Economics
-- 2017
Instructor: Jie
Brief Introduction
Topic weight:
Study Session 1-2 Ethics & Professional Standards 10%-15% Study Session 3 Quantitative Analysis 5%-10% Study Session 4 Economics 5%-10% Study Session 5-6 Financial Reporting and Analysis 15%-20% Study Session 7-8 Corporate Finance 5%-15% Study Session 9-11 Equity Valuation 15%-25% Study Session 12-13 Fixed Income 10%-20% Study Session 14 Derivative Investment 5%-15% Study Session 15 Alternative Investment 5%-10% Study Session 16-17 Portfolio Management 5%-10% Weights: 100%
Brief Introduction Content:
Ø Study Session 4: Economics for Valuation
• Reading 13: Currency Exchange Rates: Determination and Forecasting
• Reading 14: Economic Growth and Investment Decision
• Reading 15: Economics of Regulation
Brief Introduction
Exam-importance ranking:
ØReading 13: Currency Exchange Rates: Determination and Forecasting
ØReading 14: Economic Growth and Investment Decision
Brief Introduction 考纲对比:
Ø 与2016年相比，2017年的考纲没有任何变化
Brief Introduction 学习建议:
Ø 本门课程难度适中，知识点与一级经济学保持较强连贯性
Ø 可以使用Study Notes作为主要备考教材
Ø 做原版教材章节后习题
Ø 常考知识点比较固定，要记住关键的计算公式和理论
Basics of Foreign Exchange
Tasks:
Ø Calculate and Interpret the bid-ask spread on a spot or forward foreign currency quotation
Ø Describe the factors that affect the bid-offer spread
Currency Exchange Rates
Ø GBP / EUR = 0.85 Ø EUR : GBP = 0.85
Ø 1 EUR = 0.85 GBP ü GBP: Price currency ü EUR: Base currency
Ø Direct quotation: Foreign currency as the base currency.
Ø Nominal exchange rate: The price that we observe in the marketplace for foreign exchange.
Ø Real exchange rate: Adjust nominal exchange rate to reflect the relative purchasing power between countries. Currency Exchange Rates
(d/f) (d/f)
d
f
Nominal
Real
=
P
P
Ø Spot exchange rate: Currency exchange rates for immediate delivery.
Ø Forward exchange rate: Currency exchange rates for an exchange to be done in the future.
Currency Exchange Rates
Ø PC/BC=1.5067-1.5088
Ø Bid price is the price bank/dealer will pay per BC unit.
Ø Ask price is the price bank/dealer will sell a unit of BC.
Ø The difference between the offer and bid price is called the spread.
Ø Spreads are often stated as ‘pips’.
ü Example: the euro could be quoted as
$1.4124-1.4128. The spread is $0.0004 (4 pips).
Bid-Ask Spread Bid-Ask Spread
Ø The spread quoted by the dealer depends on：
• The spread in the interbank market for the same
currency pair.
• The size of the transaction.
• The relationship between the dealer and client.
Ø Interbank spread on a currency pair depends on
• Currencies involved.
• Time of day.
Cross Rate Calculation
Ø Example 1:
ü USD / EUR = 1.4, CHF / USD = 0.9, and USD / GBP = 2, Calculate GBP / EUR
Ø Answer:
ü GBP / EUR = (USD / EUR)×(GBP / USD) = 1.4 × (1/2) = 0.7
Ø Example 2:
ü USD : SFR =1.5960–70, USD : ASD =1.8225–35, Calculate SFR : ASD
Ø Answer:
ü ASD/ SFR = (ASD / USD)×(USD / SFR) = (1.8225–1.8235) ×(1/1.5970 –1/ 1.5960)
ü SFR : ASD = 1.1412–1.1425
Cross Rate Calculation
Ø Example: A dealer is quoting the AUD/GBP spot rate as
1.5060-1.5067.
ü Compute proceeds of converting 1 million GBP.
ü Compute proceeds of converting 1 million AUD.
Ø Answer:
1. Consumer: Sell AUD/GBP, using dealer bid price 1.5060. 1 million GBP x 1.5060 = 1.506 million AUD.
2. Consumer: Sell GBP/AUD, using dealer bid price 1/1.5067. 1 million AUD /1. 5067 = 663702.13 GBP.
Ø Importance: ☆☆ Ø Content:
• Bid-Ask spread
• Factors affecting bid-ask spread • cross-rate calculation
Ø Exam tips:
• 熟悉外汇买卖价差，及影响外汇价差的因素
• 能计算交叉汇率的买卖报价
Summary
Triangular Arbitrage
Mark-to-Market Values of Forward Contracts
Tasks:
Ø Identify a triangular arbitrage opportunity and calculate its profit
Ø Calculate the forward premium/discount for a given currency
Ø Triangular arbitrage means converting from currency A to currency B, then from currency B to currency C, then from currency C back to A. If we end up with more of currency A at the end than we started with, we've earned an arbitrage profit.
Ø Example:
ü USD/AUD = 0.6000 - 0.6015
ü MXN/USD = 10.7000 - 10.7200
ü MXN/AUD = 6.3000 - 6.3025
ü How to arbitrage from these markets?
Triangular Arbitrage
Ø Step One:
ü 1USD → 1/0.6015AUD → (1/0.6015)*6.3000MXN →
((1/0.6015)*6.3000)/10.720USD →0.97704USD
no profit Ø Step Two:
ü 1USD → 1*10.700MXN → (1*10.700)/6.3025AUD →
((1*10.700)/6.3025)*0.6000USD →1.01864USD,
arbitrage
Triangular Arbitrage
Ø If the forward quote is higher than spot price.
• Base currency is trading at a forward premium.
• Price currency is trading at a forward discount.
Ø If the forward quote is less than spot price.
• Base currency is trading at a forward discount.
• Price currency is trading at a forward premium.
Ø Forward premium (discount) = F–S0 (base currency) Forward Discount or Premium
Ø Example: Given the following quotes for AUD/CAD, compute the bid and offer rates for a 30- day forward contract. Maturity Rate
Spot 1.0511 / 1.0519 30-day + 3.9 / + 4.1 90-day + 15.6 / + 16.8 180-day + 46.9 / + 52.3
Ø Answer: CAD is trading at a forward premium. 30-day bid = 1.0511 + 3.9/10,000 = 1.05149 30-day offer = 1.0519 + 4.1/ 10,000 = 1.05231 30-day forward quote for AUD/CAD is 1.05149/1.05231.
Ø The value of forward contract at Maturity (T)
Ø The value of a forward currency contract prior to expiration is known as the mark-to-market value.
Mark-to-market value of a forward contract
T T
V =(FP - FP)(contract size)
t
(FP - FP)(contract size) V =
The following information is available (at t=30) for AUD interest rates: 30-day rate: 1.12%
60-day rate: 1.16% 90-day rate: 1.20%
What is mark-to-market value in AUD of Y's forward contract?
Mark-to-market value of a forward contract
Ø Answer: The forward bid price for a new contract expiring in T - t = 60 days is 1.0612 + 8.6/10,000 = 1.06206.
Ø The interest rate to use for discounting the value is also the 60-day AUD interest rate of l.16%:
Mark-to-market value of a forward contract
t
(FP - FP)(contract size) (1.06206-1.05358)(1000000)
V = 60 8463.64
• Forward premium and discount
• Mark-to-market values of forward contracts
Ø Exam tips:
• 能计算外汇三角套利
• 能计算远期升水和贴水
• 能计算远期合约的盯市价值
International Parity Relationships [1]
Tasks:
Ø Explain international parity relations
Ø Describe relations among the international parity conditions
Ø Evaluate the use international parity relations to forecast future spot exchange rates
Ø Interest Rate Parity
ü Covered Interest Rate Parity
ü Uncovered Interest Rate Parity
Ø International Fisher Relation
Ø PPP
ü Absolute PPP
ü Relative PPP
ü Ex-Ante Version of PPP
International Parity Relationships
Ø Covered interest rate parity 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.
Ø The currency with higher nominal interest rate will depreciate.
Covered Interest Rate Parity
x
Ø Uncovered interest rate parity state that the change in spot rate over the investment horizon should equal the differential in interest rates between the two countries.
Ø The expected appreciation/depreciation of the exchange
rate just offsets the yield differential, implying that the current forward exchange rate is an unbiased predictor
of the future spot rate. Uncovered Interest Rate Parity
Ø The interest rate differential between two countries should be equal to the expected inflation differential.
Ø Assumes that real interest rates are stable over time and equal across international boundaries.
International Fisher Relation
• Covered interest rate parity • Uncovered interest rate parity • International fisher relation
Ø Exam tips:
• 理解抛补利率平价，无抛补利率平价，和国际费雪关系
• 记住平价关系公式
Summary
International Parity Relationships [2]
Tasks:
Ø Explain international parity relations
Ø Describe relations among the international parity conditions
Ø Evaluate the use international parity relations to forecast future spot exchange rates
Ø Absolute PPP state that the equilibrium exchange rate bewteen two countries is determined entirely by the ratio of their national price levels.
Ø In practice, absolute PPP might not hold because the
weights 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).
Absolute Purchasing Power Parity
A
B
CPI
S(A / B) =
Ø Relative PPP: the percentage change in the spot exchange rate will be completely determined by the difference between the foreign and domestic inflation rate.
Ø The evidence suggests that the relative form of PPP holds
approximately in the long run. Relative Purchasing Power Parity
t
t x t 0
(x/y) x y
0 y 0
S
= (
1+ I
) , %ΔS
=
S -S
I - I
S
1+ I
S
Ø 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.
Ø We can also use inflation differentials to forecast future exchange rates.
Ex-Ante Version of PPP
t
t x t 0
(x / y) x y
0 y 0
E(S )= [1+ E(I )] , %ΔS =E(S ) - S E(I ) - E(I )
S 1+ E(I ) S
Ø Ex-ante PPP, uncovered interest rate parity or forward
rates to forecast future spot rates.
Ø Uncovered interest rate parity and PPP are not bound by
arbitrage and seldom work over the short and medium terms.
Ø The forward rate is not an unbiased predictor of future
spot rate。
Ø PPP holds over reasonably long time horizons.
Ø Importance: ☆☆☆ Ø Content:
• Absolute purchasing power parity
• Relative purchasing power parity
• Ex-ante version of PPP
Ø Exam tips:
• 理解绝对，相对和预期购买力平价关系
• 记住平价公式
• 理解平价条件之间的关系
Summary
Long Term Equilibrium Exchange Rates
Carry Trade
Tasks:
Ø Explain approaches to assessing long-term fair value of an exchange rate
Ø Describe the carry trade and its relation to uncovered interest rate parity
Ø Calculate the profit from a carry trade
Ø Macroeconomic balance approach: Estimates how much current exchange rates must adjust to equalize a country’s current account imbalance.
Ø External sustainability approach: Estimates how much current exchange rates must adjust to force a country’s external debt relative to GDP towards its sustainable level.
Ø Reduced-form econometric model approach: Estimates the equilibrium path of exchange rate movements based on patterns in several key macroeconomic variables, such as trade balance, net foreign asset/liability, and relative productivity.
Long Term Equilibrium Exchange Rate Assessments
Ø Two assumptions:
• Uncovered interest rate parity holds in the long run
• The real exchange rate is expected to converge to its long-run equilibrium value
Long Term Exchange Rate Determination
Ø Long-term exchange rate = equilibrium real exchange rate + (real interest rateB - real interest rateA)
- (risk premiumB - risk premiumA)
Ø A currency’s real value would be expected to rise over time in response to
• An upward revision in that currency’s real long-term
equilibrium value
• A rise in domestic relative to foreign real interest rate • A decline in domestic relative to foreign risk premia Long Term Exchange Rate Determination
Ø Uncovered interest rate parity is not bound by arbitrage. 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.
FX Carry Trade
x y x y x/y
If r > r , return r - r - %ΔS
Example: Exchange rate for USD/GBP is 1.50 today and 1.49 one year later. Interest rate is 3% for U.K and 1% for U.S. Calculation the profit to borrowing in the U.S. and investing in the U.K.
Answer: return = 3% - 1%- (1.5-1.49)/1.5 = 1.33% FX Carry Trade
Ø Risks of carry trade 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.
Ø Risk management in carry trades
• Volatility filter: Whenever implied volatility increases above a certain threshold, the carry trade positions are closed.
• 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.
FX Carry Trade
Ø Importance: ☆☆☆ Ø Content:
• Long-term equilibrium exchange rate
• Carry trade
Ø Exam tips:
• 解释评估长期公允汇率的方法
• 计算套息交易的利润
Summary
The Influence of Balance of Payment on
Exchange Rate
Tasks:
Ø Explain how flows in the balance of payment accounts affect currency exchange rate
Ø 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).
Ø Capital account (also known as the financial account) measures the flow of funds for debt and equity investment into and out of the country.
Ø Official reserve account transactions are those made from the reserves held by the official monetary authorities of the country.
Ø Current account + Capital account + Official reserve account = 0
ü When a country experiences a current account deficit,
it must generate a surplus in its capital account (or see its currency depreciate).
Ø Capital flows tend to be the dominant factor influencing exchange rates in the short term, as capital flows tend to be larger and more rapidly changing than goods flows. Balance-of-Payments
Current account imbalances and the determination of exchange rates:
Current account deficits lead to a depreciation of domestic currency, through several mechanisms:
• The flow supply/demand channel
• The portfolio balance channel
• The debt sustainability channel
Influence of BOP on Exchange Rates
Ø The flow supply/demand channel: country with persistent current account surpluses would see their currencies appreciate over time.
• The initial gap between imports and exports.
• The response of import and export prices to changes
in the exchange rate.
• The response of import and export demand to the
change in import and export prices. Influence of BOP on Exchange Rates
Ø Portfolio composition mechanism: current account imbalances shift financial wealth from deficit nations to surplus nations.
Ø Debt sustainability mechanism: When the level of debt gets too high relative to GDP, investors may question the sustainability of this level of debt, leading to a rapid depreciation of the borrower’s currency.
Capital Flows and the determination of exchange rates: As capital flows into a country, demand for that country’s currency increases, resulting in appreciation.
Ø Excessive capital inflows into emerging markets create
problems for those countries such as:
• An unwarranted real appreciation of the emerging
market currency.
• A huge buildup in external indebtedness by emerging
market governments, businesses, or banks. Influence of BOP on Exchange Rates
• A financial asset or property market bubble.
• A consumption binge that contributed to explosive
growth in domestic credit and/or the current account deficit.
• An overinvestment in risky projects and questionable
activities.
Influence of BOP on Exchange Rates
Interest rate differentials, carry trades, and the exchange rate Ø Real exchange rate (L/H) =
equilibrium real exchange rate + (real interest rateH - real interest rateL)
- (risk premiumH - risk premiumL)
Ø A high-yield country might attract significant inflows of capital that could exert considerable upward pressure on the high-yield currency’s value for persistent periods of time. Influence of BOP on Exchange Rates
Interest rate differentials, carry trades, and the exchange rate
The real exchange rate will tend to rise, relative to its long-run equilibrium value, when:
• The nominal yield spread between the high and low yield
market rises
• Inflation expectations in the high yield market decline relative to the low yield market
• The risk premium demanded by investors to hold the assets
of the high yield market declines relative to the low yield market.
Ø Importance: ☆☆ Ø Content:
• The influences of payment of balance on exchange rate
Ø Exam tips:
• 理解国际收支平衡如何影响汇率
Summary
Exchange Rate Determination Models [1]
Tasks:
Ø Describe approaches to exchange rate determination
Ø Forecast the direction of expected change in an exchange rate
Ø Explain the potential effects of monetary and fiscal policy on exchange rates
Exchange Rate Determination Models
Ø Mundell-Fleming model
Ø The monetary approach
Ø The Taylor Rule
Ø The asset market (portfolio balance) approach
Mundell-Fleming Model
ØMundell-Fleming model:
• Itdescribes how changes in monetary and fiscal policy
affect the level of interest rates and economic activity within a country, which in turn leads to changes in the direction and magnitude of trade and capital flows and ultimately to changes in the exchange rate.
Mundell-Fleming Model
Ø Expansionary Monetary Policy:
• With Flexible Exchange Rate: Downward pressure on domestic interest rates will induce capital to flow to higher-yielding market, putting downward pressure on the domestic currency. Depreciation of the currency will increase net export, reinforcing the aggregate demand impact of the expansionary monetary policy.
Mundell-Fleming Model
Ø Expansionary Monetary Policy:
• With Fixed Exchange Rate: to prevent the exchange rate from depreciating, the monetary authority will have to buy its own currency in exchange for other currencies in the FX market. Doing so will tighten domestic credit conditions and offset the intended expansionary monetary policy.
Mundell-Fleming Model
Ø Expansionary Fiscal Policy:
• With Flexible Exchange Rate: an expansionary fiscal policy will tend to exert upward pressure on domestic interest rates, which will in turn induce an inflow of capital from lower-yielding markets, putting upward pressure on the domestic currency. If capital flows are sensitive to interest rate differentials, then the domestic currency will tend to appreciate; if not, the currency will tend to depreciate.
Mundell-Fleming Model
Ø Expansionary Fiscal Policy:
Ambiguous Domesticcurrency
Ø Under conditions of High Capital Mobility Mundell-Fleming Model
Ø Under conditions of High Capital Mobility
Ø Importance: ☆☆☆
Exchange Rate Determination Models [2]
Tasks:
Ø Describe approaches to exchange rate determination
Ø Forecast the direction of expected change in an exchange rate
Ø Under monetary models, we assume that output is fixed, so that monetary policy primarily affects inflation, which in turn affects exchange rates.
ü Pure monetary model: 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.
Monetary Approach
Ø 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.
• Under an expansionary monetary policy, in the short
term, exchange rates overshoot the long-run PPP implied values. 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.
Monetary Approach
Ø Central banks are usually charged with setting policy interest rates so as to maintain price stability and achieve maximum sustainable level of employment. Taylor rule links central bank's policy rate to economic
conditions(employment level and inflation). Taylor Rule
* *
* *
( ) (y y )
R : Central bank policy rate implied by Taylor rule : Neutral real policy interest rate
: Current inflation rate; : Central bank's target inflation rate : c urrent inflation gap
y :
current output; y : target output y y : current output gap
Ø Mundell-Fleming approach focuses on the short-term
implications of fiscal policy.
• With free capital flows, an expansionary fiscal policy leads to domestic currency appreciation (via high real interest rates).
Ø Portfolio balance model focuses on the long-term implications of sustained fiscal policy (deficit or surplus) on currency values.
• Continued increases in fiscal deficits are
unsustainable and investors may refuse to fund the deficits. The government will have to monetize its debt (i.e., print money)—leading to currency depreciation.
• In the long term, the government has to reverse
course (tighter budgetary policy) leading to depreciation of the domestic currency. Asset Market (Portfolio Balance) Approach
Expansive
Asset Market (Portfolio Balance) Approach
Ø Importance: ☆☆☆ Ø Content:
• Monetary approach
• Taylor rule
• Asset market (portfolio balance) approach
Ø Exam tips:
• 掌握确定汇率的货币方法，泰勒规则，和资产市场方法
• 理解货币政策和财政政策如何影响汇率
Summary
Central Bank and Capital Control
Signs of Currency Crisis
Technical Analysis of Exchange Rate
Tasks:
Ø Describe objectives and effectiveness of central bank intervention and capital control
Ø Describe warning signs of a currency crisis
Ø Excessive capital inflows to a country can lead to a currency crisis when such capital is eventually withdrawn from the country.
Ø Objectives
• 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.
• Reduce excessive inflow of foreign capital. Central Bank Intervention and Capital Controls
Effectiveness
Ø Evidence has shown that for developed markets, central
banks are relatively ineffective.
Ø 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.
Ø The success of capital controls in emerging markets depends on persistence and size of capital flows. Central Bank Intervention and Capital Controls
Ø Terms of trade deteriorate.
Ø Official foreign exchange reserves dramatically decline.
Ø Real exchange rate is substantially higher than the
mean-reverting level.
Ø Inflation increases.
Ø Equity markets experience a boom-bust cycle.
Ø Money supply relative to bank reserves increases.
Ø Nominal private credit grows.
Signs of Currency Crisis
Ø Trend-Following Trading Rules
Ø FX Dealer Order Books
• In FX markets, volume and price data are not
immediately available to all parties. For this reason, an FX dealer’s order book may have predictive value for exchange rates
Ø Currency Options Market
• Implied volatility estimates from foreign exchange
options can give insight into markets expectations of future increases or decreases in the value of the currency. For example, if the implied volatility in a call option is higher than the implied volatility in the corresponding put option, the market expects that the currency is more likely to appreciate than depreciate.
Technical Analysis to Forecast Exchange Rates
Ø Importance: ☆ Ø Content:
• Central bank intervention and capital control • signes of a currency crisis
• Technical analysis in forecasting exchange rates
Ø Exam tips:
• 理解央行外汇干预和资本管制的目的
• 了解货币危机的信号
• 了解汇率预期的技术分析方法
Summary
Conditions of Economic Growth and
Potential GDP
Tasks:
Ø Compare factors favoring and limiting economic growth in developed and developing economies
Ø Describe relation between long-run growth rate of stock market and sustainable growth rate of economy
Ø Explain why potential GDP and its growth rate matters for equity and fixed income investors
Ø Savings and investment
Ø Financial markets and intermediaries
Ø The political stability, rule of law, and property rights
Ø Investment in human capital
Ø Tax and regulatory systems
Ø The relationship between economic growth and stock price:
Ø Over the long-term, growth in earnings relative to GDP is zero, and growth in the P/E ratio will also be zero.
Ø Over a long time horizon, the potential GDP growth rate
equals the growth rate of aggregate equity valuation. Potential GDP
Ø Positive growth in potential GDP indicates that future income will rise relative to current income.
Ø When consumers expect their incomes to rise, they
increase current consumption and save less
Ø To encourage consumers to delay consumption,
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 Potential GDP
Ø 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.
Ø Central banks are likely to adopt monetary policies consistent with the gap between potential output and actual output.
Ø It is more likely for a government to run a fiscal deficit when actual GDP growth rate is lower than its potential growth rate.
Potential GDP vs. Actual GDP
Ø Importance: ☆ Ø Content:
• Factors affecting economic growth
• Relation between stock market growth rate and
potential GDP growth rate
Ø Exam tips:
• 了解影响经济增长的因素
• 理解潜在GDP增长与股市增长的关系
Production Function
Tasks:
Ø Distinguish between capital deepening investment anf technological progress and explain how each affects economic growth and labor productivity
Ø Forecast potential GDP based on growth accounting relations
Ø Cobb-Douglas production function
ü T: TFP (total factor productivity) or technology
ü a and (1-α): Share of output allocated to capital (K) and labor (L).
Ø It exhibits constant returns to scale. Increasing all inputs by a fixed percentage leads to the same percentage increase in output.
Production Function
α (1-α)
Y = TK L
Ø Output per worker (labor productivity)
Ø Assuming the number of workers and a remain constant, increases in output can be gained by increasing capital per worker (capital deepening) or by improving technology (increasing TFP).
Ø Since a is less than one, additional capital has a diminishing effect on productivity (marginal productivity of capital).
Production Function
α (-α) α α Y= TK L = T( )K y = Tk
L L
y : labor productivity
k : capital per worker (capital deepening)
Ø In steady state (i.e., equilibrium), marginal product of capital (MPK) and marginal cost of capital (i.e., the rental price of capital, r) are equal.
Ø The ratio of rK to output (Y) measures the amount of output that is allocated to providers of capital.
Productivity Curves
Ø Growth in capital per worker (capital deepening) causes
movement along a productivity curve.
Ø The curvature of the relationship derives from the diminishing marginal productivity of capital.
Ø Economies will increase investment in capital as long as MPK > r. At the level of MPK = r, capital deepening stops and labor productivity becomes stagnant.
Ø Technological growth causes the productivity curve to
shift upwards. Productivity Curves
Ø For developed countries, the capital per worker ratio is relatively high, so those countries gain little from capital deepening and must rely on technological progress for growth in productivity.
Ø In contrast, developing nations often have low capital per worker ratios, so capital deepening can lead to at least a short-term increase in productivity.
Productivity Curves
Ø Growth rate in potential GDP = long-term growth rate of technology + a(long-term growth rate of capital) + (1-a )(long-term growth rate of labor)
Ø Change in TFP must be estimated as a residual: ex-post (realized) change in output minus output implied by ex-post changes in labor and capital.
Ø Growth rate in potential GDP = long-term growth rate of labor force + long-term growth rate in labor productivity.
Growth Accounting Relations
α (1-α) ΔY ΔT ΔK ΔL
Y = TK L , = + α + (1- α)
Y T K L
ΔY Δy ΔL , = +
Y y L
Ø Importance: ☆☆☆ Ø Content:
• Cobb Douglas production function
Ø Exam tips:
• 理解并记住柯布-道格拉斯生产函数
• 理解资本深化和技术进步如何影响经济增长和劳动生产力
• 使用柯布-道格拉斯生产函数预测经济增长
Summary
Factors Affecting Economic Growth
Tasks:
Ø Explain how natrual resources affect economic growth
Ø Explain how demographics, immigration, and labor force participation, physical and human capital investment and technological development affect the rate and sustainability of economic growth
Ø Renewable resources: are those that are replenished, such as a forest.
Ø Non-renewable resources: are finite resources that are depleted once they are consumed, such as oil and coal.
Ø ‘Dutch disease’: where currency appreciation driven by strong export demand for resources makes other segments of the economy, in particular manufacturing, globally uncompetitive.
Natural Resources
Ø 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.
• Countries with low or declining fertility rates will likely face growth challenges from labor force declines.
Ø Labor force participation can increase as more women enter the workforce.
Ø Immigration.
• 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.
Ø Average hours worked. The general trend in average hours worked is downward.
Labor Supply Factors
labor for Labor force participation =working age popucelation
Ø Human capital: Increasing human capital through education or work experience increases productivity and economic growth.
Ø Physical capital is generally separated into infrastructure, computers, and telecommunications capital (ICT) and non-ICT capital (i.e., machinery, transportation, and non-residential construction).
• Developing economies have relatively low capital to labor ratios.
• Some capital investment actually influences technological progress, thereby increasing TFP and economic growth.
Factors Affecting Economic Growth
Ø Technological development: 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. Less developed countries often copy the technological innovations of developed countries and thus invest less in R&D as a percentage of GDP.
Ø Public infrastructure: Investments in public infrastructure such as the construction of public roads, bridges, and municipal facilities, provide additional benefits to private investment.
Factors Affecting Economic Growth
Ø Importance: ☆ Ø Content:
• Factors affecting economic growth
Ø Exam tips:
• 理解自然资源，人口，移民，劳动参与率，实物投资，人
Economic Growth Theories [1]
Tasks:
Ø Compare classical growth theory, neoclassical growth theory, and endogenous growth theory
Ø Classical growth theory
Ø Neoclassical growth theory
Ø Endogenous growth theory
Economic Growth Theories
Ø The growth in real GDP is not permanent.
Ø Technological advances → investment in new capital↑→
labor productivity and new business start and demand for
labor↑→ real wages and employment↑→ population
explosion → real GDP ↓
Ø No matter how much technology advances, real wages
will eventually be driven back to the subsistence level, and no permanent productivity growth or improvement in the standard of living will occur.
Classical growth theory-Malthusian
Ø Neoclassical growth theory's focus is on estimating the
economy's long-term steady state growth rate.
Ø The economy is at equilibrium when output-to-capital ratio is constant. When output-to-capital ratio is constant, labor-to-capital ratio and output per capita also grow at the equilibrium growth rate, g*.
Neoclassical Growth Theories
α Δy ΔT Δk
y = T k = + α
y T k
ΔT Δy=Δk Δy= T = θ
y k y (1 - α) (1 - α) θ
Ø Sustainable growth rate of output (G*) is equal to the sustainable growth rate of output per capita, plus the growth of labor (ΔL).
Neoclassical Growth Theories
*
ΔY Δy ΔL , = +
Y y L ΔY= θ ΔL
Y (1- α) L θ ΔL (1- α)
Y yL
G
Ø Balanced or steady state rate of growth
In closed economy, investment must be funded by domestic saving: I=sY, and physical capital stock depreciates at a constant rate , the change in the physical capital stock is:
Neoclassical Growth Theories
Ø If the equilibrium output to capital ratio denoted by the constant :
Ø In the steady state the output to capital ratio is constant and the capital to labor ratio and output per worker grow at the same rate:
Neoclassical Growth Theories
Ø Transform the steady state equilibrium equation into a
savings/investment equation:
Ø Steady state equilibrium occurs at the output to capital ratio where savings and actual gross investment per worker generated in the economy (sy) are just sufficient to:
üProvide capital for new workers entering the workforce at rate n
üReplace plant and equipment wearing out at rate
Ø Steady state in the Neoclassical Model Neoclassical Growth Theories
Ø Impact on the steady state: Increase in the saving rate Neoclassical Growth Theories
Ø Impact on the steady state: Increase in labor force growth
Neoclassical Growth Theories
Ø Importance: ☆☆☆ Ø Content:
• Classical growth theory
• Neoclassical growth theory
Ø Exam tips:
• 理解古典增长理论和新古典增长理论
Economic Growth Theories [2]
Tasks:
Ø Compare classical growth theory, neoclassical growth theory, and endogenous growth theory
Ø Explain and evaluate convergence hypothesis
Ø Describe the expected impact of removing trade barriers on
Ø Endogenous growth theory: Assumption that certain investments increase TFP (i.e., lead to technological progress) from a societal standpoint.
Ø 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. Technological progress enhances productivity of both labor and capital.
Ø Unlike the neoclassical model, there is no steady state growth rate, so that increased investment can permanently increase the rate of growth.
Endogenous Growth Theory
Ø The difference between neoclassical and endogenous
growth theory relates to TFP.
• Neoclassical theory assumes that capital investment
will expand as technology improves (i.e., growth comes from increases in TFP not related to the investment in capital within the model).
• Endogenous growth theory assumes that capital
investment (R&D expenditures) may actually improve total factor productivity.
Endogenous Growth Theory
Ø Absolute convergence hypothesis: developing countries, regardless of their particular characteristics, will eventually catch up with the developed countries and match them in per capita output. (with assumption: all countries have access to the same technology)
Ø Club convergence hypothesis: Countries can ‘join’ the club (i.e., countries with similar institutional features such as savings rates, financial markets, property rights, health and educational services, etc.) by making appropriate institutional changes. Those countries that are not part of the club may never achieve the higher standard of living. Convergence Hypotheses
Benefits
Ø Increased investment from foreign savings.
Ø Allows focus on industries where the country has a comparative advantage.
Ø Increased markets for domestic products, resulting in economies of scale.
Ø Increased sharing of technology and higher total factor productivity growth.
Ø Increased competition leading to failure of inefficient firms and reallocation of their assets to more efficient uses.
Expected Impact of Removing Trade Barriers
Ø Importance: ☆☆☆ Ø Content:
• Endogenous growth theory
• Convergence Hypothesis
• Impact of removing trade barriers
Ø Exam tips:
• 理解内生增长理论
• 理解趋同假设
• 理解移除贸易壁垒的影响
Summary
Economics of Regulation [1]
Tasks:
Ø Describe classifications of regulations and regulators
Ø Describe uses of self-regulation in financial markets
Ø Describe the economic rationale for regulatory intervention
Ø Regulations
• Statutes: laws made by legislative bodies • Administrative regulations: rules issued by
government agencies or other bodies authorized by the government
• Judicial law: findings of the court
Classifications of Regulations and Regulators Classifications of Regulations and Regulators
Regulators
Independent regulators Government
agencies Outside bodies
SROs Non-SROs
Ø Government agencies: E.g., SEC.
Ø Independent regulators are given recognition by government agencies and have power to make rules and enforce them, but not funded by the government and hence are politically independent.
• SRO (self-regulating organizations) regulate as well as represent their members. E.g., FINRA. SROs may have inherent conflicts of interest. Not all SROs are independent regulators (i.e., have government recognition). E.g., PCAOB.
Ø Outside bodies are not regulators themselves but their product is referenced by regulators. E.g., FASB, IASB.
Classifications of Regulations and Regulators
Ø SROs without government recognition are not considered
regulators.
Ø The use of independent SROs in civil-law countries is not common.
Ø 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.
Ø Externalities deal with the consumption 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.
Economic Rationale for Regulatory Intervention
Ø Regulatory capture theory: A regulatory body will be influenced or even possibly controlled by the industry that is being regulated.
Ø Regulatory competition: Regulators compete to provide the most business-friendly regulatory environment
Ø Regulatory arbitrage: Occurs when businesses shop for a country that allows a specific behavior rather than changing the behavior. Regulatory arbitrage also entails exploiting the difference between the economic substance and interpretation of a regulation. Regulatory Interdependencies
Ø Importance: ☆ Ø Content:
• Classifications of regulations and regulators • Self-regulation in financial markets
• Regulatory intervention
• Regulatory interdependencies
Ø Exam tips:
• 了解监管与监管者分类，金融市场自律，管制干预的根据，
及管制的相互影响 Summary
Economics of Regulation [2]
Tasks:
Ø Describe tools of regulatory intervention in markets
Ø Explain purposes in regulation
Ø Describe anti-competitive behaviors targeted by antitrust laws and evaluate antitrust risk
Ø Describe benefits and costs of regulation
Ø Price mechanisms such as taxes and subsidies.
Ø 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.
Ø 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.
Tools of Regulatory Intervention
Ø Regulating commerce: To facilitate business decision making. Examples: company laws, tax laws, contract laws etc.
Ø Regulating financial markets: To prevent failures of the financial system.
• Regulation of securities markets: Including disclosure requirements, mitigating agency problem, protecting small (retail) investors
• Regulation of financial markets: Prudential supervision refers to the monitoring and regulation of financial institutions to reduce system-wide risks and to protect investors.
Purposes in Regulating Commerce and Financial Markets
Ø Antitrust laws work to promote domestic competition by
monitoring and restricting activities that reduce or distort competition.
Ø When evaluating an announced merger or acquisition, an
analyst should consider the anticipated response by regulators as part of the analysis.
Antitrust Regulation
Ø Regulatory burden refers to the cost of regulation for the regulated entity; this cost is sometimes viewed as the private costs of regulation or government burden.
Ø Net regulation burden: the private costs of regulation less the private benefits of regulation.
Ø Regulations can help or hinder a company or industry.
Ø Regulations may shrink the size of one industry (e.g., if it is heavily taxed) while increasing the size of another (e.g., an industry receiving subsidies).
Ø Regulations are not necessarily always costly for those that end up being regulated.
Ø Regulations may introduce inefficiencies in the market.
Ø Some regulations may be specifically applicable to certain sectors while others may have broad implications affecting a number of sectors.
Effects of a Specific Regulation
Ø Importance: ☆ Ø Content:
• Tools of regulatory intervention
• Purposes in regulation
• Anti-competitive behavior targeted by antitrust laws • Benefits and costs of regulation
• Effects of a specific regulation
Ø Exam tips:
• 了解监管干预的工具，监管目的，反垄断法，监管的益处
