a current account surplus), then the demand for its currency should rise, and vice versa. Such shifts in currency demand should exert upward pressure on the value of the surplus nation's currency and downward pressure on the value of the deficit nation's currency.
Portfolio Balance Channel - CORRECT ANSWER 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.
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.
The Debt Sustainability Channel - CORRECT ANSWER According to this mechanism, there should be some upper limit on the ability of countries to run persistently large current account deficits. If 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.
is the equity market trend and exchange rates correlated? - CORRECT ANSWER No. The long run correlation is close to zero. Over short and medium periods, correlations tend to swing from being highly positive to highly negative
*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.
Mundell-Fleming Model - CORRECT ANSWER describes how changes in monetary and fiscal policy within a country affect interest rates and economic activity, which in turn leads to changes in capital flows and trade and ultimately to changes in the exchange rate.
Expansionary monetary policy typically does what to interest rates? - CORRECT ANSWER reduces interest rates
Expansionary fiscal policy typically does what to interest rates? - CORRECT ANSWER increases interest rates
Monetary-Fiscal Policy Mix and the Determination of Exchange Rates under Conditions of HIGH Capital Mobility
(MUST MEMORIZE!) - CORRECT ANSWER Domestic Currency Appreciates (bullish) : restrictive domestic monetary policy and/or an expansionary fiscal policy (high capital mobility)
Domestic Currency Depreciates (bearish): expansionary domestic monetary policy and/or a restrictive fiscal policy
Indeterminate effect on domestic currency: both domestic expansionary OR both domestic restrictive under high capital mobility
*look at the chart if necessary (p561)
Is the high capital mobility chart more relevant in developed or emerging economies? - CORRECT ANSWER developed
Monetary-Fiscal Policy Mix and the Determination of Exchange Rates under Conditions of LOW Capital Mobility
(MUST MEMORIZE) - CORRECT ANSWER Domestic Currency Appreciates (bullish) : restrictive monetary AND restrictive fiscal
Domestic Currency Depreciates (bearish): expansionary monetary AND expansionary fiscal policy
Indeterminate effect on domestic currency: expansionary monetary and restrictive fiscal policies (or restrictive monetary and expansionary fiscal policies)
Is the low capital mobility chart more relevant for developed or emerging economies? - CORRECT ANSWER emerging economies
^this is becomes emerging economies need to be more protective of their exchange rate, so restriction of capital movement occurs more often for emerging economies.
Mundell-Fleming model vs. monetary model - CORRECT ANSWER In the Mundell-Fleming model, monetary policy is transmitted to the exchange rate through its impact on interest rates and output.
Monetary models of exchange rate determination generally take the opposite perspective: Output is fixed and monetary policy affects exchange rates primarily through the price level and the rate of inflation.
Monetary Model assets.... - CORRECT ANSWER The monetary approach asserts that an X percent rise in the domestic money supply will produce an X percent rise in the domestic price level. Assuming that purchasing power parity holds—that is, that changes in exchange rates reflect changes in relative inflation rates—a money supply-induced increase (decrease) in domestic prices relative to foreign prices should lead to a proportional decrease (increase) in the domestic currency's value.
Dornbusch overshooting model - CORRECT ANSWER when a change in monetary policy occurs, the foreign exchange market will initially overreact (or "overshoot") to a monetary change, achieving a new short run equilibrium. Over time, goods prices (because they lag changes in foreign exchange markets) will eventually respond, allowing the foreign exchange market to dissipate its overreaction, and the economy to reach the new long run equilibrium in all markets.
For example, a newly implement restrictive monetary policy leads to short-term appreciation of currency, which slowly depreciates to the long-run equilibrium of PPP value.
The Portfolio Balance Approach - CORRECT ANSWER A theory of exchange rate determination that emphasizes the portfolio investment decisions of global investors and the requirement that global investors willingly hold all outstanding securities denominated in each currency at prevailing prices and exchange rates.
A growing government budget deficit leads to a steady increase in the supply of domestic bonds outstanding. These bonds will be willingly held only if investors are compensated in the form of a higher expected return. Such a return could come from 1 of 2 things or a combination of both - what are those two things? - CORRECT ANSWER (1) higher interest rates and/or a higher risk premium, (2) immediate depreciation of the currency to a level sufficient to generate anticipation of gains from subsequent currency appreciation, or (3) some combination of these two factors.
What is the major insight one can draw from the portfolio balance model, with regards to a large government budget deficit in terms of the long run currency value - CORRECT ANSWER that in the long run, governments that run large budget deficits on a sustained basis could eventually see their currencies decline in value.
What do "pull" factors represent? - CORRECT ANSWER Pull factors represent a favorable set of developments that encourage foreign capital inflows
Examples:
◾ A decrease in inflation and inflation volatility;
◾more-flexible exchange rate regimes;
◾improved fiscal positions;
◾privatization of state-owned entities;
◾liberalization of financial markets; and
◾lifting of foreign exchange regulations and controls.
^Ideally, these changes will facilitate strong economic growth in the private sector, which will attract further foreign investment
*pull on foreign inflow as a result of domestic government factors/decisions
What are "push" factors? - CORRECT ANSWER Push factors driving foreign capital inflows are not determined by the domestic policies but arise from the primary sources of internationally mobile capital, notably the investor base in industrial countries.
- For example, the pursuit of low interest rate policies in industrial countries since the 2008 financial crisis has encouraged global investors to seek higher returns abroad.
- Another important push factor is the long-run trend in asset allocation by industrial country investors. For example, many fund managers have traditionally had underweight exposures to emerging market assets, but with the weight of emerging market equities in broad global equity market indexes on the rise (the EM share of world GDP is now around 40%, up from 17% in the 1960s), capital flows to EM countries, in the form of increased allocations to EM equities, are likely to rise
*foreign countries "push" for increased return which causes an inflow to domestic company sought as attractive
How do government resist excessive inflows and currency bubbles: - CORRECT ANSWER by using:
1) capital controls
2) direct intervention (selling their currency)
Warning Signs of a Currency Crisis - CORRECT ANSWER 1. Prior to a currency crisis, the 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.
3. Currency crises are often preceded by (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 precipitously as a crisis approaches.
6. In the period leading up to a crisis, the currency has risen substantially relative to its historical mean.
7. The ratio of exports to imports (known as "the terms of trade") often deteriorates before a crisis.
8. Broad money growth and the ratio of M2 (a measure of money supply) to bank reserves tend to rise prior to a crisis.
9. Inflation tends to be significantly higher in pre-crisis periods compared with tranquil periods.
best economic performance measures - CORRECT ANSWER GDP and per capita GDP are the best indicators economists have for measuring a country's standard of living and its level of economic development.
*Economic growth is calculated as the annual percentage change in real GDP or in real per capita GDP. Growth in real GDP measures how rapidly the total economy is expanding
Factors limiting growth include the following: - CORRECT ANSWER - Low rates of saving and investment
- Poorly developed financial markets
- Weak, or even corrupt, legal systems and failure to enforce laws
- Lack of property rights and political instability
- Poor public education and health services
- Tax and regulatory polices discouraging entrepreneurship
- Restrictions on international trade and flows of capital
Potential GDP - CORRECT ANSWER The maximum amount of output an economy can sustainably produce without inducing an increase in the inflation rate. The output level that corresponds to full employment with consistent wage and price expectations.
Total Factor Productivity (TFP) - CORRECT ANSWER A multiplicative scale factor that reflects the general level of productivity or technology in the economy. Changes in total factor productivity generate proportional changes in output for any input combination.
Relationship between economic growth and stock prices (formula) - CORRECT ANSWER P = GDP (E/GDP)(P/E)
where,
P = aggregate value (price) of equities
E = aggregate earnings
Logarithmic rates of change over a time horizon T (formula) - CORRECT ANSWER (1/T)%ΔP = (1/T)%ΔGDP + (1/T)%Δ(E/GDP) + (1/T)%Δ(P/E)
Over short to immediate horizons, all three of these factors contribute to appreciation or depreciation of the stock market.
**In the long run, however, the growth rate of GDP must dominate.
*earnings/GDP cannot rise forevere; earnings will have to decrease below GDP at least at some point.
* the conclusion is that the drivers of potential GDP are ultimately the drivers of stock market price performance, because E/GDP and P/E are approximately zero in the long-run which makes GDP the only variable in the equation above.
y= AF(K,L) - CORRECT ANSWER y= level of aggregate output in economy
A = Total Factor Productivity (TFP) which is the level of "technology" unless otherwise stated
K= n estimate of the capital services provided by the stock of equipment and structures used to produce goods and services
L= the quantity of labor or number of workers or hours worked in the economy
F just means function of
Cobb-Douglas production function - CORRECT ANSWER A function of the form Y = (K^α)*(L^(1-α)) relating output (Y) to labor (L) and capital (K) inputs.
where,
α = the share of GDP paid out to the suppliers of capital
(1 - α) = the share of income paid to labor
The significance of diminishing marginal returns in the Cobb-Douglas production function depends on the value of α...What does a value of α close to 0 indicate? What does a value of α close to 1 mean? - CORRECT ANSWER 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. In contrast, a value of α close to one means that the next unit of capital increases output almost as much as the previous unit of capital. In this case, diminishing marginal returns still occur but the impact is relatively small. Note that the exponents on the K and L variables in the Cobb-Douglas production function sum to one, indicating constant returns to scale—that is, there are no diminishing marginal returns if both inputs are increased proportionately.
Capital Deepening - CORRECT ANSWER An increase in the capital-to-labor ratio
Sustained growth in per capita output requires progress in __________ . - CORRECT ANSWER TFP
Growth Accounting Equation - CORRECT ANSWER ΔY/Y = ΔA/A + αΔK/K + (1 - α)ΔL/L
(α) = shares of capital
(1 - α)= share of labor in national income
^these are the elasticity's of equation. the higher the elasticity, the more the variable contributes to GDP growth.
The production function written in the form of growth rates. For the basic Cobb-Douglas production function, it states that the growth rate of output equals the rate of technological change plus α times the growth rate of capital plus (1 - α) times the growth rate of labor.
Labor productivity growth accounting equation - CORRECT ANSWER Growth rate in potential GDP = Long term growth rate of labor force + Long-termgrowthrateinlaborproductivity
States that potential GDP growth equals the growth rate of the labor input plus the growth rate of labor productivity.
Extending the Production Function - CORRECT ANSWER ◾Raw materials: natural resources such as oil, lumber, and available land (N)
◾Quantity of labor: the number of workers in the country (L)
◾Human capital: education and skill level of these workers (H)
◾Information, computer, and telecommunications (ICT) capital: computer hardware, software, and communication equipment (KIT)
◾Non-ICT capital: transport equipment, metal products and plant machinery other than computer hardware and communications equipment, and non-residential buildings and other structures (KNT)
◾Public capital: infrastructure owned and provided by the government (KP)
◾Technological knowledge: the production methods used to convert inputs into final products, reflected by total factor productivity (A)
The expanded production function is expressed mathematically as:
Y = AF(N,L,H,KIT,KNT,KP)
Even though access to natural resources (e.g., via trade) is important, ownership and production of natural resources is not necessary for a country to achieve a high level of income. - CORRECT ANSWER ....
Dutch disease - CORRECT ANSWER A situation in which currency appreciation driven by strong export demand for resources makes other segments of the economy (particularly manufacturing) globally uncompetitive.
Growth in the labor input depends on four factors: - CORRECT ANSWER 1. population growth
2. labor force participation
3. net migration
4. average hours worked.
labor force participation rate - CORRECT ANSWER The percentage of the working age population that is in the labor force.
The contribution of capital deepening can be measured as the difference between the growth rates of labor productivity and total factor productivity.
Example ahead> - CORRECT ANSWER For example, from 2005 to 2009, Ireland's labor productivity grew by 0.8 percent per year, of which 2.9 percent [0.8% - (-2.1%)] came from capital deepening, which offset the -2.1 percent decline in TFP. The larger the difference between the productivity growth measures, the more important capital deepening is as a source of economic growth.
TFP = Growth in labor productivity - growth in capital deepening
An understanding of productivity trends is critical for global investors... - CORRECT ANSWER A permanent increase in the rate of labor productivity growth will increase the sustainable rate of economic growth and raise the upper boundary for earnings growth and the potential return on equities.
In contrast, a low growth rate of labor productivity, if it persists over a number of years, suggests poor prospects for equity prices. A slowdown in productivity growth lowers both the long-run potential growth rate of the economy and the upper limit for earnings growth. Such a development would be associated with slow growth in profits and correspondingly low equity returns.
How is the long-term sustainable growth rate determined? - CORRECT ANSWER Long-term sustainable growth is determined by the rate of expansion of real potential GDP. Expansion of the supply of factors of production (inputs) and improvements in technology are the sources of growth. The factors of production include human capital, ICT and non-ICT capital, public capital, labor, and natural resources. Data for the sources of growth are available from the OECD and the Conference Board. Exhibit 12 provides data from the Conference Board on the sources of output growth for various countries. These estimates are based on the growth accounting formula.19
blue box questions pg 631 - CORRECT ANSWER
Endogenous Model - CORRECT ANSWER The final model of growth attempts to explain technology within the model itself— thus the term endogenous growth.
Classical Model - CORRECT ANSWER Ultimately, population grows so much that labor productivity falls and per capita income returns back to the subsistence level (minimum income needed to maintain life).
-theory failed, next came neoclassical
- diminishing marginal returns wipe out growth
----------------------
The classical model predicts that in the long run, the adoption of new technology results in a larger but not richer population. Thus, the standard of living is constant over time even with technological progress, and there is no growth in per capita output. As a result of this gloomy forecast, economics was labeled the "dismal science."
Neoclassical Model - CORRECT ANSWER Objective: to determine the long-run growth rate of output per capita and relate it to (a) the savings/investment rate, (b) the rate of technological change, and (c) population growth.
In the neoclassical model, long-run per capita growth depends solely on exogenous (external/from outside) technological progress.
Neoclassical Model: Steady State Growth Rate calculation questions.. see page 637 blue box - CORRECT ANSWER ...
Impact of various parameters in the model:
- savings rate
- labor force growth
- depreciation rate
- growth in TFP - CORRECT ANSWER In sum, such factors as the saving rate, the growth rate of the labor force, and the depreciation rate change the level of output per worker but do not permanently change the growth rate of output per worker. A permanent increase in the growth rate in output per worker can only occur if there is a change in the growth rate of TFP.
Criticism of Neoclassical Model - CORRECT ANSWER The problem with these findings is that the neoclassical model provides no explicit explanation of the economic determinants of technological progress or how TFP changes over time. Because technology is determined outside the model (i.e., exogenously), critics argue that the neoclassical model ignores the very factor driving growth in the economy. Technology is simply the residual or the part of growth that cannot be explained by other inputs, such as capital and labor. This lack of an explanation for technology led to growing dissatisfaction with the neoclassical model.
The other source of criticism of the neoclassical model is the prediction that the steady state rate of economic growth is unrelated to the rate of saving and investment. Long-run growth of output in the Solow model depends only on the rates of growth of the labor force and technology.
4 major groups of conclusions from the neoclassical model: - CORRECT ANSWER 1. Capital Accumulation
- Capital accumulation affects the level of output but not the growth rate in the long run.
2. Capital Deepening vs.
Technology
- Long-term sustainable growth cannot rely solely on capital deepening investment—that is, on increasing the stock of capital relative to labor
- In the absence of improvements in TFP, the growth of labor productivity and per capita output would eventually slow
- 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. This results in an upward shift in the production function—the economy produces more goods and services for any given mix of labor and capital inputs.
3. Convergence
- Given the relative scarcity and hence high marginal productivity of capital and potentially higher saving rates in developing countries, the growth rates of developing countries should exceed those of developed countries.
- As a result, there should be a convergence of per capita incomes between developed and developing countries over time.
4. Effects of Savings on Growth
- The initial impact of a higher saving rate is to temporarily raise the rate of growth in the economy. In response to the higher saving rate, growth exceeds the steady state growth rate during a transition period. However, the economy returns to the balanced growth path after the transition period.
Endogenous Growth Theory - CORRECT ANSWER -These models focus on explaining technological progress rather than treating it as exogenous.
-In these models, self-sustaining growth emerges as a natural consequence of the model and the economy does not necessarily converge to a steady state rate of growth.
-Unlike the neoclassical model, there are no diminishing marginal returns to capital for the economy as a whole in the endogenous growth models.
-Increasing the saving rate permanently increases the rate of economic growth.
-These models also allow for the possibility of increasing returns to scale.
-Finally, according to the endogenous growth theory, there is NO REASON why the incomes of developed and developing countries should converge.
Endogenous Growth Theory
Output per Worker Formula: - CORRECT ANSWER ∆ye/ye = ∆ke/ke = sc - δ - n
Because all the terms on the right-hand side of this equation are constant, this is both the long-run and short-run growth rate in this model.
Examination of the equation shows that a higher saving rate (s) implies a PERMENANTLY higher growth rate. This is the key result of the endogenous growth model.
Neoclassical growth theory predicts two types of convergence:
1)absolute convergence 2)conditional convergence.
what do these two mean? - CORRECT ANSWER 1. 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.
*implies convergence of per capita GROWTH RATES among all countries. It does not, however, imply that the LEVEL of per capita income will be the same in all countries
2. Conditional Convergence - The idea that convergence of per capita income is conditional on the countries having the same: savings rate, population growth rate, and 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
Club Convergence - CORRECT ANSWER The idea that only rich and middle-income countries sharing a set of favorable attributes (i.e., are members of the "club") will converge to the income level of the richest countries. (others will diverge)
Non-Convergence Trap - CORRECT ANSWER A situation in which a country remains relative poor, or even falls further behind, because it fails to implement necessary institutional reforms (ie failure to reform labor markets) and/or adopt leading technologies.
*Convergence means that the rate of growth of potential GDP should be higher in developing countries that have made the institutional changes that are a precondition for growth and that enable these countries to become members of the convergence club
Why do countries fail to converge? - CORRECT ANSWER - low rates of investment and savings
- lack of property rights
- political instability
- poor education and health
- restrictions on trade
- tax and regulatory policies that discourage work and investing.
Does the endogenous growth model make predictions about convergence? - CORRECT ANSWER No, because the model assumes high per capita income countries (developed) can stay ahead of developing countries
Growth in an Open Economy - CORRECT ANSWER According to the neoclassical model, convergence should occur more quickly if economies are open and there is free trade and international borrowing and lending.
Two contrasting strategies for economic development:
1) inward-oriented policies
2) outward-oriented policies - CORRECT ANSWER 1) Inward-oriented policies attempt to develop domestic industries by restricting imports. Instead of importing goods and services, these policies encourage the production of domestic substitutes, despite the fact that it may be more costly to do so. These policies are also called import substitution policies.
2) Outward-oriented policies attempt to integrate domestic industries with those of the global economy through trade and make exports a key driver of growth. (evidence says this is better policy for convergence)
Very good blue box example on pg 658. It wraps up everything learned in this section - CORRECT ANSWER *pg 658. - must understand as it will be tested
Regulatory Arbitrage - CORRECT ANSWER Entities identify and use some aspect of regulations that allows them to exploit differences in economic substance and regulatory interpretation or in foreign and domestic regulatory regimes to their (the entities) advantage.
Regulatory Capture Theory - CORRECT ANSWER Regulatory body is influenced or controlled by industry being regulated
Regulatory capture happens when a regulatory agency, formed to act in the public's interest, eventually acts in ways that benefit the industry it is supposed to be regulating, rather than the public.
Regulatory Burden - CORRECT ANSWER The costs of regulation for the regulated entity.
Net Regulatory Burden - CORRECT ANSWER The private costs of regulation less the private benefits of regulation.
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