2024 Level 1 - Economics Prerequisite Readings

Last Revised: 08/24/2023 2024 Level 1 - Economics Prerequisite Readings Page Topics in Demand and Supply Analysis 2 Introduction to the Firm and Market Organization 10 Aggregate Output, Prices, and Economic Growth 16 Introduction to Business Cycles 31 Monetary and Fiscal Policy 41 International Trade and Capital Flows 46 Currency Exchange Rates 54 M.M141013373. This document should be used in conjunction with the corresponding prerequisite readings in the 2024 Level 1 CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant accuracy or quality of the products or services offered by MarkMeldrum.com. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. © 2533695 Ontario Limited d/b/a MarkMeldrum.com. All rights reserved. 1 Last Revised: 08/24/2023 Topics in Demand and Supply Analysis a. calculate and interpret price, income, and cross-price elasticities of demand and describe factors that affect each measure b. compare substitution and income effects c. contrast normal goods with inferior goods d. describe the phenomenon of diminishing marginal returns e. determine and interpret breakeven and shutdown points of production M.M141013373. 2 Last Revised: 08/24/2023 Elasticity ⇒ Demand analysis – the consumer Law of Demand ⇒ as Px ↑, 𝐐𝐝𝐱 ↓ Px ↓, 𝐐𝐝𝐱 ↑ - but by how much? - how sensitive is Qx to changes in Px Page 1 LOS a - calculate - interpret - other variables also influence 𝐐𝐝𝐱 - incomes - prices of substitutes & complements - captured in the demand function 𝐐𝐝𝐱 = 𝐟(𝐏𝐱 , 𝐈, 𝐏𝐲 ) e.g./ 𝐐𝐝𝐱 = 𝟖𝟒. 𝟓 − 𝟔. 𝟑𝟗𝐏𝐱 + 𝟎. 𝟐𝟓𝐈 − 𝟐𝐏𝐲 or 𝐐𝐝𝐱 = 𝐚 − 𝐛𝟏 𝐏𝐱 + 𝐛𝟐 𝐈 − 𝐛𝟑 𝐏𝐲 negative = complement positive = substitute called sensitivities 𝐐𝐝𝐱 Page 2 LOS a - calculate - interpret = 𝟖𝟒. 𝟓 − 𝟔. 𝟑𝟗𝐏𝐱 + 𝟎. 𝟐𝟓𝐈 − 𝟐𝐏𝐲 1) own price elasticity e.g./ Px = $1.48 𝐄𝐏𝐝𝐱 I = $50(000) ∆𝐐𝐝𝐱 %∆𝐐𝐝𝐱 ∆𝐐𝐝𝐱 𝐏𝐱 𝐐𝐝 = = 𝐱 =A BC D ∆𝐏𝐱 %∆𝐏𝐱 ∆𝐏𝐱 𝐐𝐝𝐱 𝐏𝐱 coefficient (-b1) Py = $20 (000) 𝐐𝐝𝐱 = 𝟖𝟒. 𝟓 − 𝟔. 𝟑𝟗(𝟏. 𝟒𝟖) + 𝟎. 𝟐𝟓(𝟓𝟎) − 𝟐(𝟐𝟎) = 𝟒𝟕. 𝟓𝟒 ∴ 𝐄𝐏𝐝𝐱 = −𝟔. 𝟑𝟗<𝟏. 𝟒𝟖=𝟒𝟕. 𝟓𝟒> = −. 𝟐𝟎 - at a price of $1.48, a 1% rise in price would result in a drop in 𝐐𝐝𝐱 of 0.2% perfectly !𝐄 𝐝 ! < 𝟏 – inelastic !𝐄 𝐝 ! = 𝟏 – unit elastic P P M.M141013373. perfectly elastic !𝐄 𝐝 ! > 𝟏 – elastic Q 3 inelastic Q Last Revised: 08/24/2023 𝐐𝐝𝐱 = 𝟖𝟒. 𝟓 − 𝟔. 𝟑𝟗𝐏𝐱 + 𝟎. 𝟐𝟓𝐈 − 𝟐𝐏𝐲 1) own price elasticity P more elastic · close substitutes available · large %’age of household budget · long-term demand · optional/discretionary less elastic · no close substitutes · small %’age of household budget · short-term demand · necessity/non-discretionary 𝐐𝐝𝐱 Page 3 LOS a - calculate - interpret elastic - as Px ↓ (P × Q) ↑ inelastic Total Expenditure as Px ↓ (P × Q) ↓ TR Q Page 4 LOS a - calculate - interpret = 𝟖𝟒. 𝟓 − 𝟔. 𝟑𝟗𝐏𝐱 + 𝟎. 𝟐𝟓𝐈 − 𝟐𝐏𝐲 2. Income elasticity of demand %∆𝐐𝐝𝐱 ∆𝐐𝐝𝐱 𝐈 𝐄𝐈𝐝 = =A B C = 𝐝D 𝐐𝐱 %∆𝐈 ∆𝐈 . 𝟐𝟓<𝟓𝟎=𝟒𝟕. 𝟓𝟒> = 𝟎. 𝟐𝟔 - a 1% increase in Incomes results in a 0.26% increase in 𝐐𝐝𝐱 𝐄𝐈𝐝 > 𝟎 – normal good 𝐄𝐈𝐝 < 𝟎 – inferior good 3. Cross-price elasticity of demand %∆𝐐𝐝𝐱 ∆𝐐𝐝𝐱 𝐏𝐲 𝐄𝐏𝐝𝐲 = =A B C G 𝐝D 𝐐𝐱 %∆𝐏𝐲 ∆𝐏𝐲 𝐄𝐏𝐝𝐲 < 𝟎 – complement M.M141013373. −𝟐<𝟐𝟎 =𝟒𝟕. 𝟓𝟒> = −. 𝟖𝟒 𝐄𝐏𝐝𝐲 > 𝟎 - substitute 4 - a 1% rise in Py results in a 0.84% decrease in 𝐐𝐝𝐱 Last Revised: 08/24/2023 Substitution & Income Effects Px · as Px ↓, Qx ↑ ⇒ substitution effect P1 Page 5 LOS b - compare - tends to always be positive (Law of Demand) P2 Q1 Q2 · as Px ↓, purchasing power increases ⇒ Income effect 𝐈= 𝐏𝐲 𝐈= 𝐏𝐱 𝐈= 𝐏𝐱 substitution effect - if income effect is positive, then 𝐐𝐝𝐱 ↑ (normal good) - if income effect is negative, then 𝐐𝐝𝐱 ↓ (inferior good) income effect Normal good - buy more when Px ↓ - buy more as I ↑ Inferior good - buy more when Px ↓ - buy less as I ↑ Page 6 LOS b - compare - reinforce one another (𝐐𝐝𝐱 ↑) - offsetting (𝐐𝐝𝐱 ↑ but not as much) · if income & substitution effect results in 𝐐𝐝𝐱 ↓ - Giffen good (pos. sub. effect but 𝐝 - as the real price drops, 𝐐𝐱 ↓ much larger neg. Inc. effect) M.M141013373. - Veblen good - as the nominal price ↑, 𝐐𝐝𝐱 ↑ 5 Last Revised: 08/24/2023 Diminishing Marginal Returns · increasing marginal returns – the productivity of each additional unit of a resource (L, K) increases as each additional unit of that input are employed specialization - adding labour H𝐘=𝐋 ↑L division of labour Page 7 LOS d - describe - however, after a certain output, law of diminishing returns takes over - K being used at 100% capacity – adding H𝐘=𝐋 ↓L Labour will not increase output - Let w = wage rate/hr. of labour - Let r = rental rate/hr. of capital ∴ to lower TC, w must ↓, r must ↓, ∴ TC = wL + rK or productivity of L and/or K must ↑ - benefits of increased productivity/ · lower TC = increased productivity · increase in MVequity · increase in worker rewards, which motivates further productivity increases from labour Page 8 LOS d - describe - companies that lag the industry in productivity will be less profitable and less competitive - Total, Average & Marginal Product/ Q Q/L ∆𝐐= ∆𝐋 - increasing returns ⇒ MPL ↑ M.M141013373. - decreasing returns ⇒ MPL ↓ - negative returns ⇒ MPL < 0 6 L Q Q/L ∆𝐐$ ∆𝐋 0 1 2 3 4 5 6 7 0 100 210 300 360 400 420 350 0 100 105 100 90 80 70 50 100 110 90 60 40 20 -70 Last Revised: 08/24/2023 Breakeven/Shutdown Points TR perfect competition P MR = AR imperfect competition MR = 0 increasing decreasing MR TR MR MR = 0 TR – max. TR = P × Q MR = ∆TR/∆Q accounting costs + an equity charge imperfect competition perfect competition MR < P MR = P P MR P - sell 1 more Q at P Costs TVC TFC Q - sell 1 more Q at lower P Marginal Cost = ∆𝐓𝐂=∆𝐐 short-run MC SMC – additional cost of labour input/Q MC = w/MPL ATC AVC AFC Q Page 10 LOS e - determine TC = TVC + TFC Cost/unit A D TFC = all economic fixed costs (includes required rate of return) TC A Page 9 LOS e - determine Economic Profit Total Revenue – economic costs long-run M.M141013373. - if w ↑, MC ↑ - if MPL ↑, MC ↓ LMC - additional cost of all inputs/Q Average variable costs = TVC/Q AVC = w/APL 7 - if w ↑, AVC ↑ - if APL ↑, AVC ↓ Last Revised: 08/24/2023 Cost/unit MC T • R ATC AVC • S AFC • Q QAVC T – lowest point on the ATC curve MC = ATC Economic Breakeven Point Cost/unit P3 P2 P1 R – lowest point on the MC curve - beyond this point, fixed input constraints reduce the productivity of labour S – lowest point on the AVC curve MC = AVC · before QAVC, MC < AVC ∴ AVC is downward sloping (decreasing costs/unit) · beyond QAVC, MC > AVC ∴ AVC is upward sloping (increasing costs/unit) Shutdown Point Page 12 LOS e - determine MC T R • • •S abnormal economic profit ATC AVC AFC Q · at P3, MR > ATC - make economic profit on each unit of Q - above breakeven - short-run ⇒ produce - long-run ⇒ stay Page 11 LOS e - determine · at P1, MR < AVC - lose money on each Q - shutdown at any P below S - short-run ⇒ shutdown - long-run ⇒ exit · at P2, MR > AVC but MR < ATC - each unit sold covers VC and contributes something towards FC M.M141013373. - short-run ⇒ produce - long-run ⇒ exit 8 Last Revised: 08/24/2023 P P MC ATC demand curve P = MR Q* TR Page 13 LOS e - determine 2 • P •1 Q TR MC ATC Demand Curve Q MR Q* 1. MR = MC - determines optimal output TR TR Q Q Imperfect Competition Perfect Competition M.M141013373. 9 2. Demand curve determines optimal price Last Revised: 08/24/2023 Introduction to the Firm and Market Organization a. describe characteristics of perfect competition, monopolistic competition, oligopoly, and pure monopoly b. explain relationships between price, marginal revenue, marginal cost, economic profit, and the elasticity of demand under each market structure c. describe a firm’s supply function under each market structure d. describe and determine the optimal price and output for firms under each market structure e. explain factors affecting long-run equilibrium under each market structure f. describe pricing strategy under each market structure M.M141013373. 10 Last Revised: 08/24/2023 Market Structure Page 1 LOS a - describe - significant determinant of long-term profitability - factors that determine market structure Perfect Competition Monopolistic Competition Oligopoly ➀ number and relative size of firms many many few ➁ degree of product differentiation homogeneous standardized differentiated homogeneous standardized ➂ seller power over pricing decisions none some very low low df ➃ Barriers to entry/exit ➄ Degree of non-price competition • none Perfect Competition P TR Q P P infinitely elastic considerable very high Advertising/ Product Differentiation Advertising Page 2 LOS b-f - explain P Monopolistic Competition TR Q P MR price taker prices are industry determined unique high Demand Analysis = MR = AR = demand curve Q one some or considerable Advertising/ Product Differentiation differentiated product + non-price competition df = some pricing M.M141013373. power Monopoly AR = demand curve Q downward sloping demand curve since prices are firm determined 11 Last Revised: 08/24/2023 Proof: Page 2a 𝐐 = 𝐚 − 𝐛𝐏 𝐏 = 𝐚=𝐛 − 𝐛𝐐 𝐌𝐑 = 𝐦 = −𝐛 𝐓𝐑 = 𝐏 × 𝐐 𝐓𝐑 = <𝐚=𝐛 − 𝐛𝐐>𝐐 𝐓𝐑 = 𝐚=𝐛 ∙ 𝐐 − 𝐛𝐐𝟐 Perfect Competition cost/unit P economic BEP ∴ 𝐦 = −𝟐𝐛 slope of MR curve = 2x slope of demand curve Page 3 LOS b-f - describe Supply Analysis ROE > RRR MC P ATC AVC shutdown point Q level of output is determined by the MC schedule (MR = MC) df 𝐝𝐓𝐑 𝐚 = =𝐛 − 𝟐𝐛𝐐 𝐝𝐐 differentiated product + non-price P competition df = some pricing power Monopolistic Competition * no well-defined supply curve MC ATC MR Q * M.M141013373. 12 level of output determined by MR = MC but price determined by demand curve Q Last Revised: 08/24/2023 Perfect Competition MC economic profit < 0 p Optimal Price/Output Page 4 LOS b-f - describe Monopolistic Competition differentiated product ATC1 + ATC non-price P competition C MR = AR df = some ATC2 pricing economic profit > 0 power MC ATC Q Q - optimal output D MR optimal output 𝛑 = TR – TC = economic profit TR = P × Q TC = C1 × Q 𝛑 = TR - TC = economic profit > 0 Surplus Q: Why is equilibrium desirable? demand curve can be interpreted as a ‘marginal value curve’ (diminishing marginal utility) consumer surplus P1 D Q1 df Total expenditure = P1 × Q1 e.g./ 𝐐𝐝𝐱 = 180 - 2𝐏𝐱 , what is consumer surplus if 𝐏𝐱 = 65? 𝐐𝐝𝐱 = 180 - 2(65) 90 M.M141013373. = 50 Int. at 𝐐𝐝𝐱 = 0 65 50 2𝐏𝐱 = 180 𝐏𝐱 = 90 13 consumer surplus 𝟏$ bh 𝟐 = 𝟏$𝟐 (50)(90 - 65) = 625 Page 15 LOS j - calculate - interpret Last Revised: 08/24/2023 Market Structure Perfect Competition Page 5 LOS b-f - describe Long-run Equilibrium Monopolistic Competition differentiated product + MC non-price ATC1 competition P df = some MR = MC minimum = AC pricing efficient power P - economic profit > 0 encourages firm entry - drives down demand for all firms MC ATC minimum efficient scale scale Q Q - horizontal demand curve - profit max when MR = MC (= P = AC) economic profit D MR 1) MR = MC ⇒ max profit 2) P = AC ⇒ economic profit = 0 - downward sloping demand curve Single supplier + high barriers to entry = considerable pricing power patents, copyrights control over critical resources gov’t. authorization (natural monopoly) network effects - monopolist’s demand schedule = AD curve ` in that relevant AC market M.M141013373. MC QE MR Page 12 LOS b-f - explain Monopoly/ Demand analysis PE D Supply analysis/ - no well-defined supply function - profit-maximizing level of output MR = MC - more like a supply point 14 Last Revised: 08/24/2023 Page 13 LOS b-f - explain Monopoly/ Long-run equilibrium/ PR - regulated price QR - regulated output ` PM LRAC LRMC PR PC MR QM QR QC D unregulated monopoly EL = (PM,QM) regulated monopoly 1. P = LRMC + subsidy up to LRAC 2. P = LRAC (authorized monopoly) 3. National ownership M.M141013373. 15 Last Revised: 08/24/2023 Aggregate Output, Prices, and Economic Growth a. calculate and explain gross domestic product (GDP) using expenditure and income approaches b. compare the sum-of-value-added and value-of-final-output methods of calculating GDP c. compare nominal and real GDP and calculate and interpret the GDP deflator d. compare GDP, national income, personal income, and personal disposable income e. explain the fundamental relationship among saving, investment, the fiscal balance, and the trade balance f. explain how the aggregate demand curve is generated g. explain the aggregate supply curve in the short run and long run h. explain causes of movements along and shifts in aggregate demand and supply curves i. describe how fluctuations in aggregate demand and aggregate supply cause short-run changes in the economy and the business cycle j. distinguish among the following types of macroeconomic equilibria: long-run full employment, short-run recessionary gap, short-run inflationary gap, and short-run stagflation k. explain how a short-run macroeconomic equilibrium may occur at a level above or below full employment l. analyze the effect of combined changes in aggregate supply and demand on the economy m. describe sources, measurement, and sustainability of economic growth M.M141013373. n. describe the production function approach to analyzing the sources of economic growth o. define and contrast input growth and growth of total factor productivity as components of economic growth 16 Last Revised: 08/24/2023 Aggregate Output, Prices, and Economic Growth Aggregate output (AO) - value of all g/s produced in a specified time period = Aggregate Income (AI) - value of all payments earned by the suppliers of the factors of production Page 1 LOS a - calculate - explain wages, rent, interest, profit Households Indirect Investment Funds Direct - since households are the ultimate Investment owners of productive assets, plus Companies the source of all labour, it is standard to attribute all income Productive Assets to the household sector ➞ Aggregate Expenditure (AE) ➞ total amount spent on g/s produced in the domestic economy during a period AO = AI = AE = Y Page 2 LOS a - calculate - explain ➞ GDP – gross domestic product ➞ measures: a) the market value of all final g/s produced within an economy in a given period of time (output definition) - all g/s must be produced during the measurement period - excluded ➞ previous period production, transfer pmts. from gov’t. to households, capital gains - only g/s whose value can be determined by being sold in a market - only market value of final g/s are included or/ b) the aggregate income earned by all households, all companies, and the government within the economy in a given period of time (income definition) M.M141013373. ∴ Income approach ➞ GDP = total amt. of income earned (over a period) Expenditure approach ➞ GDP = total amount spent (over a period) 17 Last Revised: 08/24/2023 ➞ value of GDP based on expenditure ➞ 2 measurement methods 1/ value of final output (Exhibit #2) 2/ sum of value added (example #1) Page 3 LOS b - compare Note: g/s whose market price cannot be determined: - use of imputed price e.g. owner-occupied housing ➞ purchase/sale of houses not included ➞ estimate of ‘rent’ is included instead government services ➞ included at cost with no value-added ➞ non-market transactions, barter and black market/illegal activities are excluded ➞ Nominal vs. Real GDP/ · real GDP ➞ removes the effect of changes in the general price level Page 4 LOS c - compare - calculate - interpret · per capita real GDP ➞ real GDP/population ➞ measures the standard of living in an economy · nominal GDP ➞ value of g/s produced at current prices e.g./ output Price nominal GDP YR 1 300,000 18,750 5.625B 7% growth in nominal GDP YR 2 300,000 20,062.50 6.01875B 𝑷𝒕 × 𝑸 𝒕 M.M141013373. = 5.625B ➞ 0% growth in real GDP - real GDP ➞ 𝑷𝑩 × 𝑸𝒕 = 18,750 × 300,000 base year - if YR 2 output = 309,000, real GDPYR2 = 18,750 × 309,000 = 5.79375 B 3% growth in GDPr 18 Last Revised: 08/24/2023 ➞ GDP deflator (or implicit price deflator for GDP) 𝐆𝐃𝐏 𝐝𝐞𝐟𝐥𝐚𝐭𝐨𝐫 = 𝟏𝟎𝟎 × 𝐆𝐃𝐏𝐧 𝐧𝐨𝐦𝐢𝐧𝐚𝐥 𝐆𝐃𝐏 D × 𝟏𝟎𝟎 C⇒ 𝐆𝐃𝐏𝐫 = 𝐆𝐃𝐏 𝐝𝐞𝐟𝐚𝐥𝐭𝐨𝐫 𝐫𝐞𝐚𝐥 𝐆𝐃𝐏 - using YR2 data at 309,000 units, €20,062.50/unit = (𝟑𝟎𝟗, 𝟎𝟎𝟎 × 𝟐𝟎, 𝟎𝟔𝟐. 𝟓𝟎) 𝟐𝟎, 𝟎𝟔𝟐. 𝟓𝟎 × 𝟏𝟎𝟎 = × 𝟏𝟎𝟎 = 𝟏𝟎𝟕 (𝟑𝟎𝟗, 𝟎𝟎𝟎 × 𝟏𝟖, 𝟕𝟓𝟎) 𝟏𝟖, 𝟕𝟓𝟎 ➞ also: 𝐧𝐨𝐦𝐢𝐧𝐚𝐥 𝐆𝐃𝐏 = [(𝟏 + 𝐆𝐃𝐏𝐫 )(𝟏 + 𝐢𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧)] − 𝟏 (example #2) Page 5 LOS c - compare - calculate - interpret 𝑮𝑫𝑷𝒏 𝟏. 𝟎𝟕 e.g. output ↑ 3% prices ↑ 7% GDPn = [(1.03)(1.07)] – 1 = 10.2% Page 6 LOS d - compare ➞ Components of GDP/ GDP = C + I + G + (X – M) C = consumer spending G = government spending = GC + GI I = private domestic investment (capital goods + Inventory) X = exports M = imports GDP = (C + GC) + (I + GI) + (X – M) 𝑺𝑯 𝑺𝑯 M.M141013373. 19 Last Revised: 08/24/2023 ➞ household sector = C + S ➞ Investment (I) most volatile component of GDP ➞ Government (G), net Taxes (T) = gross taxes – transfer payments if G > T ➞ fiscal deficit included in C ➞ External Sector ➞ (X – M) < 0 ➞ trade deficit > 0 ➞ trade surplus Page 7 LOS d - compare · GDP = C + I + G + (X – M) statistical = C + (bus. Inv. + 𝚫Inventories) + (GC + GI) + (X - M) + discrepancy data are more timely and reliable · National Income = Y = net domestic Income + CFC + e.g./ NI = all income + what needs to be reinvested to wages maintain the capital return on capital stock sales tax statistical discrepancy consumption of fixed capital (i.e. depreciation) ➞ personal income = all income received by households = wages + net mixed income + net property income (whether earned or not) ➞ disposable income = personal income – net personal taxes Page 8 LOS d - compare taxes paid transfers received ➞ personal savings = disposable income – C + 𝚫pension entitlements M.M141013373. 20 some payroll taxes are for gov’t. sponsored personal pensions Last Revised: 08/24/2023 · IS ➞ Investment and Savings Y = C + I + G + (X - M) (Y – T) = C + I + (G - T) + (X – M) (Yd – C) = I + (G - T) + (X – M) ∴ S = I + (G – T) + (X – M) SB + SH net taxes ➞ ➞ ➞ ➞ subtract T from both sides (Y – T) = disposable income (Yd) subtract C from both sides (Yd – C) = S - in words, domestic savings is used to finance: · Investment · fiscal deficit · trade surpluses must hold for AE = AI Recall: AO = AE = AI if AE > AI, then AE > AO must borrow Page 9 LOS e - explain ➞ G - T > 0 = fiscal deficit ➞ X – M > 0 = trade surplus (example #4) must import Page 10 LOS f - explain AE = C ➞ an increasing function of Yd ➞ a decreasing function of r (real interest rate) MPS = 1 – MPC ⇒ larger MPC is (i.e. C/Y), greater the impact + I ➞ a decreasing function of r (cost of financing) ➞ an increasing function of AE (stronger demand = ↑ investment spending) + G ➞ G - T = G - t(Y) ➞ taxes are an increasing function of AE gov’t. expenditure treated as exogeneous ∴ fiscal balance will increase as AE decreases and decrease as AE increases ∴ deficit ∴ surplus + (X - M) ➞ decreasing functionM.M141013373. of domestic income ➞ increasing function of foreign income ➞ negatively related to the fx-rate 21 Last Revised: 08/24/2023 Aggregate Demand - quantity of g/s that households, businesses, government, and international customers want to buy at any given level of prices 𝑷𝟐 Downward slope of AD curve results from 3 effects: B A 𝑷𝟏 𝑨𝑫𝒅 𝒀𝟐 Page 11 LOS f - explain 𝒀𝟏 1/ Wealth effect: a rise in the general price level (𝑷𝟏 to 𝑷𝟐 ) decreases the quantity of g/s that can be purchased with a fixed quantity of nominal wealth i.e. consumers are less wealthy and Downward slope of AD curve results from 3 effects: ∴ demand fewer g/s Page 12 LOS f - explain 2/ Interest Rate Effect: as 𝑷 changes, demand for money changes - as 𝑷 ↑, demand for money increases - since the money supply is fixed, the price of money ↑ - price of money = the interest rate - as 𝑷 ↓, less demand to hold money, more investment, bond prices ↑, interest rates ↓ - as 𝑷 ↑, more demand to hold money, less investment, bond prices ↓, interest rates ↑ - as 𝒓 ↑, businesses invest less since borrowing costs ↑, consumers M.M141013373. finance fewer big-ticket items (durable goods) in total, as 𝑷 ↑, demand for money ↑, 𝒓 ↑, which leads to AD ↓ 𝑷↓ ↓, ↓ ↑ 22 Last Revised: 08/24/2023 Downward slope of AD curve results from 3 effects: 3/ the real exchange rate Page 13 LOS f - explain as 𝑷 ↑, real exchange rate ↑ - makes domestic g/s more expensive in other countries - reduces exports - also makes foreign goods less expensive ➞ raising imports ∴ (𝐱 − 𝐦) ↓ - Recall: as 𝑷 ↑, 𝒓 ↑, capital inflows raise demand for the local currency and thus the real exchange rate increases - reverse for 𝑷 ↓ drop in AD rise in AD M.M141013373. 23 Page 14 LOS f - explain Last Revised: 08/24/2023 Page 15 LOS g - explain determined by potential GDP short-run ➞ wages and raw material prices somewhat inflexible - as price level rises, companies increase output deflationary inflationary companies will +/- output without changing prices full employment or natural level of output all costs adjust higher, selling prices are higher, profit margins revert to the mean ➞ AS is unaffected but the price level is higher ➞ Shifts in AD/AS Page 16 LOS h - explain long-run growth rate of GDP SRAS2 SRAS1 SRAS2 AD2 Y1 expansion AD1 Y2 expansion business cycle SRAS1 contraction - business cycle is a direct result of short-run fluctuations of real GDP AD2 Y2 Y1 contraction - Shifts in AD/ M.M141013373. 1/ household wealth ➞ wealth effect: more wealth, less current savings, more current consumption (AD ➞ right) 2/ consumer and business – confidence increases, MPC ↑, MPI ↑ expectation (AD ➞ right) 24 AD1 Last Revised: 08/24/2023 - Shifts in AD/ 3/ Capacity utilization > 82% to 85%, I ↑ (AD ➞ right) 4/ Fiscal policy ➞ G ↑ or T ↓, C ↑ (AD ➞ right) 5/ Monetary policy ➞ increase money supply by: a) buying securities from banks b) lowering the required reserve ratio c) reducing target interest rate as M ↑, AD ➞ right 6/ Exchange rate – affect the price of X and M ↓ fx-rate ➞ ↑X, ↓ M AD ➞ right 7/ Global growth ➞ higher X, AD ➞ right Page 17 LOS h - explain (example #8) Page 18 LOS h - explain · Shifts in SRAS/ - factors that change cost of production or expected profit margins will cause SRAS to shift plus: factors that shift LRAS will also shift SRAS in the same way 1/ changes in nominal wages ↑ W raises production costs ➞ SRAS ➞ left no impact on LRAS ↑ W may be offset by ↑ productivity %𝚫 unit labour cost = %𝚫W - %𝚫productivity (example #9) 2/ changes in input prices ↑ RM prices raise cost of production SRAS ➞ left 3/ change in expectations about future prices ➞ expectations of being able to increase prices in future SRAS ➞ right - but temporary and small (difficult to predict impact) 4/ changes in business taxes and subsidies ↑ T and ↓ S raise production costs/unit SRAS ➞ left 5/ changes in fx-rate – higher fx-rate, ↓ Mp ➞ if those are RM, lowers production costs SRAS ➞ right M.M141013373. 25 Last Revised: 08/24/2023 · Shifts in LRAS/ 1/ Supply of Labour · population · participation rate · net immigration Page 19 LOS h - explain ↑ workforce, ↑ potential GDP LRAS ➞ right 2/ supply of natural resources – increased availability LRAS ➞ right 3/ supply of physical capital – increased capital stock, increase in productive capacity LRAS ➞ right 4/ supply of human capital – higher quality of labour, ↑ potential GDP LRAS ➞ right · training · education · skills 5/ Labour productivity and technology – more efficient workforce, higher output per hour worked, lower production costs/unit - typically obtained through technological advances LRAS ➞ right (example #10, #11) P LRAS - long-run full employment equilibrium - AD intersects SRAS on the LRAS curve - economy is at potential GDP Page 20 LOS i - explain SRAS growth rate AD Y1 P SRhg ← level P1 LRg SRLg expansion contraction Y LOS j - distinguish LRAS SRAS P1 P2 AD2 Y2 Y1 LRg AD1 Recessionary gap/ ➞ left = lower Y, lower P AD M.M141013373. - companies cut production, cut workforce (movement along SRAS) - recessionary gap = (Y1 – Y2) - equilibrium GDP < potential GDP Y 26 Last Revised: 08/24/2023 Page 21 LOS j, k - Recessionary gap ➞ Investment Implications - distinguish - reduce investments in cyclical · corporate profits decline - explain companies, commodities, or · commodity prices decline commodity–oriented companies, and · interest rates decline speculative equity companies · demand for credit declines - increase investments in defensive stocks, IG/gov’t. long-term bonds LRAS P2 Inflationary gap – economic expansion, real GDP and employment increase SRAS - higher output at higher prices - companies increase production, may have to compete on wages to attract employees AD2 - inflationary gap = (Y2 – Y1) - equilibrium GDP > potential GDP AD1 Y1 Y2 - Inflationary gap ➞ Investment · corporate profits rise · commodity prices increase · interest rates rise · inflationary pressure builds P LRAS SRAS2 SRAS1 P2 P1 Page 22 Implications LOS j, k - increase investments in cyclical - distinguish - explain companies, commodities, or commodity–oriented companies, and speculative fixed-income securities - reduce investments in defensive stocks, IG/gov’t. long-term bonds Stagflation ➞ SRAS shifts to the left - lower output at higher prices - higher unemployment, higher inflation - reduce exposure to both equities and fixed income - increase exposure to commodities M.M141013373. AD Y2 ← Y1 Y 27 Last Revised: 08/24/2023 Page 23 LOS L - analyze (example #13) LOS m - describe - economic growth is calculated as %𝚫 in real GDP has a limit ➞ sustainable growth rate of increase in the economy’s productive capacity or potential GDP LRAS – the factors that shift LRAS right also increase potential GDP Page 24 · Y = AF(L, K) - output depends on inputs L and K LOS n and the level of technology (A) - describe Y = output L = labour constant returns to scale ➞ double the inputs, double the K = capital outputs A = total factor productivity ➞ Diminishing returns to scale with respect to any individual input · as K increases while holding L and A constant, output increases at a decreasing rate Y/L M.M141013373. Y/LA developed economy output gap Y/LO developing economy K/LO K/LA K/L 28 developing economy growth rate developed economy growth rate Last Revised: 08/24/2023 ➞ Growth in potential GDP = growth in technology + WL (growth in Labour) + WC (growth in capital) 𝐖𝐋 = 𝐖𝐚𝐠𝐞𝐬 𝐆𝐃𝐏 𝐖𝐂 = 𝐈 − 𝐖𝐋 Page 25 LOS n - describe 𝐜𝐨𝐫𝐩𝐨𝐫𝐚𝐭𝐞 𝐩𝐫𝐨𝐟𝐢𝐭𝐬, 𝐧𝐞𝐭 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 relative shares of capital and labour in national income 𝐢𝐧𝐜𝐨𝐦𝐞, 𝐧𝐞𝐭 𝐫𝐞𝐧𝐭𝐚𝐥 𝐢𝐧𝐜𝐨𝐦𝐞, 𝐝𝐞𝐩𝐫𝐞𝐜𝐢𝐚𝐭𝐢𝐨𝐧 𝐆𝐃𝐏 e.g. U.S. ➞ WL = .7 ∴ ↑ in L will have a larger effect ➞ WC = .3 on GDP than an increase in K ➞ Growth in per capita GDP = growth in technology + WC (growth in K/L) · daycare · child benefits Page 26 LOS o - distinguish ➞ Sources of Economic Growth/ immigration 1/ Labour Supply (quantity variable) ➞ labour force = participation rate × population ➞ potential size (quantity) = labour force × Avg. hours worked per worker business cycle 2/ Human Capital (quality variable) sensitive - education, training, experience 3/ Physical Capital Stock – increases from year to year as long as net investment is positive (gross Inv. – Dep.) 4/ Technology – most important factor - allow economies to overcome the limits imposed by M.M141013373. diminishing marginal returns TFP growth = growth in potential GDP – [WL (growth in labour) + WC (growth in Capital)] residual 29 Last Revised: 08/24/2023 ➞ Sources of Economic Growth/ renewable (forest) 5/ Natural Resources non-renewable (oil) imports can overcome these deficits Page 27 LOS o - distinguish ➞ Measures of sustainable growth/ - recall the growth accounting equation: 𝐠𝐫𝐨𝐰𝐭𝐡 𝐢𝐧 𝐠𝐫𝐨𝐰𝐭𝐡 𝐢𝐧 𝐆𝐫𝐨𝐰𝐭𝐡 𝐢𝐧 𝐠𝐫𝐨𝐰𝐭𝐡 𝐢𝐧 = + 𝐖𝐋 < > + 𝐖𝐂 C D 𝐩𝐨𝐭𝐞𝐧𝐭𝐢𝐚𝐥 𝐆𝐃𝐏 𝐭𝐞𝐜𝐡𝐧𝐨𝐥𝐨𝐠𝐲 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 𝐋𝐚𝐛𝐨𝐮𝐫 unobservable unobservable ∴ focus on labour productivity = data may not be available 𝐑𝐞𝐚𝐥 𝐆𝐃𝐏 𝐀𝐠𝐠𝐫𝐞𝐠𝐚𝐭𝐞 𝐇𝐨𝐮𝐫𝐬 both observable depends on · K/L · A ∴ growth in = LT growth rate of labour force + LT labour productivity growth potential GDP rate M.M141013373. 30 Last Revised: 08/24/2023 Introduction to Business Cycles a. describe how resource use, consumer and business activity, housing sector activity, and external trade sector activity vary as an economy moves through the business cycle b. describe types of unemployment, and compare measures of unemployment c. explain inflation, hyperinflation, disinflation, and deflation d. explain the construction of indexes used to measure inflation e. compare inflation measures, including their uses and limitations f. contrast cost-push and demand-pull inflation M.M141013373. 31 Last Revised: 08/24/2023 Understanding Business Cycles average hours worked bearish bullish big theme bullish capacity utilization rates this determines move into high operating leverage sectors - bullish for capital equipment this keeps demand for employment M.M141013373. low preserve cash flow 32 Last Revised: 08/24/2023 Consumer Spending - less cyclical than investment spending economic data ➞ Consumer confidence, ISM Services, Retail Sales Household Incomes ➞ 𝒀𝒅 - disposable income positively related to spending on durable goods - permanent income: excludes temporary income and unsustainable losses and gains ➞ correlates well with non-discretionary spending Household Savings ➞ ↑ 𝑺 may indicate future caution stock of 𝑺 may indicate future consumption potential without a need for ↑ Incomes Housing Sector Behavior New/Existing Home Sales (Demand) M.M141013373. Building Permits (Supply - construction activity) HPI - Housing Price Index (median home prices) 33 Last Revised: 08/24/2023 𝐈 C D − 𝐥𝐨𝐰 𝐀𝐯𝐠. $ Housing Sector Behavior 𝒓↓ low ratio begins to work against higher housing prices rates rise 𝒓↑ HPI low rates support prices rising incomes rates still supportive housing prices rising 𝐈 C D − 𝐡𝐢𝐠𝐡 𝐀𝐯𝐠. $ construction rises construction drops - late buyers (momentum and speculation) - encourages overbuilding - inventories rise rate of family formation a key influence External Trade Sector Behavior imports peak imports drop imports increase domestic economy below average ROW (primary trading partners) exports drop exports rise high rate encourages imports discourages exports FX-rate low rates ↓ imports ↑ exports M.M141013373. Trade Balance data. 34 short-term fluctuations have minimal effect need to move in one direction for some time Last Revised: 08/24/2023 low unemployment ‘tight labour market’ - potential for price-wage inflationary (few available workers spiral + escalators tied to CPI) high unemployment Terminology: Employed: those with a job Labour force: those with a job + those looking for a job (employed) (unemployed) Unemployed: those without a job but looking long-term unemployed ➞ 3-4 months but still looking frictionally unemployed ➞ natural movement from job-to-job Unemployment Rate: 𝐔𝐧𝐞𝐦𝐩𝐥𝐨𝐲𝐞𝐝= 𝐋𝐚𝐛𝐨𝐮𝐫 𝐟𝐨𝐫𝐜𝐞 Terminology: 𝐋𝐚𝐛𝐨𝐮𝐫 𝐟𝐨𝐫𝐜𝐞 Activity Ratio (Participation Rate): 𝐏𝐨𝐩𝐮𝐥𝐚𝐭𝐢𝐨𝐧 of working age Underemployed: has a job below qualifications (16 to 64) or has PT but wants FT Discouraged worker: person who has stopped looking for work - not counted as unemployed Voluntarily unemployed: person who could get a job but refuses the work Unemployment Rate: surveys (US BLS) claims for UI M.M141013373. all working age regardless of willingness - lagging indicator - labour force responds to the economic environment - changes in participation rate produce paradoxical results - business response does not lead 35 Last Revised: 08/24/2023 Productivity = Output/Hours worked (leading to coincident) hours/OT cut temporary staff cuts productivity drops F/T job cuts - payrolls Add F/T jobs drop Add P/T or temporary workers productivity rises increase in hours/overtime Economic Data: Payrolls (PT/FT) Hours worked Temporary Workers Inflation: a sustained rise in the overall level of prices - the same amount of money purchases fewer goods (erodes purchasing power and real incomes) - pro-cyclical with a lag (a year or more) Inflation Rate = 𝐏𝐫𝐢𝐜𝐞 𝐈𝐧𝐝𝐞𝐱 𝟏 − 𝐏𝐫𝐢𝐜𝐞 𝐈𝐧𝐝𝐞𝐱 𝟎 𝐏𝐫𝐢𝐜𝐞 𝐈𝐧𝐝𝐞𝐱 𝟎 - lagging indicator Inflation Expectations - leading indicator, especially for the direction of monetary policy Terminology: Deflation: a sustained decrease in the aggregate price level (value of money increases) Hyperinflation: an extremely fast increase in the aggregate price level - typically as a result of a rapid increase in the money supply M.M141013373. Disinflation: a decline in the rate of increase e.g. YR1 - 3% YR2 - 2.5% 36 YR3 - 2% YR4 - 1.5% Last Revised: 08/24/2023 Measuring Inflation: Price Index ➞ the average prices of a representative basket of goods/services Laspeyres Index - composition of the representative basket held constant as of a base year (updated every 5 years) e.g. YR0 YR1 YR2 𝑾𝑸𝟎 × 𝑷𝟎 𝑾𝑸𝟎 × 𝑷𝟏 𝑾𝑸𝟎 × 𝑷𝟐 Index = *𝑾𝑸𝟎 × 𝑷𝟏 . × 𝟏𝟎𝟎 𝑾𝑸𝟎 × 𝑷𝟎 Inflation = 𝐈𝐧𝐝𝐞𝐱 𝟏 * .−𝟏 𝐈𝐧𝐝𝐞𝐱 𝟎 Rate Issues/ substitution ➞ if the basket is not adjusted, results in an upward bias can use quality ➞ if not adjusted for, results in an upward bias new products ➞ not included until update - results in an upward bias hedonic pricing chained Price Index - solves substitution bias Fisher Index . 𝑰𝑷 × 𝑰𝑳 Laspeyres Index Paasche Index 𝑾𝑸𝟏 × 𝑷𝟏 𝑾𝑸𝟏 × 𝑷𝟎 current basket 𝑾𝑸𝟎 × 𝑷𝟏 𝑾𝑸𝟎 × 𝑷𝟎 constant basket - different names, weights, methodologies CPI-U reflecting HICP domestic conditions M.M141013373. PCE and preferences or constraints 37 household survey - urban vs. rural business survey LOS i - compare CPI-U PCE Last Revised: 08/24/2023 𝑰𝑳 = C 𝟓𝟏𝟓 D × 𝟏𝟎𝟎 = 𝟏𝟏𝟐. 𝟒𝟒 𝟒𝟓𝟖 𝑰𝑷 = C 𝟓𝟓𝟎 D − 𝟏 = 𝟏𝟏𝟔. 𝟎𝟑 𝟒𝟕𝟒 𝐅𝐢𝐬𝐡𝐞𝐫 = √𝟏𝟏𝟐. 𝟒𝟒 × 𝟏𝟏𝟔. 𝟎𝟑 = 𝟏𝟏𝟒. 𝟐𝟐 2019 50 x 3 = 150 70 x 4.4 = 308 458 2019 70 x 3 = 210 60 x 4.4 = 264 474 2020 50 x 4 = 200 70 x 4.5 = 315 515 2020 70 x 4 = 280 60 x 4.5 = 275 550 chained Price Index - solves substitution bias Fisher Index . 𝑰𝑷 × 𝑰𝑳 Laspeyres Index Paasche Index 𝑾𝑸𝟏 × 𝑷𝟏 𝑾𝑸𝟏 × 𝑷𝟎 current basket 𝑾𝑸𝟎 × 𝑷𝟏 𝑾𝑸𝟎 × 𝑷𝟎 constant basket M.M141013373. - different names, weights, methodologies CPI-U reflecting HICP domestic conditions PCE and preferences or constraints 38 household survey - urban vs. rural business survey CPI-U PCE Last Revised: 08/24/2023 Producer Price Index - measures price changes paid by domestic producers - may lead to changes in CPI (fuels, farm products, machinery and equipment by raw materials, intermediate goods and finished goods) - bonds, contracts, leases, pensions, labour contracts ➞ may be indexed to some price index - different central banks follow different measures ECB - HICP India - WPI US - PCE (Fisher Index) - Nominal GDP adjusted to real GDP by a price index - called a price deflator - headline vs. core ➞ strips out volatile components (energy and food) Cost-Push Inflation: rising costs (usually wages) compel business to raise prices largest input cost. very little excess wage inflation pressure NAIRU non-accelerating inflation rate of unemployment rising excess wage inflation pressure (natural rate of unemployment) Indicators: hourly wages, weekly earnings 𝐓𝐨𝐭𝐚𝐥 𝐰/𝐡𝐫 - must consider productivity: Unit Labour Cost = 𝐎𝐮𝐭𝐩𝐮𝐭/𝐡𝐫 M.M141013373. typically rise in tight labour markets 39 Last Revised: 08/24/2023 Demand-Pull Inflation: Capacity utilization closer to Actual output vs. potential capacity, greater pressure on prices Commodity Prices - input costs Monetarists/ too much money (increases in the money supply in excess of trend growth) Assessing inflationary potential/ Velocity = 𝐍𝐨𝐦𝐢𝐧𝐚𝐥 𝐆𝐃𝐏 𝐦𝐨𝐧𝐞𝐲 𝐬𝐮𝐩𝐩𝐥𝐲 if velocity ↓ due to 𝑴 ↑, may be inflationary if velocity ↑ due to 𝒏𝑮𝑫𝑷 ↑, may be disinflationary or deflationary Inflation expectations ➞ may become self-fulfilling M.M141013373. 40 Last Revised: 08/24/2023 Monetary and Fiscal Policy a. compare monetary and fiscal policy b. describe functions and definitions of money c. explain the money creation process d. describe theories of the demand for and supply of money e. describe the Fisher effect f. contrast the costs of expected and unexpected inflation M.M141013373. 41 Last Revised: 08/24/2023 Monetary & Fiscal Policy Government Central Banks interest rates money supply spending Taxation attempt to engineer an economy where: 1) growth is stable and positive 2) inflation is stable and low (pos.) Money tions c n u · medium of exchange f · store of value · unit of account defin ities must: qu al · be readily acceptable · have a known value · be easily divisible · have a high value:weight ratio · be difficult to counterfeit itions What constitutes money? - broad def’n narrow def’n - narrow + coins/notes in circulation - savings/money market accts. demand deposits chequing account balances - time deposits < 100k - retail money – market/mutual fund traveller’s cheques of accts. non-bank issuers (M2) (M1) Money Creation promissory M.M141013373. note exchange exchange exchange Gold Goldsmith 42 Last Revised: 08/24/2023 promissory note exchange exchange exchange Gold Goldsmith loan now: more promissory notes than money there is gold for creation ⇒ fractional reserve banking process Example: Reserve Requirement = 10% Bank 1 Bank 2 Bank 3 res. 10 100 dep. res. 9 90 dep. 81 dep. etc… loan 90 loan 81 purchases seller purchases seller Σ of money created = 𝐧𝐞𝐰 𝐝𝐞𝐩𝐨𝐬𝐢𝐭 𝐫𝐞𝐬. 𝐫𝐞𝐪. 𝟏 money multiplier = 𝐫𝐞𝐬. 𝐫𝐞𝐪. i.e. 𝟏𝟎𝟎 = $𝟏𝟎𝟎𝟎 .𝟏 𝟏 = 𝟏𝟎 .𝟏 Set by central bank ⇒ ∴ Monetary Policy tool Quantity Theory of Money - in words: the amount of money real output used to buy stuff = the price quantity of monetary value of output level M.M141013373. money - since we assume V is constant: velocity of money then spending (P × Y) is proportional to M (money supply) M × V = P × Y Money neutrality ⇒ is M ↑, only P ↑ (Monetarist Theory) 43 Last Revised: 08/24/2023 Demand for Money transactions · pro-cyclical · 𝐭𝐫𝐚𝐧𝐬. 𝐛𝐚𝐥. ⇒ fairly stable 𝐆𝐃𝐏 MS2 I precautionary · rainy day fund speculative · inversely related to asset yields (counter-cyclical) · positively related to perceived risk Supply & Demand MS MS1 I1 I0 I2 MD M1 M0 M2 M @ I1 - excess MS (M0 – M1) ∴ less speculative demand - demand for yield drives prices up and I ↓ @ I2 – excess MD (M2 – M1) ∴ more speculative demand - less demand for yielding assets drives I ↑ The Fisher Effect ⇒ in words first: the real rate of interest is stable over time ∴ changes in nominal rates are the result of changes in expected inflation Rnom = Rreal + 𝝅𝒆 But: who knows? uncertaintyM.M141013373. = risk ∴R nom a required real return inflation expectation premium risk premium 44 Last Revised: 08/24/2023 Costs of Inflation High Inflation Expected & Predictable ⇒ wages could increase by the expectation ⇒ nominal interest rates would be set to the expectation ⇒ prices would reflect the expectation ⇒ ⇒ · Expectations would become reality ⇒ ⇒ M.M141013373. 45 Unexpected Unpredictable lagging incomes - shoe leather costs (unwillingness to hold cash balances) borrowers benefit at expense of lenders (too high) (so rates will include an uncertainty premium) frequent price changes - menu costs reduces the information content of prices Last Revised: 08/24/2023 International Trade and Capital Flows a. compare gross domestic product and gross national product b. describe benefits and costs of international trade c. contrast comparative advantage and absolute advantage d. compare the Ricardian and Heckscher-Ohlin models of trade and the source(s) of comparative advantage in each model e. describe the balance of payments accounts including their components f. explain how decisions by consumers, firms, and governments affect the balance of payments M.M141013373. 46 Last Revised: 08/24/2023 International Trade GDP GNP vs. (more in use) located within a country/economy the market value of final g/s produced by factors of supplied by citizens of a country production (either in or out of country) ∴ production of g/s by in production outside the country by its citizens out country Closed vs. X 0 0 0 𝐞𝐱𝐩𝐨𝐫𝐭 𝐩𝐫𝐢𝐜𝐞 𝐢𝐧𝐝𝐞𝐱 𝐢𝐦𝐩𝐨𝐫𝐭 𝐩𝐫𝐢𝐜𝐞 𝐢𝐧𝐝𝐞𝐱 set to 100 in same base year - M ⇒ balanced ⇒ surplus ⇒ deficit open autarky ⇒ autarkic prices in Terms of trade: ROW imports (Y) exports (X) Net exports = = > < out foreigners in the country world prices M.M141013373. 47 > 100 ⇒ fewer exports needed to pay for the same level of imports terms of trade improved < 100 ⇒ more exports needed to pay for the same level of imports terms of trade worsened Last Revised: 08/24/2023 Free trade ⇒ no gov’t. restrictions on trade vs. ⇒ global AD & AS determine Eq & Ep of X/M Trade Protection ⇒ tariffs, quotas, etc… Dom. S PA P1 trade @ P1 tradeoff lower P Dom. D lower dom. production GJ GA Gk lower dom. excess demand employment imports P2 PA excess supply Dom. S GC GA GD tradeoff higher P Dom. D higher dom. prod. & empl. trade @ P2 exports if the trade affected sector is labour intensive: exports - positive imports - negative Benefits: countries gain from exchange & specialization industries experience greater economies of scale households/firms have greater product variety competition is increased resources allocated more efficiently exports occur @ higher prices imports occur @ lower prices reduces monopoly power of domestic firms trade Costs: + GDP efficient allocation higher productivity knowledge spillovers pace of innovation comp. necessity incentives potential for greater income M.M141013373. inequality loss of jobs in developed countries = structural unemployment (most difficult to fix) 48 Last Revised: 08/24/2023 Gains from Trade Absolute Advantage ⇒ make it cheaper than other trading partners Comparative Advantage ⇒ opportunity cost of making output is lower than opportunity cost of trading partners U.K. India Mach. 4 2 U.K. 2-cloth India 8-cloth Cloth 8 16 𝟏9 mach. 𝟐 𝟏9 mach. 𝟖 U.K. India Mach. 4 2 U.K. 2-cloth India 3-cloth if U.K. could sell 1 mach. > 2 cloth & India could buy 1 mach. < 8 cloth win - win Cloth 8 6 𝟏9 mach. 𝟐 𝟏9 mach. 𝟑 @3 U.K. wins a bit India wins a lot @7 U.K. wins a lot India wins a bit Cloth PA CA CG 1600 - 400 200 240 Ø 400 640 1200 - 160 1600 800 960 400 300 400 1600 400 - PF UK P 100 200 1200 1600 M.M141013373. 400 U.K. (200, 400) India (100, 800) 49 - 100 - Ø PPF India 800 - - U.K. Machines 200 400 Cloth India Machines 100 Cloth 800 World Machines 300 Cloth 1200 PG Machines 1 mach. = 2 cloth 1 mach. = 8 cloth Last Revised: 08/24/2023 Cloth 120 - Pt - world price line - new consumption possibilities line a.k.a trading possibilities line m = opp. cost of X in terms of Y in the world market 90 - PA 60 - Autarkic Price 30 - Line I1 A (60,60) 𝐐𝐲 = 𝐈=𝐏 − 𝐲 90 Comparative Advantage 1. Ricardian ⇒ trade is based on technological differences ⇒ results in differences in labour productivity (comp. adv.) Assumptions: Labour is the only variable factor input Technology varies across countries # of hours to make X/Y aLX ≠ bLX if aLX > bLX b make X aLY ≠ bLY if aLY < bLY a makes Y - - - - 60 120 ∴@ Pt A −𝐏𝐱 = opp. cost of 𝐏𝐲 x in terms of B (120,30) 30 𝐏𝐱 𝐐 𝐏𝐲 𝐱 Machines Y in the 2. Hecksher-Ohlin ⇒ trade is based on endowment of factors of production ⇒ comp. adv. lies in goods produced with relatively abundant factor X - cap. int. 𝐊 𝐊 C D > C D Y - Lab. int. 𝐋 𝐀 𝐋 𝐁 labour abundant cap. abundant country (Y) country (X) Assumptions: Identical technologies within industries across countries M.M141013373. Both L & K are variable factor inputs 50 Last Revised: 08/24/2023 Balance of Payments Double Entry Debits increases in real assets Credits decreases in real assets increases in financial assets decreases in financial assets decreases in financial liabilities increases in financial liabilities exports imports financial transactions transfer payments Components 1. Current Account - measures the flow of g/s 2. Capital Account - measures the transfer of capital 3. Financial Account - records investment flows BOP identity: 1 = 2 + 3 A = L + OE Current Account 1. Merchandise trade - all commodities and manufactured goods bought, sold, given away 2. Services e.g. - tourism, transportation, engineering, business services - fees on patents, copyrights 3. Income Receipts - dividends, interest (software, books, movies) 4. Unilateral transfers - one-way transfer of assets Capital Account - foreign direct aid - income earned from abroad sent back home 1) Capital transfers ⇒ debt forgiveness, migrants transfers, gift/inheritance taxes, death duties, transfer of funds linked to the sale/purchase of fixed assets M.M141013373. 2) Sale and purchase of non-produced, non-financial assets - rights to natural resources, sale/purchase of intangible assets 51 Last Revised: 08/24/2023 Financial Account 1) financial assets abroad official reserve assets government assets private assets gold forex securities 2) foreign owned financial assets within the country official assets bonds, stocks, MBS Examples other foreign assets - direct inv. - foreign liabilities sell $50M of goods terms: 90 days (Acts. Rec.) (Inv.) ($1M in transp. costs) Financial Account $50M Current Account $50M goods $49M services $1M Examples 2) import $45M, terms of 90-days Current Account $45M Financial Account $45M (Inv.) (Acts. Pay.) 3) Buy $100M in bonds from foreign country (same currency) (Invest)+ Financial Account $100M (cash)Financial Account $100M 4) Switzerland $20 EUR CHF local bank sell EUR so, instead replace CHF SNB buy EUR will affect EUR.CHF (Cash) Fin. Act. $20M M.M141013373. (st. Liab.) Fin. Act. $20M 52 German Bank deposits rather than sells (foreign reserves) Last Revised: 08/24/2023 Recall: Y = C + I + G + (X - M) equals the current account balance measures the size and direction of international borrowing (lending) < 𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐜𝐚𝐩𝐢𝐭𝐚𝐥 + 𝐟𝐢𝐚𝐧𝐧𝐜𝐢𝐚𝐥 <=< < 𝐚𝐜𝐜𝐨𝐮𝐧𝐭 𝐚𝐜𝐜𝐨𝐮𝐧𝐭 hence the term ‘balance’ of payments So, Y = C + I + G + (X - M) (X - M) = Y - C - I - G or CA = Y - (C + I + G) Recall: Yd = Y - (T + R) and Yd = C + Sp or C = Yd - Sp = Y - (T + R) - Sp if CA < 0, then must borrow from abroad if CA > 0, must be lending abroad CA = = = = = Y - [(Y - (T + R) - Sp) + I + G] Y - (Y + R + T - Sp + I + G) Y - Y - R + T + Sp - I - G) Sp + T - R - I - G Sp - I + (T - G - R) CA = Y - (C + I + G) -10 20 10 CA = Sp - I + Sg CA + I = Sp + Sg dom. I gov’t. surplus Sg or Sp = I + CA - Sg or CA = Sp + Sg - I if CA < 0, dom. I can be > Sp + Sg CA < 0 M.M141013373. 53 if Sp to low I is too high Sy < 0 Last Revised: 08/24/2023 Currency Exchange Rates a. define an exchange rate and distinguish between nominal and real exchange rates and spot and forward exchange rates b. calculate and interpret the percentage change in a currency relative to another currency c. describe functions of and participants in the foreign exchange market d. explain the effects of exchange rates on countries’ international trade and capital flows M.M141013373. 54 Last Revised: 08/24/2023 FX - Market USD EUR GBP JPY CAD AUD NZD NOK SEK CHF RVB SGD etc… individual currencies So… EUR.USD = EUR.USD = 1.0950 exchange rates price 𝐔𝐒𝐃= 𝐄𝐔𝐑 if 𝐔𝐒𝐃= 𝐄𝐔𝐑 et1 = 1.0950 et2 = 1.0900 USD appreciated or EUR depreciated · Nominal exchange rate Page 1 EUR.USD USD.CAD GBP.USD USD.JPY base USD.CAD = 1.3925 in terms of A/B 𝐔𝐒𝐃 = 𝟏. 𝟎𝟗𝟓𝟎 𝐄𝐔𝐑 buys (1) need 𝐂𝐀𝐃 = 𝟏. 𝟑𝟗𝟐𝟓 𝐔𝐒𝐃 (1) to get Page 2 EUR.USD or 𝐔𝐒𝐃=𝐄𝐔𝐑 C𝐒𝒅7 D spot rates Now, let’s assume 𝒇 1) a world of homogenous g/s d - domestic direct 2) no market frictions f - foreign 3) no trade barriers (i.e. capital restrictions) 𝑺𝒇 indirect = 𝒅 if an iPad cost £ 500 or $750, we would expect 𝐔𝐒𝐃= [GBP.USD = 1.5000] 𝐆𝐁𝐏 = 𝟏. 𝟓𝟎𝟎𝟎 called Purchasing Power Parity (theory) for ∀ goods/baskets rarely satisfied (if ever) Reality Check: nominal exchange rates exhibit persistent M.M141013373. deviations from PPP 55 Last Revised: 08/24/2023 Page 3 Real Exchange Rates A if 𝐀=𝐁 ↑ (B.A) or if 𝐂𝐏𝐈𝐁 ↑ · A-lander will suffer a loss of PP in terms of B-land g/s B you live in A-land… and want to buy from B-land ① foreign price level in domestic = 𝑺𝑨7𝑩 × 𝑪𝑷𝑰𝑩 currency and if CPIA = price level in A - land real exchange 𝑪𝑷𝑰𝑩 𝑺 = 𝑨7 × rate 𝑩 𝑪𝑷𝑰𝑨 Real Exchange Rates Example/ GBP real fx-rate = so, if 𝑺𝑮𝑩𝑷7 𝑬𝑼𝑹 But: if 𝐂𝐏𝐈𝐀 ↑ (and I & CPI move together) · A-lander will gain PP in terms of B-land g/s Page 4 want to EUR buy g/s 𝑺𝑮𝑩𝑷7 𝑬𝑼𝑹 × 𝐂𝐏𝐈𝐄𝐔𝐑 𝐂𝐏𝐈𝐆𝐁𝐏 ↑ 10%, 𝐂𝐏𝐈𝐄𝐔𝐑 ↑ 5%, 𝐂𝐏𝐈𝐆𝐁𝐏 ↑ 2% - what is the change in the real fx-rate? 𝟏 + %𝚫𝐂𝐏𝐈𝐄𝐔𝐑 𝟏. 𝟎𝟓 ‚ − 𝟏 = C𝟏. 𝟏𝟎 × D = 𝟏𝟑. 𝟐𝟑 𝑬𝑼𝑹 𝟏 + %𝚫𝐂𝐏𝐈𝐆𝐁𝐏 𝟏. 𝟎𝟐 shortcut ∼ 10% + 5% - 2% ∴ real fx-rate is 13.23% higher = 13% - means ⇒ need 13.23% M.M141013373. more £ to buy same g/s in £ •<𝟏 + %𝚫𝐒𝑮𝑩𝑷7 >× 56 Last Revised: 08/24/2023 Page 5 Real Exchange Rates Example/ real CNY of 𝐂𝐍𝐘= 𝐔𝐒𝐃 ↓ 𝟑% (1) buys fx-rate USD to get 1 USD.CNY ↓ 𝟑% needs so, CNY appreciated against USD. CPICNY = 4.5% 𝟏. 𝟎𝟏𝟓 𝟏. 𝟎𝟏𝟓 real fx. rate •𝟏 + (−. 𝟎𝟑) × ‚ − 𝟏 = C. 𝟗𝟕 × D − 𝟏 = −𝟓. 𝟕𝟖% 𝟏. 𝟎𝟒𝟓 𝟏. 𝟎𝟒𝟓 (shortcut -3% + 1.5% - 4.5% = -6%) means ⇒ need 6% less CNY to buy same g/s in USD CPIUSD = 1.5% e.g./ Setup: hold bonds in HKD, live in AUD 1) if 𝐒𝐀𝐔𝐃7 ↑, HKD bonds ↑ in AUD terms? 𝑺 <𝐒𝐀𝐔𝐃7 > = < 𝒅=𝐟> 𝐇𝐊𝐃 𝐇𝐊𝐃 yes, if 𝐒𝐀𝐔𝐃7 2) if 𝐒𝐀𝐔𝐃7 𝐇𝐊𝐃 𝐇𝐊𝐃 ① 3) if CPIAUD ↑, HKD buys more AUD. ↑, relative purchasing power in HKD ↑ no, HKD buy more AUD, but they do not buy more g/s denominated in HKD ② ↑, then 𝐫𝐞𝐚𝐥𝐀𝐔𝐃7 ↑ ⇒ implies that relative 𝐇𝐊𝐃 purchasing power of AUD income is higher 𝐂𝐏𝐈𝐇𝐊𝐃 𝐂𝐏𝐈𝐇𝐊𝐃 × ① no 𝐒𝐀𝐔𝐃7 (if CPI ↑, ↓, 𝐫𝐞𝐚𝐥𝐀𝐔𝐃7 ↓) 𝐇𝐊𝐃 𝐂𝐏𝐈𝐀𝐔𝐃 𝐂𝐏𝐈𝐀𝐔𝐃 𝐇𝐊𝐃 ② no if 𝐫𝐞𝐚𝐥𝐀𝐔𝐃7 𝐇𝐊𝐃 ↑, purchasing power of AUD ↓ M.M141013373. 57 Page 5b Last Revised: 08/24/2023 Page 5c e.g./ Setup: hold bonds in HKD, live in AUD 4) if 𝐒𝐀𝐔𝐃7 𝐇𝐊𝐃 ↓, then 𝐫𝐞𝐚𝐥𝐀𝐔𝐃7 𝐇𝐊𝐃 ↓ & increase the <𝐒𝐀𝐔𝐃7 𝐇𝐊𝐃 𝐒 > = < 𝐝=𝐟> relative purchasing power of AUD income 𝐂𝐏𝐈𝐇𝐊𝐃 - implies AUD is yes:C𝐒𝐀𝐔𝐃7 × D = 𝐫𝐞𝐚𝐥𝐀𝐔𝐃7 𝐇𝐊𝐃 𝐇𝐊𝐃 𝐂𝐏𝐈𝐀𝐔𝐃 strengthening against HKD 5) 𝐒𝐀𝐔𝐃7 ↑ 5%, CPIHKD ↑ 5%, CPIAUD ↑ 2% 𝐇𝐊𝐃 (HKD bonds in AUD ↑ or ↓?) ↑ 5% 6) change in relative purchasing power of AUD income 𝐫𝐞𝐚𝐥𝐀𝐔𝐃7 𝐇𝐊𝐃 = •C(𝟏 + . 𝟎𝟓) × 𝟏. 𝟎𝟓 D‚ − 𝟏 = 𝟖. 𝟎𝟖𝟗% 𝟏. 𝟎𝟐 FX - Market Products spot rates ⇒ for immediate delivery (i.e. on the spot) (24 hours/day - on business days) (T + 2 settlement) forward exchange rates ⇒ delivery at a future date agreed (OTC) upon today futures ⇒ exchange-traded forwards (standardized) Fx-swap · rolling an existing, but expiring forward, to a future date - requires simultaneous spot transaction + new forward agreement original/ sell €100M @ 𝐔𝐒𝐃=𝐄𝐔𝐑 = 𝟏. 𝟐𝟓𝟎𝟎 - - - 6 mos. 12 mos. M.M141013373. swap/ spot-buy sell 𝐔𝐒𝐃 =𝐄𝐔𝐑 = 𝟏. 𝟐𝟒𝟎𝟎 €100M @ 58 €100M Page 6 Last Revised: 08/24/2023 FX- Rate Calculations Page 8 price Direct 𝐀= 𝐁 e.g./ 𝐝= 𝐟 𝐂𝐀𝐃= 𝐔𝐒𝐃 = 𝟏. 𝟑𝟑𝟎𝟎 base Indirect 𝐁= 𝐀 𝟏 𝐔𝐒𝐃= 𝐂𝐀𝐃 = 𝟏. 𝟑𝟑𝟎𝟎 = 𝟎. 𝟕𝟓𝟏𝟗 𝐟= 𝐝 Quote Conventions EUR euro JPY dollar-yen GBP sterling CAD loonie AUD aussie NZD kiwi CHF swissie 𝐔𝐒𝐃= 𝐄𝐔𝐑 𝐉𝐏𝐘= 𝐂𝐀𝐃 𝐔𝐒𝐃= 𝐆𝐁𝐏 𝐂𝐀𝐃= 𝐔𝐒𝐃 𝐔𝐒𝐃= 𝐀𝐔𝐃 𝐔𝐒𝐃= 𝐍𝐙𝐃 𝐂𝐇𝐅= 𝐔𝐒𝐃 euro-yen EURGBP euro-sterling EURCHF euro-swiss GBPJPY sterling-yen EURCAD euro-cad CADJPY cad-yen 1.39 16.8M Bid Sell USD (Buy CAD) 1.39 19.2M 06 Major Pairs USD.CAD AUD.USD NZD.USD USD.CHF 𝐉𝐏𝐘= 𝐄𝐔𝐑 𝐆𝐁𝐏= 𝐄𝐔𝐑 𝐂𝐇𝐅= 𝐄𝐔𝐑 𝐉𝐏𝐘= 𝐆𝐁𝐏 𝐂𝐀𝐃= 𝐄𝐔𝐑 𝐉𝐏𝐘= 𝐂𝐀𝐃 1.39025 M.M141013373. Buy 02 GBP.USD Page 9 B.A. USD.CAD Sell USD.JPY 𝐀$ 𝐁 Quote Conventions EURJPY EUR.USD dollar cents EUR.JPY EUR.GBP EUR.CHF cross pairs GBP.JPY EUR.CAD CAD.JPY some quotes pips 100 pips = 1 cent Yen 110.63 Offer Buy USD (Sell CAD) 59 Last Revised: 08/24/2023 t0 t1 𝐔𝐒𝐃= 𝐄𝐔𝐑 = 𝟏. 𝟐𝟓𝟎𝟎 𝟏. 𝟑𝟎 − 𝟏. 𝟐𝟓 = 𝟒% 𝟏. 𝟐𝟓 Page 10 𝐔𝐒𝐃= 𝐄𝐔𝐑 = 𝟏. 𝟑𝟎𝟎𝟎 ⇒ interpreted from the point of view of the base ∴ the EUR has appreciated relative to the USD by 4% Inverse/ 𝟏 𝐄𝐔𝐑= 𝐔𝐒𝐃 = 𝟏. 𝟐𝟓𝟎𝟎 = 𝟎. 𝟖𝟎𝟎𝟎 𝐄𝐔𝐑= 𝟏 𝐔𝐒𝐃 = =𝟏. 𝟑𝟎𝟎𝟎 = 𝟎. 𝟕𝟔𝟗𝟐 . 𝟕𝟔𝟗𝟐 − . 𝟖𝟎𝟎𝟎 = −𝟑. 𝟖𝟓% . 𝟖𝟎𝟎𝟎 Identical Statements ∴ the USD has depreciated 3.85% relative to the EUR FX - Market Participants · · · · facilitate trade in g/s facilitate capital flows (FDI of indirect Inv.) hedge forex risk speculate ⇒ Participants · Corporations ⇒ hedging, capital flows · Funds ⇒ insurance, mutual, pension, endowments, ETFs (a.k.a. non-leveraged institutional or real money funds) · Leveraged Funds ⇒ hedge funds, prop. traders, leveraged ETFs, etc… · Retail ⇒ Individual Account M.M141013373. · Government/Quasi-Gov’t. · Central Banks - manage foreign reserves, currency intervention · Sovereign Wealth Funds (SWFs) 60 Page 7 Last Revised: 08/24/2023 FX, International Trade, Capital Flows surplus trade offset by deficit Cap. + Fin. Acct. CA deficit surplus Cap. Act. ∴ if fx-rates affect, they must affect Recall (X - M) = (S - I) + (T - G) CA or = SP - I + Sg Short to intermediate effect SP + Sg = CA + I So, take country Capital Flows trade surplus ⇒ ⇒ enter A · places upward · drive up currency pressure on & fin. assets currency Recall from Micro: 𝑬 = − %𝚫𝐐 %𝚫𝐏 Marshall-Lerner Condition 𝐖𝐗 𝐄𝐗 + 𝐖𝐌 (𝑬𝐌 − 𝟏) > 𝟎 𝐖𝐗 = 𝐗 𝐗+𝐌 𝐖𝐌 = L.T. effect Trade surplus shrinks · may even become negative elastic unit elastic inelastic ⇒ if this condition holds, then fx-rate management will have an effect on the trade balance 𝐌 𝐗+𝐌 price elasticity of domestic demand for M - assumes imports are billed in price elasticity of the foreign currency foreign demand for X So, if 𝐖𝐌 > 𝐖𝐗 ⇒ trade deficit - assumes exports are billed then fx-rate deval./deprec. will in the domestic currency and M.M141013373. help 𝐖𝐌 = 𝑾𝑿 that Pd is unchanged 61 Last Revised: 08/24/2023 𝐖𝐗 𝐄𝐗 + 𝐖𝐌 (𝐄𝐌 − 𝟏) > 𝟎 larger as 𝐄𝐗 increases · the more elastic demand is for X and M, the more likely deval./deprec. will improve a trade balance if 𝐄𝐌 < 𝟏, this term negative 𝐖𝐌 > 𝐖𝐗 𝐖𝐗 > 𝐖𝐌 - 𝐖𝐌 = 𝐖𝐗 𝐄𝐌 becomes more critical for success Initial condition met? 𝐖𝐗 𝐄𝐗 + 𝐖𝐌 (𝐄𝐌 − 𝟏) > 𝟎 e.g. X M .4(.75) + .6(.65 - 1) 𝑬𝐝 .75 .65 .30 + (-.21) = .09 > 0 dep. € 10% ∅ 𝐏𝐝 10% new x 430M ∅ 𝐏𝐟 -10% y 621M (𝟏 − 𝐄 ) %𝚫𝐏 (𝟏 − . 𝟔𝟓 ) 𝟏𝟎% X = 400M M = 600M (191M) 𝟑. 𝟓% U.S. (200M) ∴ deficit worsens CA - - 62 3 - 2 - 1 - t = 0 - - 𝐖𝐗 𝐄𝐗 + 𝐖𝐌 (𝐄𝐌 − 𝟏) > 𝟎 fx-rate changes will be more effective for trade adjustment if X & M · have substitutes · trade in competitive markets · are luxury goods, rather than necessities · are goods that represent a large portion of consumer expenditures J-curve + · in the short run: . fx-rate ↓, but 𝐄𝐝 < 1 /dep dev. · consumers need time to change behavior 0 M.M141013373. 4 in the long run · consumers respond to the change in etc… relative prices Last Revised: 08/24/2023 Absorption Approach Y = C + I + G + (X - M) B A ⇒Y = A + B (Y - A) > 0 surplus or B = Y - A (Y - A) < 0 = deficit A = total absorption B = trade balance ∴ to improve trade balance, increase incomes/output and/or reduce absorption a lower fx-rate will shift a lower fx-rate may cause demand to domestic g/s a wealth effect (if there is excess capacity) ⇒ lower purchasing power of · if MPC < 1, output rises faster domestic currency denominated than absorption assets may boost MPS ⇒ trade balance improves (weak argument) M.M141013373. 63