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2017CFA
二级培训项目
Economics
Topic Weightings in CFA Level II
Session NO. Content Weightings
Study Session 1-2 Ethics & Professional Standards 10-15
Study Session 3 Quantitative Methods 5-10
Study Session 4 Economic Analysis 5-10
Study Session 5-6 Financial Statement Analysis 15-20
Study Session 7-8 Corporate Finance 5-15
Study Session 9-11 Equity Analysis 15-25
Study Session 12-13 Fixed Income Analysis 10-20
Study Session 14 Derivative Investments 5-15
Study Session 15 Alternative Investments 5-10
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Framework
Economic Analysis
SS4 Economics for Valuation
1. R13 Currency exchange rate:
determination and forecasting
2. R14 Economic Growth and
investment decision
Reading
13
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Framework
1. Currency Exchange Rates 2. Spot Rate And Forward Rate 3. Bid-Ask Spread
4. Cross Rate
5. Triangular Arbitrage
6. Forward Discount And Premium 7. Mark-to-market value
8. The International Parity Relationships 9. Balance-of-Payments Accounts
10. FX Carry Trade
Currency Exchange Rates
Warm-up
Exchange rate is simply the price or cost of units of one currency in terms of another.
Nominal exchange rate: the price that we observe in the marketplace for foreign exchange.
Real exchange rate: the focus shifts from the quotations in the foreign exchange market to what the currencies actually purchase in terms of real goods and services.
FX real(d/f) = FX nominal (d/f) *CPIf/CPId
Changes in real exchange rates can be used when analyzing economic changes over time.
When the real exchange rate (d/f) increases, exports of goods and services have gotten relatively less expensive to foreigners, and
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Example: At a base period, the CPIs of the U.S. and U.K. are both 100, and the exchange rate is $1.70 per euro. Three years later, the exchange rate is $1.60 per euro, and the CPI has risen to 110 in the U.S. and 112 in the U.K.. What is the real exchange rate?
Solution: The real exchange rate is $1.60 per euro * 112/110 = $1.629 per euro.
Currency Exchange Rates
Warm-up: FX Appreciation and Depreciation
Example: the dollar-Swiss franc rate increase from USD: CHF = 1.7799 to 1.8100. The Swiss franc has depreciated relative to the dollar– it now takes more Swiss francs to buy a dollar.
An increase in the numerical value of the exchange rate means that the
base currency has appreciated and that the price currency depreciated.
1.7799CHF/USD to 1.8100CHF/USD
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Spot Rate And Forward Rate
Spot rates are exchange rates for immediate delivery of the currency.
Spot markets refer to transactions that call for immediate delivery of the currency. In practice, the settlement period is two business days after the trade date.
Forward rates are exchange rates for currency transactions that will occur in the future.
Bid-Ask Spread
The spread on a foreign currency quotation
The bid price is smaller and listed first. It is the price the bank/dealer will pay per FC unit.
The ask price is higher and always listed second. It is the price at which the bank will sell a unit of FC.
The difference between the offer and bid price is called the spread.
Spreads are often stated as ‘pips’.
Example: the euro could be quoted as $1.4124-1.4128. The spread is $0.0004 (4 pips).
The spread on a forward foreign currency quotation
Consider a 6-month (180 days) forward exchange rate quote from a U.S. currency dealer of GBP:USD = 1.6384 / 1.6407.
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Bid-Ask Spread
The spread quoted by the dealer depends on：
The spread in the interbank market for the same currency pair. Dealer
spreads vary directly with spreads quoted in the interbank market.
The size of the transaction. Larger, liquidity-demanding transactions
generally get quoted a larger spread.
The relationship between the dealer and client. Sometimes dealers will
Bid-Ask Spread
The interbank spread on a currency pair depends on：
Currencies involved. Similar to stocks, high-volume currency pairs (e.g.,
USD/EUR, USD/JPY, and USD/GBP) command lower spreads than do lower-volume currency pairs (e.g., AUD/CAD).
Time of day. The time overlap during the trading day when both the
New York and London currency markets are open is considered the most liquid time window; spreads are narrower during this period than at other times of the day.
Market volatility. Higher volatility leads to higher spreads to compensate
market traders for the increased risk of holding those currencies.
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Cross Rate
Calculate cross rate
假设USD:IDR=2400，
2400IDR /USD，1.6 NZD/USD
求NZD/IDR?
因此， 1.6/2400NZD/IDR即 0.00067NZD/IDR
方法2
(USD:NZD)/(USD:IDR)=IDR:NZD =1.6/2400
Example
Calculate cross rate with bid-ask spreads
解题技巧：
相乘同边，相除对角，乘小除大
Example1: AUD: USD = 0.6000 - 0.6015
USD: MXN =10.7000 - 10.7200
此时应当左右两边相乘，得
AUD: MXN = 6.4200 – 6.4481
Example2: USD: SFR =1.5960 – 70
USD: ASD =1.8225 – 35，求SFR:ASD 此时应当下式除以上式，交叉，
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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.
Example
Example: AUD: USD=0.6000 - 0.6015 USD: MXN=10.7000 - 10.7200 AUD: MXN=6.3000 - 6.3025 How to arbitrage from these markets? 0.6000-0.6015USD/AUD (1)
10.700-10.720MXN/USD (2) 6.3000-6.3025MXN/AUD (3)
Correct Answer:
Step One: 1$(1) → 1/0.6015AUD(3) → (1/0.6015)*6.3000MXN(2) →
((1/0.6015)*6.3000)/10.720USD → 0.97704USD
Step Two: 1$(2) → 1*10.700MXN(3) → (1*10.700)/6.3025AUD(1) →
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Example: Triangular Arbitrage
Mehmet is looking at two possible trades to deter mine their profit potential. The first trade involves a possible triangular arbitrage trade using the Swiss, U.S. and Brazilian currencies, to be executed based on
a dealer’s bid/offer rate quote of 0.5161/0.5163 in CHF/BRL and the
interbank spot rate quotes presented in the following Exhibit.
Based on Exhibit, the most appropriate recommendation regarding the triangular arbitrage trade is to:
A. decline the trade, no arbitrage profits are possible.
B. execute the trade, buy BRL in the interbank market and sell it to the dealer.
C. execute the trade, buy BRL from the dealer and sell it in the interbank.
Correct Answer: B
Currency Pair Bid/Offer
CHF/USD 0.9099/0.9101
Forward Discount And Premium
Forward discount or premium
With the convention of giving the value of the quoted currency (the first
currency) in terms of units of the second currency, there is a premium on the quoted currency when the forward exchange rate is higher than the spot rate and a discount otherwise.
Example: One month forward rate is EUR: USD=1.2468, the spot rate is 1.2500, it is a discount for EUR
When a trader announces that a currency quotes at a premium, the
premium should be added to the spot exchange rate to obtain the value of the forward exchange rate.
The forward premium or discount
0
forward prmium
=F-S
or discount for Y
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Example
Given the following quotes for AUD/CAD, compute the bid and offer rates for a 30- day forward contract.
Correct Answer:
Since the forward quotes presented are all positive, the CAD (i.e., the base currency) 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
The 30-day forward quote for AUD/CAD is 1.05149/1.05231.
Maturity Rate
Spot 1.0511/1.0519
30-day +3.9/+4.1
90-day +15.6/+16.8
Mark-to-market value
Mark-to-market value of a forward contract
The value of the forward contract will changes as forward quotes for the currency pair change in the market.
The value of a forward contract (to the party buying the base currency) at maturity (time T) is：
The value of a forward currency contract prior to expiration is also known as the mark-to-market value.
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Example
Yew Mun Yip has entered into a 90-day forward contract long CAD 1 million against AUD at a forward rate of 1.05358 AUD/CAD. Thirty days after initiation, the following AUD/CAD quotes are available：
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 the mark-to-market value in AUD of Yip's forward contract?
Maturity Rate
Spot 1.0612/1.0614
30-day +4.9/+5.2
60-day +8.6/+9.0
90-day +14.6/+16.8
Example
Correct Answer:
The forward bid price for a new contract expiring in T - t = 60 days
is 1.0612 + 8.6/10,000 = 1.06206.
The interest rate to use for discounting the value is also the 60-day
AUD interest rate of l.16%：
1.06206 1.05358 1, 000, 000
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The International Parity Relationships
Interest Rate Parity
Covered Interest Rate Parity
Uncovered Interest Rate Parity
International Fisher Relation
PPP
Absolute PPP
Relative PPP
Covered Interest Rate Parity
Covered Interest rate parity (IRP)
The word 'covered’ in the context of covered interest parity means bound by arbitrage.
Covered interest rate parity holds when any forward premium or
discount exactly offsets differences in interest rates, so that an investor would earn the same return investing in either currency.
Interest differential ≈forward differential Interest rate parity relationship:
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Covered Interest Rate Parity
Covered interest arbitrage is a trading strategy that exploits currency position when the interest rate parity equation is not satisfied.
When currencies are freely traded and forward contracts are available in the marketplace, interest rate parity must hold.
If it does not hold, arbitrage trading will take place until interest rate parity holds with respect to the forward exchange rate.
You can check for an arbitrage opportunity by using the covered interest differential, which says that the domestic interest rate should be the same as the hedged foreign interest rate.
The difference between the domestic interest rate and the hedged foreign interest rate (covered interest differential) should be zero.
Summary for Covered Interest Rate Parity
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Example :
Example: Calculating the forward premium (discount)
The following table shows the mid-market (average of the bid and offer) for the current CAD/AUD spot exchange rate as well as for AUD and
CAD 270-day LIBOR (annualized):
The forward premium (discount) for a 270-day forward contract for CAD/AUD would be closest to:
A. - 0.0346 B. - 0.0254 C. +0.0261
Example :
Correct Answer: B The equation to calculate the forward premium (discount) is:
/ / /
CAD AUD CAD AUD CAD AUD
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Summary for arbitrage
Covered Interest Rate Parity
The U.S. dollar interest rate is 8%, and the euro interest rate is 6%. The spot
exchange rate is $ 1.30 per euro, and the forward rate is $ 1.35 per euro. Determine whether a profitable arbitrage exists, and illustrate such an arbitrage if it does.
First we note that the forward value of the euro is " too high―. Interest rate
parity would require a forward rate of : $ 1.30 ( 1.08 / 1.06 ) = $ 1.3245 . The forward rate of $ 1.35 is higher than that implied by interest rate parity,
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Covered Interest Rate Parity
Initially :
Step1 : Borrow $ l,000 at 8% and purchased 1,000 / 1.30 = 769 . 23
euros.
Step2 : Invest the euros at 6%
Step3：Sell the expected proceeds at the end of one year, 769.23 ( 1.06 )
= 815.38 euros, forward 1 year at $ 1.35 each. After one year :
Step1 : Sell the 815.38 euros under the terms of the forward contract at
$1.35 to get $1,100.76.
Step2 : Repay the $ 1,000 8 % loan, which is $ 1,080.
Uncovered Interest Rate Parity
Uncovered interest rate parity
If forward currency contracts are not available, or if capital flows are restricted so as to prevent arbitrage, the relationship need not hold.
Uncovered interest rate parity refers to such a situation; uncovered in this context means not bound by arbitrage.
Uncovered interest rate parity suggests that nominal interest rates reflect expected changes in exchange rates.
The base currency is expected to appreciate (depreciate) by approximately RX - RY when the difference is positive (negative). Uncovered interest rate parity assumes that investors are risk-neutral.
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Uncovered Interest Rate Parity
Comparing covered and uncovered interest parity Covered interest rate parity derives the no-arbitrage forward rate, while uncovered interest rate parity derives the expected future spot rate. Covered interest parity is assumed by arbitrage.
F = E(S1)
If uncovered interest rate parity holds, the forward rate is an unbiased predictor of expected future spot rates.
International Fisher Relation
International Fisher relation
The international Fisher relation specifies that the interest rate differential
between two countries should be equal to the expected inflation differential.
The condition assumes that real interest rates are stable over time and equal
across international boundaries.
The international Fisher relation is correct because differences in real interest
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International Fisher Relation
International Fisher relation
Exact methodology:
Linear approximation:
The relation between nominal interest rate and real interest rate:
Absolute PPP
Law of one price : identical goods should have the same price in all locations.
Absolute PPP compares the price of a basket of similar goods between countries, asks if the law of one price is correct on average.
In practice, even if the law of one price held for every good in two
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Relative PPP
Relative PPP: change in the exchange rate depends on the inflation rates in the two countries. In its approximate form, the difference in inflation rates is equal to the expected depreciation (appreciation) of the currency. The
country with the higher inflation should see its currency depreciate. The formal equation for relative PPP is as follows: S (X/Y)
Because there is no true arbitrage available to force the PPP relation to hold, violations of the relative PPP relation in the short run are common.
Ex-Ante Version of PPP
Ex-Ante Version of PPP39-108
The International Parity Relationships Combined
0
The International Parity Relationships Combined
Several observations can be made from the relationships among the various
parity relationships:
Covered interest parity holds by arbitrage. If forward rates are
unbiased predictors of future spot rates, uncovered interest rate parity also holds (and vice versa).
Interest rate differentials should mirror inflation differentials. This
holds true if the international Fisher relation holds. If that is true, we can also use inflation differentials to forecast future exchange rates — which is the premise of the ex-ante version of PPP
By combining relative purchasing power parity with the international
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Forecast Future Spot Exchange Rates
As stated earlier, uncovered interest rate parity and PPP are not bound by arbitrage and seldom work over the short and medium terms. Similarly, the forward rate is not an unbiased predictor of future spot rate. However, PPP holds over reasonably long time horizons.
If relative PPP holds at any point in time, the real exchange rate would be
Long-Run Fair Value of An Exchange Rate
Assess the long-run fair value of an exchange rate
Macroeconomic balance approach. Estimates how much current
exchange rates must adjust to equalize a country’s expected current account imbalance and that country’s sustainable current account
imbalance.
External sustainability approach. Estimates how much current exchange
rates must adjust to force a country’s external debt (asset) relative to
GDP towards its sustainable level.
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
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Balance-of-Payments Accounts
Balance-of-payments accounts
Current Account measures the exchange of goods, the exchange of
services, the exchange of investment income, and unilateral transfer (gifts to and from other nations)
Financial Account (also known as the capital account) measures the flow of funds for debt and equity investment into and out of the country, including direct investment made by companies; portfolio investments in equity,
bonds, and other securities; and other investments and liabilities such as deposits or borrowing with foreign banks.
Official reserve account transactions are those made from the reserves held by the official monetary authorities of the country. Normally the official
reserve account balance does not change significantly from year to year.
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
Balance-of-Payments Accounts
Influence of BOP on exchange rates
Current account influence: current account deficits lead to a depreciation of domestic currency
Flow mechanism. Current account deficits in a country increase the supply of that currency in the markets. This puts downward pressure on the exchange value of that currency.
The initial deficit.
The influence of exchange rates on domestic import and export prices.
Price elasticity of demand of the traded goods.
Portfolio composition mechanism. Investor countries may find their portfolios' composition being dominated by few investee currencies. When rebalance, it can have a significant negative impact on the value of those investee country currencies.
Debt sustainability mechanism. When the level of debt gets too high relative to GDP, investors may question the sustainability of this level of
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Balance-of-Payments Accounts
Influence of BOP on exchange rates
Capital account influence
Capital account flows are one of the major determinants of exchange rates.
As capital flows into a country, demand for that country’s currency increases, resulting in appreciation.
Excessive capital inflows into emerging markets create problems for those countries such as:
Excessive real appreciation of the domestic currency. Financial asset and/or real estate bubbles.
Increases in external debt by businesses or government.
Influence of BOP on exchange rates
Capital account influence
real exchange rate (A/B) = equilibrium real exchange rate
+ (real interest rateB - real interest rateA) - (risk premiumB - risk premiumA)
In the short term, the real value of a currency Fluctuates around its
long-term, equilibrium value.
The real value of a currency is positively related to its real interest rate
and negatively related to the risk premium investors demand for investing in assets denominated in the currency.
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Taylor Rule
Central banks are usually charged with setting policy interest rates so as to Maintain price stability (inflation target)
Achieve the maximum sustainable level of employment R = rn +π +α(π – π*) +β(y – y*)
R: central bank policy rate implied by the Taylor rule rn : neutral real policy interest rate
π: current inflation rate
π*: central bank’s target inflation rate
y: log of current level of output
y*: log of central bank’s target(sustainable) output
α, β: policy response coefficients
Example
As an example, let’s use the data in Exhibit for Country Z and apply the Taylor rule to determine the appropriate policy rate.
(α=0.5, β=0.5)
Exhibit %
Neutral real policy rate 2.75
Current policy rate (nominal) 3.00
Current inflation rate 2.67
Target inflation rate 3.27
Current level of output 3.50
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Example
The policy rate (in %) should be closest to: A. 4.87
B. 5.12 C. 5.79
Correct Answer: A
The Taylor rule to determine the appropriate policy rate is:
i=2.75+2.67+0.5(2.67-3.27)+0.5(3.50-4.00) =2.75-0.30-0.25
=4.87%
* *
(
)
(
)
n
Real Exchange Rate
If we substitute the real interest rate equation above into our previous equation, we obtain:
real exchange rate (A/B)
= equilibrium real exchange rate
+ difference in neutral real policy interest rate (B – A) + α [difference in inflation gap (B-A)]
+ β [difference in output gap (B-A)] - (risk premiumB - risk premiumA)
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FX Carry Trade
FX carry trade
Uncovered interest rate parity is not bound by arbitrage. In a FX carry
Example
Example Carry Trade
Interest Rates Currency Pair Exchange Rates
Today One year later U.K. 3% USD/GBP 1.50 1.50
U.S. 1%
Compute the profit to an investor borrowing in the United States and investing in the U.K.
Correct Answer:
return=interest earned on investment – funding cost -currency depreciation
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Example
Example Carry Trade
After one year, the all-in return to this trade, measured in JPY terms, will be…?
Correct Answer:
Today’s one-year Currency Pair Exchange Rates
LIBOR Today One year later
JPY 0.1% JPY/USD 81.30 80.00
AUD 4.5% USD/AUD 1.0750 1.0803
/
81.3 1.0750
87.4
/
80.00 1.0803
86.42
1
(1 4.50%) 86.42 1.0333
87.40
3.33% 0.1%
3.23%
JPY AUD spot
JPY AUD one year later
gross return
net return
all
in return
FX Carry Trade
Risks of the carry trade
The risk is that the funding currency may appreciate significantly against
the currency of the investment.
Crash risk
The return distribution of the carry trade is not normal; it is
characterized by negative skewness and excess kurtosis (i.e., fat tails), meaning that the probability of a large loss is higher than the
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FX Carry Trade
Risk management in carry trade
Volatility filter: Whenever implied volatility increases above a certain
threshold, the carry trade positions are closed (i.e., reversed).
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
Exchange Rate Determination Models
Exchange rate determination models
Mundell-Fleming model
The monetary approach
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Mundell-Fleming Model
Flexible Exchange Rate Regimes
High capital mobility
Monetary policy
Expansionary monetary policy will reduce the interest rate and,
consequently, the inflow of capital investment in physical and financial assets. This decrease in financial inflows reduces the
demand for the domestic currency, resulting in depreciation of the domestic currency.
Restrictive monetary policy should have the opposite effect,
Mundell-Fleming Model
Flexible Exchange Rate Regimes
High capital mobility
Fiscal policy
Expansionary fiscal policy will increase government borrowing and, consequently, real interest rates. An increase in real interest rates will attract foreign investors, improve the financial account, and
consequently, increase the demand for the domestic currency. Expansionary fiscal policy will also increase economic activity
(growth) and inflation, leading to a deterioration of the current account and a decrease in demand for the domestic currency.
With these two opposite effects on currency demand, the net effect of expansionary fiscal policy on exchange rates is subject to some debate. If the flow of capital is sensitive to the interest rate
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Mundell-Fleming Model
Flexible Exchange Rate Regimes
Low capital mobility
In that case, the impact of trade imbalance on exchange rates (goods
How effect) is greater than the impact of interest rates (financial flows effect). In such a case, expansionary fiscal or monetary policy leads to increases in net imports, leading to depreciation of the domestic
Mundell-Fleming Model
Fixed Exchange Rate Regimes
Monetary policy
An expansionary (restrictive) monetary policy would lead to
depreciation (appreciation) of domestic currency as stated above.
Under a fixed rate regime, the government would then have to purchase
(sell) its own currency in the foreign exchange market. This action essentially reverses the expansionary (restrictive) stance.
This explains why in a world with mobility of capital, governments
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Fixed Exchange Rate Regimes
Fiscal policy
Expansionary (restrictive) fiscal policy leads to appreciation (depreciation)
of domestic currency.
Under a fixed exchange rate regime, the government would then sell
Monetary Approach
Compare Mundell-Fleming model with monetary model
With the Mundell-Fleming model, we assume that inflation (price levels)
play no role in exchange rate determination.
Under monetary models, we assume that output is fixed, so that
monetary policy primarily affects inflation, which in turn affects exchange rates.
Main approaches
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Monetary Approach
Main approaches
Pure monetary model.
Dornbusch overshooting model.
This model assumes that prices are sticky (inflexible) in the short term and, hence, do not immediately reflect changes in monetary policy.
In the case of an expansionary monetary policy, prices increase over time. This leads to a decrease in real interest rates—and depreciation of the domestic currency due to capital outflows.
In the short term, exchange rates overshoot the long-run PPP
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Portfolio Balance (Asset Market) Models
Compare Mundell-Fleming model with portfolio balance model The Mundell-Fleming approach focuses on the short-term implications of fiscal policy.
The portfolio balance model focuses on the long-term implications of sustained fiscal policy (deficit or surplus) on currency values.
Main approach:
Continued increases in fiscal deficits are unsustainable and investors may refuse to fund the deficits—leading to currency depreciation. Portfolio balance model:
In the long term, the government has to reverse course (tighter
budgetary policy) leading to depreciation of the domestic currency. If the government does not reverse course, it will have to monetize
its debt (i.e., print money), which would also lead to depreciation of the domestic currency.
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Central Bank Intervention
Excessive capital inflows to a country can also lead to a currency crisis when such capital is eventually withdrawn from the country.
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.
Effectiveness
Evidence has shown that for developed markets, central banks are relatively ineffective.
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.
Signs of Currency Crisis
Terms of trade deteriorate.
Official foreign exchange reserves dramatically decline.
Real exchange rate is substantially higher than the mean-reverting level.
Inflation increases.
Equity markets experience a boom-bust cycle.
Money supply relative to bank reserves increases.
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Technical Analysis
Trend-Following Trading Rules
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 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.
Reading
14
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Framework
1. Preconditions for Growth
2. Stock Market, Sustainable Growth Rate of Economy
3. Importance of Potential GDP
4. Factor Inputs and Economic Growth
5. Productivity Curve
6. Factors Affecting Economic Growth
Preconditions for Growth
Preconditions for Growth Savings and investment
Financial markets and intermediaries
The political stability, rule of law, and property rights Investment in human capital
Tax and regulatory systems
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Stock Market, Sustainable Growth Rate
Growth in aggregate stock market valuation: P = GDP*(E/GDP)*(P/E)
%△P = %△GDP + %△(E/GDP) + %△(P/E)
Over the long-term, we have to recognize that growth in earnings
relative to GDP is zero; labor will be unwilling to accept an ever decreasing share of GDP.
Growth in the P/E ratio will also be zero over the long term; investors
will not continue to pay an ever increasing price for the same level of earnings forever.
Hence over a sufficiently long time horizon, the potential GDP growth
Importance of Potential GDP
Growth in potential GDP
When consumers expect their incomes to rise, they increase current
consumption and save less for future consumption (i.e., they are less likely to worry about funding their future consumption).
To encourage consumers to delay consumption (i.e., to encourage
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Importance of Potential GDP
The relationship between actual GDP and potential GDP
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.
Central banks are likely to adopt monetary policies consistent with the
gap between potential output and actual output.
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 growth rate
A higher potential GDP growth rate reduces expected credit risk and
Factor Inputs and Economic Growth
Cobb-Douglas production function
where:
α and (1 —α)= the share of output allocated to capital (K) and labor (L), respectively [α and (1 —α) are also referred to as capital’s and labor’s share of total factor cost, where α< 1]
T = a scale factor that represents the technological progress of the economy, often referred to as total factor productivity (TFP)
It exhibits constant returns to scale: increasing all inputs by a fixed
percentage leads to the same percentage increase in output.
1
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Factor Inputs and Economic Growth
Output per worker (labor productivity)
Output per worker=Y/L=T(K/L)α
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).
Factor Inputs and Economic Growth
Since α is less than one, additional capital has a diminishing effect on productivity.
Lower the value of α, lower the benefit of capital deepening. Developed
markets typically have a high capital to labor ratio and a lower a as compared to developing markets, and therefore developed markets stand to gain less in increased productivity from capital deepening.
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.
In contrast, developing nations often have low capital per worker ratios, so capital deepening can lead to at least a short-term
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Productivity Curve
Effect of increase in capital Effect of change in technology Labor productivity
Capital per labor hour LP2
LP1
LP0 Economic
Growth
More technology
Less technology
Productivity Curve
Factor Inputs and Economic Growth
In steady state (i.e., equilibrium), the marginal product of capital and
marginal cost of capital (i.e., the rental price of capital, r) are equal; hence:
αY/K=r, α=rK/Y
r is rate of return and K is amount of capital. rK measures the amount of
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Growth Accounting Relations
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)
The change in total factor productivity (technology) must be estimated
as a residual: the ex-post (realized) change in output minus the output implied by ex-post changes in labor and capital.
Example
Based upon the country factors provided in Exhibit 1, the country most likely to be considered a developing country is:
A. Country A. B. Country B. C. Country C. Correct Answer: C
Based upon Exhibit 1, capital deepening as a source of growth was most important for:
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Natural Resources
The role of natural resources in economic growth is complex. In some instances, countries with abundant natural resources (e.g., Brazil) have
grown rapidly. Yet other countries (e.g., some of the resource-rich countries of Africa) have not. Conversely, some resource-poor countries have
managed impressive growth.
‘Dutch disease’: global demand for a country’s natural resources drives up
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Labor Supply Factors
Demographics. 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.
Labor force participation=
Labor force participation can increase as more women enter the workforce.
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.
Average hours worked. The general trend in average hours worked is downward.
force
age population
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Factors Affecting Economic Growth
Human capital. Increasing human capital through education or work experience increases productivity and economic growth.
Physical capital.
Physical capital is generally separated into infrastructure, computers, and telecommunications capital (ICT) and non-ICT capital (i.e.,
machinery, transportation, and non-residential construction). Why capital increases may still result in economic growth
Many countries (e.g., developing economies) have relatively low capital to labor ratios
Some capital investment actually influences technological progress, thereby increasing TFP and economic growth.
Public infrastructure.
Factors Affecting Economic Growth
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.
In contrast, less developed countries often copy the technological
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Economic Growth Theories
Classical growth theory
Neoclassical growth theory
Classical Growth Theories
Classical theory
The growth in real GDP is not permanent.
Technological advances → investment in new capital↑ → labor
productivity and new business start and demand for labor ↑ → real
wages and employment ↑ → population explosion → real GDP ↓
Subsistence real wage: minimum real wage necessary to support life支
持生活的实际工资底线
No matter how much technology advances, real wages will eventually be
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Classical Growth Theories
Effect of change in technology Labor productivity
Capital per labor hour LP2
LP1
LP0
Population grows
Classical theory and the productivity curve
C1 C0
B
Neoclassical Growth Theories
Long-term steady state growth rate The economy is at equilibrium when the output-to-capital ratio is constant. When the output-to-capital ratio is constant, the labor-to-capital ratio and output per capita also grow at the equilibrium growth rate, g*.
Sustainable growth of output per capita (or output per worker) (g*) is equal to the growth rate in technology (θ) divided by labor’s share of GDP (1-α)
Sustainable growth rate of output (G*) is equal to the sustainable growth rate of output per capita, plus the growth of labor (ΔL)
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Neoclassical Growth Theories
Capital deepening affects the level of output but not the growth rate in the long run. Capital deepening may temporarily increase the growth rate, but the growth rate will revert back to the sustainable level if there is no
technological progress.
An economy’s growth rate will move towards its steady state regardless of the initial capital to labor ratio or level of technology. In the steady state, the growth rate in productivity (i.e., output per worker) is a function only of the growth rate of technology (θ) and labor’s share of total output (1 - α).
In the steady state, marginal product of capital (MPK) = αY/K is constant, but marginal productivity is diminishing.
An increase in savings will only temporarily raise economic growth. However, countries with higher savings rates will enjoy higher capital to labor ratio and higher productivity.
Endogenous Growth Theory
Assumption The driving force behind the endogenous growth theory result is the assumption that certain investments increase TFP (i.e., lead to
technological progress) from a societal standpoint.
Increasing R&D investments, for example, results in benefits that are also external to the firm making the R&D investments.
主要思想：
In contrast to the neoclassical model, endogenous growth theory
contends that technological growth emerges as a result of investment in both physical and human capital (hence the name endogenous which means coming from within). Technological progress enhances
productivity of both labor and capital.
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Endogenous Growth Theory
The difference between neoclassical and endogenous growth theory relates to total factor productivity.
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.
Under endogenous growth theory, private sector investments in R&D and knowledge capital benefit the society overall.
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Convergence Hypotheses
Whether productivity, and hence, living standards tend to converge over time
Absolute convergence hypothesis
Less developed countries will achieve equal living standards over time
Conditional convergence hypothesis
Convergence in living standards will only occur for countries with the same savings rates, population growth rates, and production functions.
Club convergence hypothesis
Countries may be part of a ‘club’ (i.e., countries with similar
institutional features such as savings rates, financial markets, property rights, health and educational services, etc.).
Countries can ‘join’ the club by making appropriate institutional
changes. Those countries that are not part of the club may never achieve the higher standard of living.
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Expected Impact of Removing Trade Barriers
Benefit Increased investment from foreign savings.
Allows focus on industries where the country has a comparative advantage.
Increased markets for domestic products, resulting in economies of scale.
Increased sharing of technology and higher total factor productivity growth.
Increased competition leading to failure of inefficient firms and reallocation of their assets to more efficient uses.
The neoclassical model’s predictions in an open economy (i.e., an economy without any barriers to trade or capital flow) focus on the convergence.
Reading
15
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Framework
1. Classifications of Regulations And Regulators
2. Types of Regulators
3. Economic Rationale for Regulatory Intervention
4. Regulatory Interdependencies 5. Tools of Regulatory Intervention 6. Regulating Commerce And Financial
Markets
7. Antitrust Regulation
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Classifications of Regulations And Regulators
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 Regulators
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.
Some independent regulators are self-regulating organizations (SROs) that regulate as well as represent their members. Not all SROs are
independent regulators (i.e., have government recognition). Also, not all independent regulators are SROs.
SROs may have inherent conflicts of interest.
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Types of Regulators
Regulators
Government
agencies
Independent
regulators
Outside
bodies
Uses of Self-Regulation in Financial Markets
SROs without government recognition are not considered regulators.
The use of independent SROs in civil-law countries is not common; in such
countries, formal government agencies fulfill the role of SROs.
In common-law countries such as the U.K. and the United States,
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Economic Rationale for Regulatory Intervention
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.
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.
Since people share in the consumption of public goods but don’t
necessarily bear a cost that is proportionate to consumption,
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Regulatory Interdependencies
Regulatory capture theory A regulatory body will be influenced or even possibly controlled by the industry that is being regulated.
The rationale is that regulators often have experience in the industry, and this affects the regulators' ability to render impartial decisions. Regulatory competition
Regulators compete to provide the most business-friendly regulatory environment
Regulatory arbitrage
Occurs when businesses shop for a country that allows a specific behavior rather than changing the behavior.
Regulatory arbitrage also entails exploiting the difference between the economic substance and interpretation of a regulation.
To avoid regulatory arbitrage, cooperation at a global level to achieve a cohesive regulatory framework is necessary.
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Tools of Regulatory Intervention
Price mechanisms. Price mechanisms such as taxes and subsidies can be used to further specific regulatory objectives.
Restricting/requiring certain activities. Regulators may ban certain
activities (e.g., use of specific chemicals) or require that certain activities be performed (e.g., filing of 10-k reports by publicly listed companies) to
further their objectives.
Provision of public goods or financing of private projects. Regulators may provide public goods (e.g., national defense) or fund private projects (e.g., small business loans) depending on their political priorities and
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Regulating Commerce And Financial Markets
Regulating commerce. To facilitate business decision making. Examples of regulations covering commerce include company laws ,tax laws, contract laws, competition laws, banking laws, bankruptcy laws, and dispute resolution systems. Regulating financial markets.
Regulation of securities markets 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.
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Antitrust Regulation
Antitrust laws work to promote domestic competition by monitoring and
restricting activities that reduce or distort competition.
When evaluating an announced merger or acquisition, an analyst should
Cost Benefit Analysis of Regulation
Regulatory burden (also known as government burden) refers to the cost of compliance for the regulated entity. Regulatory burden minus the private benefits of regulation is known as the net regulatory burden.
Regulators should be aware of unintended consequences of regulations.
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Effects of A Specific Regulation
Regulations can help or hinder a company or industry.
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).
Regulations are not necessarily always costly for those that end up being
regulated.
Regulations may introduce inefficiencies in the market.
Some regulations may be specifically applicable to certain sectors while
It’s not the end but just beginning.
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一旦变换看问题的角度，你的生活会豁然开朗，幸福快乐会接踵而来。别交 出掌握命运的主动权，也别指望局面会丌可思议的好转。你必须不内心希望不热 情步调一致。建立自信，敢于不困难短兵相接，而非绕道而行。记住，力量丌是 驾驭局势的法宝，无坚丌摧的能力才是最重要的。
