CFA 2018 Level 1 Economics

(1)

Price elasticity Income elasticity Cross price elasticity

Demand curve

Sensitivity of quantity demanded to change in price Sensitivity of quantity demanded to change in income Sensitivity of quantity demanded to change in price of related goods (compliment or substitute)

Every Giffen good is an inferior good but every inferior good is not a Giffen good For Giffen goods, income effect is more dominant than substitution effect

Price

elasticity

Income

Cross price

elasticity

% ∆ in Qd

% ∆ in P % ∆ in Q% ∆ in Pyd

% ∆ in Qd

% ∆ in I P > 1 = Demand is elastice

P < 1 = Demand is inelastice

P = +ve: Good is substitutee

P = −ve: Good is complemente

I = +ve: Good is a normal goode

I = −ve: Good is an inferior goode

P =e I =e P =e

Topics in Demand And Supply Analysis

Elasticities of demand

Substitution and income effects

LOS a

LOS b & c

Quantity Price

High Pe

Low Pe

P is close to 1e

Particulars Substitution effect Income effect

Normal good (P 10%)

_È

Ç

Q 10%d

Ç

Q 10%d

Inferior but not Giffen good (P 10%)

_È

Ç

Q 10%d

È

Q 5%d

Inferior and Giffen good (P 10%)

_È

Ç

Q 10%d

È

Q 15%d

Veblen Good - Higher price makes goods more desirable Eg. Louis Vuitton bag

May have a positively sloped demand curve

(2)

Diminishing marginal returns

Breakeven and shutdown points of production

LOS d

LOS e

Marginal returns refer to the additional output produced by using one more unit of labor or capital while keeping the other constant

Quantity of labor

Quantity Cost

Total output

Marginal product increasing

Marginal cost curve

ATC curve AVC curve

AFC curve Marginal

product

decreasing Marginal _product negative

Inputs beyond this quantity are said to produce diminishing marginal returns

Perfect

competition

Imperfect

competition

Monopolistic

competition

Monopoly

Oligopoly

Breakeven quantity -P = ATC, TR = TC In short run shutdown if,

P < AVC

In long run shutdown if, P < ATC

Breakeven quantity -TR = TC

In short run shutdown if, TR < TVC, P < AVC In long run shutdown if,

TR < TC, P < ATC

ª P = Price

ª ATC = Average total cost

ª TR = Total revenue

ª TC = Total cost

ª AVC = Average variable cost

(3)

Economies and diseconomies of scale

LOS f

Quantity VC per unit

TVC

TFC

TC

MC

1 10 10 100 110

-2 9 18 100 118 8

3 8 24 100 124 6

4 7 28 100 128 4

5 8 40 100 140 12

6 9 54 100 154 14

7 10 70 100 170 16

Economies of scale

Diseconomies of scale

Economies of scale Diseconomies of scale

Constant returns to scale

Short run ATC curves

Long run ATC curve

Long run ATC curve shows minimum ATC for each level of output assuming that scale of the ﬁrm can be adjusted

(4)

In equilibrium, P = MR = MC =ATC P - Perfectly elastice

Economic proﬁt = 0

In equilibrium, P > MR = MC

P > 1e

Economic proﬁt = 0

In equilibrium, P > MR = MC

P > 1e

Economic proﬁt -+ve in long run In equilibrium,

P > MR = MC P > 1e

Economic proﬁt -+ve in long run Proﬁts may be zero

The Firm And Market Structures

Characteristics of different markets

Firm’s supply function (Perfect competition)

Relationships between P, MR, MC, economic

proﬁt and P under different market structures

e

LOS a

LOS c

LOS b

Characteristics

Perfect

competition

Monopolistic

competition

Oligopoly

Monopoly

No. of sellers Many Many Few One

Product

differentiation Homogeneous Differentiated Homogeneous Unique

Barriers to entry Very low Low High Very high

Pricing power of

ﬁrm None Some considerableSome or Considerable

Non price

competition None

Advertising + Product differentiation

Advertising

Perfect

competition

Monopolistic

competition

Monopoly

Oligopoly

Quantity Quantity

Cost Cost

Short run market supply

curve ATC curve

AVC curve

D = MR

In the short run, MC curve is above AVC curve In the long run, supply curve MC is above ATC curve There is no well deﬁned supply curve for other markets

(5)

Under monopolistic competition, oligopoly and monopoly, equilibrium quantity is determined by the intersection of MC and MR

Firms maximize proﬁts by producing the quantity where MC = MR In perfect competition P = MR

In monopolistic competition and monopoly, price is the intersection of demand curve and proﬁt maximizing quantity of output

Increase in a ﬁrm’s product price will not be followed by its competitors, but a decrease in price will Kink is the price above which the demand is elastic and below which the demand is inelastic

LOS d

LOS e

Optimal price and output for ﬁrms

Factors affecting long-run equilibrium under each market structure

Pricing strategies in oligopoly

Kinked demand curve

An increase in demand will increase economic profits in the short run under all market structures +ve economic profits result in entry of firms into the industry (except oligopoly and monopoly)

−ve economic proﬁts result in exit of ﬁrms

When ﬁrms enter an industry, market supply increases, which causes decrease in market price and an increase in equilibrium quantity

Kink

More elastic

Less elastic

1

Marginal revenue curve

Q1

P1

Demand

curve _{MR = P ×} 1

Pe

1 −

)

(6)

Nash equilibrium

Dominant ﬁrm model

Nash equilibrium is reached when the choices of all ﬁrms are such that there is no other choice that makes any ﬁrm better off. Eg. prisoner’s dilemma

One firm has significantly large market share because of its greater scale and lower cost structure (Dominant firm)

Market price is determined by the dominant ﬁrm and other ﬁrms take this price as given

Firm’s decisions are interdependent

If there is a price war, then dominant ﬁrm’s market share Ç

If there is no price war, then over time dominant ﬁrm’s market share È

Single ﬁrm supplying the entire market demand for the product

3

4 Natural monopoly

-LOS f

Pricing strategies

Firms under any market maximize proﬁts by producing the quantity where MC = MR

In perfect competition P = MR = AR =MC = ATC

In monopolistic competition, oligopoly and monopoly, price is the intersection of demand curve and proﬁt maximizing quantity of output

Pricing strategies under oligopoly - Kinked demand curve, Cournot model, Nash equilibrium, dominant ﬁrm model

Considers a duopoly i.e. two ﬁrms with identical and constant marginal cost of production Price

Quantity

-Cournot model

Perfect competition

Monopoly

2 A - High price:

1000

B - High price:

700

A - Low price:

1400

B - High price:

100

A - Low price:

500

B - Low price:

500

A - High price:

300

B - Low price:

1300 Firms - A & B

Choices: High price

Low price

(7)

LOS h

Identifying the market structure in which ﬁrm operates

Œ Examine no. of ﬁrms in the industry, check if products are homogeneous or differentiated, see barriers to entry/exit and check if there is any non price competition

Compare these with the characteristics that deﬁne each market structure

LOS g

N-ﬁrm concentration

ratio

Hirschman Index

Herﬁndahl-Eg. N = 4

Add up the market share of 4 largest companies in the industry

Limitations :

Œ Does not comment on pricing power Does not capture the merger effect

Eg. N = 4

Add up the square of market shares of 4 largest companies in the industry

It captures the merger effect Limitations :

Œ Does not comment on pricing power

Both the ratios are used to measure the degree of monopoly or market power of a ﬁrm None of the ratios consider barriers to entry

(8)

Expenditure approach

Income approach

-Total amount spent on goods and services produced during the period

Total income earned by households and companies during the period

Calculated as;

Consumption (C) + Investment (I) + Government expenditure (G) + [Exports − Imports] (X − M)

Calculated as;

Consumption (C) + Savings (S) + Taxes (T)

Sum of value

added

Value of ﬁnal

output

GDP is calculated by adding the value created at each

stage of production

GDP is calculated using only the ﬁnal value of good and

services

Nominal GDP

Real GDP × 100

Output - Current year Output - Current year

Prices - Current year Prices - Base year

ª Gross domestic product (GDP) is the total market value of ﬁnal goods and services produced within a country during a certain time period

ª It is most widely used measure of the size of a nation’s economy ª It includes only purchases of newly produced goods and services ª Sale or resale of goods produced in previous periods is excluded

ª Goods and services provided by government are included in GDP (valued at cost) ª Value of owner-occupied housing is also included in GDP (value is estimated)

Aggregate Output, Prices And Economic Growth

GDP using expenditure and income approach

Expenditure approach

Nominal GDP

GDP deﬂator

-Real GDP

LOS a

LOS b

LOS c

(9)

National income

Personal income

Personal disposable income

-GDP under income approach can also be calculated as :

LOS d

Compensation to employees

National income

Personal income

+ Transfer payments by govt. − Corporate and indirect taxes

− Personal taxes

− Undistributed corporate proﬁts

+ Corporate and govt. proﬁts before tax + Non corporate business income + Rent

+ (Indirect taxes − Subsidies) + Interest

National

income

+

Capital consumption

allowance

+

discrepancy

Statistical

Depreciation of

physical capital Adjustment for difference between GDP under income and expenditure

approach

LOS e

Fundamental relationship among C, S, T, I, G and (X − M)

Total income must equal total expenditures

GDP under income approach = GDP under expenditure approach C + S + T = C + I + G + (X − M)

S = I + (G − T) + (X − M)

(G − T) = (S − I) + (M − X) Fiscal deficit must be financed by some combination of trade deficit or

excess of savings over investment Fiscal

deﬁcit surplusTrade

(10)

IS and LM curves

Aggregate demand curve

LOS f

Real income

Output (y) Output

(y)

LM1

LM2

IS

Real income Real interest

rate (r)

Price Real interest

rate (r)

Real interest rate (r)

Œ +ve relation

r and (S − I)

−ve relation y and (S − I)

Therefore, −ve relation b/w

r and y

Assumption - Real money

supply is constant

(S − I) = (G − T) + (X − M)

y ÇFiscal deﬁcit & Trade surplusÈ= (S −I)È

Ÿ y Ç= Precautionary & transaction demand Ç Ÿ Demand for money = Cost of money Ç Ç

Ÿ r = y Ç Ç

Real money supply - ‘Constant’ P = MS/P Ç È

If MS/P then, LM curve È

shifts to the left (increases real interest rate) IS curve - −ve relation (r & y) LM curve - +ve relation (r & y) Aggregate demand curve

-−ve relation (p & y) IS - Investment and Savings

LM - Liquidity and Money supply

ª Marginal propensity to save (MPS) - Proportion of additional income that is saved

ª Marginal propensity to consume (MPC) - Proportion of additional income spent on consumption ª MPS + MPC = 100%

(11)

Aggregate supply curve

Causes of movements along and shifts in aggregate

demand and supply curves

LOS g

LOS h

Potential GDP Price

LRAS _SRAS

VSRAS

è VSRAS - Firms adjust output without changing price. VSRAS curve is perfectly elastic è SRAS - When prices increase, input costs (such as wages) do not increase as they

are ﬁxed in the short run

è LRAS - All input prices are variable in the long run. LRAS curve is perfectly inelastic and it shows the level of potential GDP

è Price level has no long run effect on aggregate supply

Output Output

Price Price

Movement along the curve Shift in curve

Q1

Aggregate demand curve Aggregate supply curve

Q2

P1

P2

Reasons : _Reasons

Change in price (all other factors keeping constant)

ª Increase in consumers’

wealth

ª Optimistic business

expectations

ª High future income

expectation by consumer

ª High capacity utilization ª Expansionary monetary

policy

ª Expansionary ﬁscal policy ª Home currency

depreciation

ª Global economic growth

ª Increase in productivity ª Increase in supply and

quality of labor

ª Increase in supply of

natural resources

ª Increase in the stock of

physical capital

ª Technology improvement ª Currency appreciation

(12)

Short-run effects of changes in aggregate demand and supply

Recessionary gap

Inﬂationary gap

Stagﬂation

LOS i, j & k

Type of change Real GDP Unemployment Price level

Ç

Aggregate demand

Ç

_È

Ç

È

Aggregate demand

_È

Ç

È

Ç

Aggregate supply

Ç

È

Aggregate supply

_È

Ç

Aggregate

demand Aggregate supply Real GDP Price level

Ç

Or

È

Ç

Or

È

Ç

_È

Ç

Or

È

Ç

È

Ç

Or

È

Potential GDP > Real GDP Real GDP > Potential GDP

High inﬂation combined with slow economic growth and high level of unemployment

LOS l

LOS m

Short-run effects of shifts in both aggregate demand and supply

Sources of

economic growth economic growthSustainability of

ª Labor supply ª Human capital

ª Physical capital stock ª Technology

ª Natural resources

ª Rate of increase in the labor force ª Rate of increase in

labor productivity

Output Output Output Output

Q0 Q0 Q0 Q0

P1

P1 P1

P1

P0 P0 P0 P₀

Q1 Q1 Q1 Q1

Price Price Price Price

(13)

Growth in technology + W (Growth in labor)L + W (Growth in capital)C

Growth in technology + W (Growth in capital)C

Growth in per capita potential GDP

Growth in potential GDP

LOS n & o

Production function

Describes relationship between output and labor, capital and total factor productivity

Total factor productivity (TFP) - It is a multiplier that quantiﬁes the amount of output growth that cannot be explained by the increases in labor and capital. Increase in total

factor productivity can be attributed to advances in technology

∆Y = TFP +

α

× ∆K + (1 −

α

) × ∆L

Above model is on neoclassical economics Growth

in GDP explained by the Share of growth capital

Growth of labor Residual income

that explains the effect of technology

Growth of capital

(14)

GDP Ç

Supply (labor) Ç

Subsistence Wages Ç

Economy neutral stay

Population explosion Wages È

ª Firms are slow in laying off employees in early contraction period ª Firms are slow in hiring employees in early expansion period

ª Housing activity decreases if home prices rise faster than income

ª Firms use their physical capital more intensively during expansion and less intensively during contraction

ª Imports increase during expansion ª Exports increase during contraction

ª Expansion - Increase in output, employment, consumer spending, business investment and inﬂation ª Contraction - Decrease in output, employment, consumer spending, business investment and inﬂation

ª Peak - Inventory/sales ratio is highest

ª Trough - Inventory/sales ratio is lowest

ª Business cycles recur but not at regular intervals

ª Beginning of expansion/contraction - 2 consecutive quarters of growth/decline in real GDP

Trend Cycle

Peak _Trough

Understanding Business Cycles

Business cycle and its phases

Fluctuations in sector as economy moves through the business cycle

Theories of the business cycle

Classical economics

LOS a

LOS b

LOS c

Time Real GDP

Contraction

Expansion

(15)

Neoclassical school

Keynesian school

New Keynesian school

Monetarist school

Austrian school

New classical school

Economists believe that shifts in ADC and ASC are caused by changes in technology

They also believe business cycles are temporary

Economists believe that shifts in aggregate demand are due to changes in expectations

Keynesian economists believe that wages are downward sloping

Policy prescription - Increase aggregate demand directly, through monetary policy or ﬁscal policy

Adds the assertion that inputs as well as wages are sticky

Business cycles are caused by inappropriate decisions by the monetary authorities

They suggest, the central bank should follow a policy of steady and predictable increases in money supply

They believe that business cycles are caused by government intervention

These economists introduced real business cycle theory (RBC)

RBC emphasizes the effect of real economic variables such as change in technology and external shocks

RBC holds that policymakers should not intervene in business cycles

LOS d

Types of unemployment

Frictional Structural Cyclical

Caused by changes in general level of economic

activity

+ve in contraction & −ve in expansion

Caused by long-run changes in the economy

Workers lack requisite skills

Time taken by employees to ﬁnd the jobs that ﬁt

them

(16)

Labor force = Workers employed + workers unemployed

Underemployed worker - Worker employed at a low paying job despite being qualiﬁed

Discouraged worker - Workers who are not actively seeking work. They are not considered as a part of unemployed workers and therefore not a part of labor force

Workers unemployed Labor force Unemployment rate =

Labor force Working age population Activity ratio/Labor force participation ratio =

LOS f

LOS e

LOS g

Construction of indices used to measure inﬂation

Inflation, hyperinflation, disinflation and deflation

Inﬂation measures

Consumer price index (CPI) - Cost of basket at current prices_{Cost of basket at base prices} x 100

ª Weights assigned to each good and service in CPI basket can differ signiﬁcantly across countries and regions

ª Headline inﬂation - Price indexes for all goods

ª Core inﬂation - Price indexes that exclude food and energy (because their prices are volatile)

Laspeyres price index Paasche price index Fisher price index

Quantity

-It is geometric mean of a LPI

ª Hyperinﬂation - Inﬂation that accelerates out of control

ª To consider a situation of rising prices as inﬂation, the prices of almost all goods should rise ª Inﬂation erodes the purchasing power of currency

ª Inﬂation favors borrowers at the expense of lenders

Hedonic pricing is used to measure the upward bias present Inﬂation

Disinﬂation

Deﬂation

(17)

Economic indicators

LOS i

Leading

Coincident

Lagging

Manufacturers’ new orders for consumer goods and materials Manufacturers’ new orders for non-defense capital goods

ex-aircraft Building permits S&P 500 equity price index 10-year T-bonds less federal

funds

Consumer expectations

Inventory-sales ratio Labor cost per output Average prime lending rate

Change in consumer price index

Average duration of unemployment Real personal income

Index of industrial production Manufacturing and trade sales

Cost-push inﬂation

Demand-pull inﬂation

Caused by increase in

aggregate demand Increases price level and temporarily increase real GDP

above nominal GDP Central bank can try to bring economy back to potential GDP Aka wage pushed inﬂation

Caused by decrease in aggregate supply Initially decreases GDP

LOS h

(18)

Quantity of money Total spending

Money supply × Velocity

=

Price × Real Output

Velocity - Average number of times a unit of currency changes hands Monetarists believe that money is not neutral in the short run

Money neutrality - Money Supply Price «¢ « ª Money - Generally accepted medium of exchange

ª Primary functions

-Ÿ Serves as a medium of exchange Ÿ Serves as a unit of account Ÿ Provides store of value

ª Narrow money = Currency and coins in circulation + Balances in checkable bank deposits ª Broad money = Narrow money + Amount available in liquid assets

LOS b

LOS c

LOS d

Functions and deﬁnitions of money

Fractional reserve banking system

Demand for money

Quantity theory of money

Monetary And Fiscal Policy

LOS a

Fiscal policy

Monetary policy

Undertaken by country’s central bank

Expansionary (accommodative) - When the central bank increases the quantity of money and credit

Contractionary (restrictive) -When the central bank reduces the quantity of money and credit Undertaken by government

Budget surplus = (T − G) > 0 Budget deﬁcit = (G − T) < 0 Can also be used as a tool for

redistribution of income and wealth

Total amount of money created - _{Reserve ratio}New deposit Money multiplier - _{Reserve ratio}1

ª Transaction demand -Money held to meet the need for undertaking transactions GDP «¢ Transaction demand«

ª Precautionary demand -Money held for unforeseen future needs

GDP «¢ Precautionary demand«

ª Speculative demand - Money that is available to take advantage of investment opportunities in future

Opportunity cost »¢ Speculative demand«

(19)

Supply of money

Quantity Quantity

Excess of supply

Excess of demand

Nominal

interest rate interest rateNominal

r1

r2

r3

Money supply

Money demand

Supply of money is determined by central bank and is independent of interest rate Therefore MS is always perfectly inelastic

Investors require risk premium for expected inﬂation

LOS e

LOS f

Fischer effect

Roles and objectives of central banks

100

110

Consumption cost -

107 True saving - 3

Nominal risk-free rate = Real risk-free rate + Expected inﬂation

Nominal risk-free rate = Real risk-free rate + Expected inﬂation + Risk premium

@ 10% p.a.

Inﬂation Real rate of

return

Roles Objectives

è Sole supplier of currency

è Banker to the government and other banks

è Regulator and supervisor of payments system

è Lender of last resort

è Holder of gold and foreign exchange reserves

è Conductor of monetary policy

è Primary objective - Control inﬂation è Stability in exchange rates with

foreign currencies è Full employment

è Sustainable positive economic growth è Moderate long-term interest rates

(20)

Costs of expected and unexpected inﬂation

Tools used to implement monetary policy

Monetary transmission mechanism

Qualities of effective central bank

LOS g

LOS h

LOS i

LOS j

When inﬂation is higher than expected, borrowers gain at the expense of lenders Unexpected inﬂation can increase the magnitude and frequency of business cycle

ª Policy rate/discount rate/reﬁnancing rate/2-week repo rate ª Reserve requirements

ª Open market operations

Expansionary policy

Contractionary policy

« Policy rate

« Reserve ratio Selling securities

» Policy rate

» Reserve ratio Buying securities

Monetary policy

(increase in ofﬁcial interest rate)

Exchange (appreciate) (foreign investors might

want to invest) Asset prices

(fall as discount rate for future CFs increase) Market interest rates

(increase) Growth expectations(decrease)

Domestic demand (reduces)

Net external demand (decreases) (Exports decrease,

Imports increase)

Inﬂation rate

(decreases)

Independence

Credibility Transparency

Central bank is free from political interference

Central bank follows through on its stated policy intentions Central bank discloses the state of economic environment by issuing inﬂation reports

Operational independence - Central bank is allowed to independently determine the policy rate

Target independence - Central bank sets the target inﬂation level

(21)

Effects of changes in monetary policy

Determining whether a monetary policy is expansionary or contractionary

Limitations of monetary policy

Interest rate targeting

Exchange rate targeting

LOS k

LOS m

LOS n

LOS l

Contractionary

Expansionary

» Economic growth « Market interest rates

» Inﬂation « Domestic currency

« Imports

» Exports

« Economic growth

» Market interest rates « Inﬂation

» Domestic currency

» Imports « Exports

Most widely used method for making monetary policy decisions

Increasing money supply when speciﬁc interest rates rise above the target band and decreasing money supply when rates

fall below the target band

ª Neutral interest rate - It is the rate of interest that neither spurs nor slows the economy ª Neutral interest rate = Real trend rate of growth + long run expected inﬂation

ª Expansionary policy - Policy rate < Neutral interest rate ª Contractionary policy - Policy rate > Neutral interest rate

Greater volatility of money supply to maintain stable foreign exchange rate Developing countries target a foreign exchange rate between their currency and another (often the U.S. dollar), rather than

targeting inﬂation

฀ Monetary policy changes may affect inﬂation expectations to such an extent that long-term

interest rates move opposite to short-term interest rates

฀ Individuals may be willing to hold greater cash balances without a change in short-term rates

(liquidity trap)

฀ Banks may be unwilling to lend greater amounts, even when they have increased excess reserves ฀ Short-term rates cannot be reduced below zero

฀ Developing economies face unique challenges in utilizing monetary policy due to undeveloped

ﬁnancial markets, rapid ﬁnancial innovation, and lack of credibility of monetary authority

FinTree

Roles and objectives of ﬁscal policy

Roles Objectives

LOS o

è Determining taxation policies and government spending to meet macroeconomic goals

è Inﬂuencing the level of economic

activity

(22)

Arguments about size of ﬁscal deﬁcit

Fiscal policy tools

Fiscal multiplier

-LOS q

Spending tools

Revenue tools

Transfer payments, current spending (goods and services

used by government), and capital spending (investment

projects)

Direct taxes (levied on income or wealth)

Indirect taxes (levied on goods and services)

1

1 − MPC (1 − t)

If tax rate then, ﬁscal multiplier « »

If MPC then, ﬁscal multiplier « «

Recardian equivalence - Taxpayers increase savings in order to offset the expected cost of higher future taxes

Arguments for

Arguments against

Debt may be ﬁnanced by domestic citizens Deﬁcits for capital spending can boost

productive capacity of the economy Fiscal deﬁcits may prompt needed tax

reform

Defecits aid in increasing GDP and unemployment

Ricardian equivalence may prevail When the economy is operating below full

employment, deﬁcits do not crowd out private investment

Higher future taxes lead to disincentives to work

Fiscal deﬁcits may not be ﬁnanced by the market when debt levels are high Crowding-out effect as government borrowing increases interest rates and

decreases private sector investment

LOS k

LOS r

Implementation of ﬁscal policy and difﬁculties of implementation

ª Delays in realizing the effects of ﬁscal policy changes limit their usefulness ª Causes of delay;

Ÿ Recognition lag Ÿ Action lag Ÿ Impact lag

ª Additional macroeconomic issues; Ÿ Misreading economic statistics Ÿ Crowding-out effect

Ÿ Supply shortages Ÿ Limits to deﬁcits Ÿ Multiple targets

(23)

LOS s

LOS t

Determining whether a ﬁscal policy is expansionary or contractionary

Interaction of monetary and ﬁscal policy

» in surplus - Expansionary « in surplus - Contractionary

» in deﬁcit - Contractionary « in deﬁcit - Expansionary

Monetary policy Fiscal policy Interest rate Output Private sector

spending Public sector spending

Contractionary Contractionary « » » »

Expansionary Expansionary » « « «

Contractionary Expansionary « « » «

Expansionary Contractionary » Varies « »

(24)

Country B has absolute advantage in producing both food and drink because it is able to produce more than Country A

Country B should produce (and export) food and Country A should produce (export) drink Since opportunity cost of Country B is lower, it has comparative advantage in producing food

Opportunity cost of good x - Quantity of ‘X’ should be in the denominator

Opportunity cost of food for Country A =

Opportunity cost of food for Country B =

Gross domestic

product (GDP) Gross national product (GNP)

4

Total market value of goods and services produced within

a country during a certain time period

Total market value of goods and services produced by labor and capital of a country (can be within the country or

outside the country)

Absolute advantage Comparative advantage

-Lower cost in terms of resources

Opportunity cost in terms of other goods

Food

Country A Country B

Drink

Beneﬁts of trade > Costs of trade for economy as a whole

LOS b

LOS c

Beneﬁts and costs of international trade

Comparative advantage and absolute advantage

International Trade And Capital Flows

LOS a

Beneﬁts

Costs

Costs of trade are primarily borne by those in domestic industries that compete with

imported goods Unemployment increases,

income inequality One country can specialize in

the production of one good and beneﬁt from economies

of scale

There is more product variety, more competition, and more efﬁcient allocation of resources

(25)

LOS d

Ricardian

model

Heckscher–Ohlin

model

Two factors of production - labor and capital

Comparative advantage - Differences in relative amounts of

each factor

Country that has more capital will specialize in capital intensive good and trade for less capital intensive

good Only one factor of production -

labor

Comparative advantage - Differences in labor productivity

Heckscher-Ohlin model

Arguments that have support for capital restriction

Arguments that have little support for capital restriction

Types of trade restrictions

ª This model says price of scarce factor of production in each country will increase ª The good that country exports will rise in price

ª The good that country imports will fall in price

LOS e

Types of trade and capital restrictions

Infant industry

Protecting domestic jobs

Protecting domestic industries National security

Tariffs VER

Export subsidy

Taxes on imported good Voluntary export restraint

Domestic producers gain Foreign exporters lose

No capture of quota rents Protects domestic consumers

in importing country

Ç in domestic price _{voluntarily unit the quantity}Agreement by a govt to of good to be exported

È in quantity imported

Payment by government to its exporters

Generally export subsidies will beneﬁt the producer (exporter)

Generally it will result in increase of price and reduction of consumer surplus in the exporting country In a small country, price will increase by the amount of subsidy to equal world price + subsidy

For a large country, world price decreases and some beneﬁts from subsidy accrue to foreign customers while foreign producers are negatively affected

Protection from foreign competition is given to new industries

Some jobs are lost, some jobs are created and prices for domestic consumers will be less without import restrictions Firms often use political inﬂuence to get protection from foreign competition to the detriment of consumers, who pay higher prices

It is in the best interest of a country to protect producers of goods crucial to it’s national defense so that those goods are available domestically in the event of conﬂict

Quotas

Restriction on quantity of goods to be imported If domestic government collects the full value of import license, result is same as for a tariff If domestic government does not charge for the

import licenses, there would be gain to importers, this is referred to as quota rent

(26)

Capital Restrictions

ª Prohibition of investment in the domestic country by foreigners

ª Prohibition of or taxes on the income earned on foreign investments by domestic citizens ª Prohibition of foreign investment in certain domestic industries

ª Restrictions on repatriation of earnings of foreign entities operating in a country

LOS f

Trading blocs

Free Trade Areas

Customs Union

Common Markets

Economic Union

Monetary Union

E

No barriers Eg. NAFTA

Eg. European union (EU)

Eg. Euro-zone

No barriers among member countries

No barriers among member countries No barriers to the movement of labor and

capital goods among member countries

No barriers to the movement of labor and capital goods among member countries

Member countries establish common institutions and economic policy for the

union

Member countries establish common institutions and economic policy for the union

Member countries adopt a single currency Countries adopt common set of trade

restrictions with non-members

Countries adopt common set of trade restrictions with non-members

FinTree

$ $ $

(27)

è Reduce the volatility of asset prices (domestic ) è Maintain ﬁxed exchange rates

è Keeping domestic interest rates low

è Protect strategic industries (eg. defense industries)

LOS g

LOS i

LOS h

Common objectives of capital restrictions

Effect of decisions by consumers, ﬁrms, and governments on BOP

Balance of payments (BOP)

Current

Account AccountCapital Financial Account

Goods and services

Capital transfers Income

receipts Unilateral transfers

Sales and purchases of

non-ﬁnancial assets

Foreign-owned assets in the

country

Government-owned assets abroad

Import/ export of goods and

services

Include gold, foreign currencies,

foreign securities, reserve position in

IMF etc.

Include domestic securities, domestic currencies, domestic

liabilities to foreigners reported

by domestic banks Dividend

and interest income on

foreign securities

Include transfer of title to ﬁxed assets, debt forgiveness

Include rights to natural resources and

intangible assets, such as patents,

copyrights etc.

ª Current Account is similar to Income statement ª Capital Account is similar to Balance sheet ª Current Account deﬁcit - Imports > Exports

ª Any surplus in the current account must be offset by a deﬁcit in the capital and ﬁnancial accounts (vice versa)

X – M (trade deﬁcit) = Private savings + Government savings – Investment

If a country’s net savings (both government and private) are less than the amount of investment in domestic capital, this investment must be ﬁnanced by foreign borrowing.

Foreign borrowing results in capital account surplus (trade deﬁcit)

(28)

International organizations that facilitate trade

LOS j

International Monetary

Fund (IMF) World Bank Organization (WTO)World Trade

Promoting international monetary cooperation Facilitating the expansion

and balanced growth of international trade Promoting exchange

stability Assisting in the establishment of a multilateral system of

payments

Making resources available (with adequate safeguards) to members experiencing

BOP difﬁculties

Vital source of ﬁnancial and technical assistance to

developing countries Provides resources, knowledge and helps form partnerships in public and

private sectors Also provides loans at low interest rate, interest-free

credits, and grants to developing countries

Made up of two development institutions

-International Bank for Reconstruction and

Development

(IBRD) - Reduce poverty in middle income countries International Development

Association (IDA) - Focus on world’s poorest

countries

Only international organization that deals with global rules of trade

between nations Goal - Ensuring that trade

ﬂows as smoothly, predictably and freely as

possible

Multilateral trading system - Agreements that have

legal ground-rules for international commerce

and guarantee member countries important trade

rights

(29)

€ - Appreciated

$ - Depreciated

€ - Depreciated

$ - Appreciated

Eg.

Sell side - Originators of forward foreign exchange contracts. Usually large multinational banks

Buy side - Include corporations, governments and government entities, investment fund managers, hedge fund managers, investors and central bank

Exchange rate Spot exchange rate Forward exchange rate Real exchange rate Leveraged account

Price currency Base currency

Price of one unit of currency in terms of another Exchange rate for immediate delivery

Exchange rate for a transaction to be done in future Measures changes in relative purchasing power over time Investment ﬁrms that use derivatives/leverages

LOS d

Cross currency rates

Functions of and participants in the foreign exchange market

Currency Exchange Rates

LOS a,b & c

% Appreciation - _{Opening value}Closing value − 1 % Depreciation - Opening value_{Closing value} − 1

ZAR 52

ZAR 6500 Dong$ Find DongSW

= 12.62 Dong_SW 1

1.03 × 0.002 × 6500

Real exchange rate (d/f) = Nominal exchange rate (d/f) x CPI(f)_CPI(d)

Transaction cycle for forex in spot market is T + 2

(30)

Eg.

Points in Percentage (PIP)

Interest rate parity

LOS e

LOS f, g & h

International Fischer relationship (precise)

Interest rate parity

1 + Nominal interest rate = (1 + Real interest rate) × (1 + Expected inﬂation)

$1mln

_₹

50mln

₹

55mln 55

1.02 53.92

$1.02mln

₹

55mln 53.92

(31)

Arbitrage proﬁt

Eg.

Spot = 1 Yr. forward =

Country uses the currency of another country

and does not have its own monetary policy

Country pegs its currency within margins of ±1% versus

another currency

Exchange rate is adjusted periodically, to

adjust for higher inﬂation

versus the currency used

in the peg

Monetary authority inﬂuences the exchange rate in response to

speciﬁc indicators, such

as BOP

Explicit commitment to

exchange domestic currency

for a foreign currency at a ﬁxed

exchange rate

Permitted ﬂuctuations in currency value relative to another

currency is wider eg. ±2%

Width of bands that identify

permissible exchange rates is

increased over time

Exchange rate is market determined.

Intervention is used only to slow the rate of change

and reduce short term ﬂuctuations Several

countries use common No arbitrage price =

=

There is arbitrage because ‘No arbitrage price’ ≠ Forward price

LOS i

Forward discount/premium

Exchange rate regimes

Forward premium on USD =

=

Countries that do not issue

their own currencies Countries that issue their own currencies

Formal dollarization

Currency board

arrangement horizontal bandsPeg with

Management within crawling

bands

(32)

Effects of exchange rates on international

trade and capital ﬂows

Marshall-Lerner condition

J-Curve effect

W E + W (E − 1) > 0

X X M M

LOS j

Export

proportion proportionImport P of e

Export ImportP of e

Elasticities (E) of export and import demand must meet Marshall-Lerner condition for depreciation of domestic currency to reduce existing trade deﬁcit

Currency depreciation may worsen trade deﬁcit initially. Importers adjust over time by reducing quantities. Marshall-Lerner conditions take effect and the currency

depreciation begins to improve the trade balance

Export (Gems and Jewelry)

P of demand e Ç

USD price È

Q dÇ

Exports Ç

P of demand e Ç

INR price Ç

Q dÈ

Imports È

Import (Cars)

If INR depreciates from 65 to 80

Balance of trade

Time

Before currency depreciation

After currency depreciation 0

(33)

Absorption approach

It is a macroeconomic technique that focuses on capital account Balance of trade = National income − Total expenditure