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CFA2: Economics

Economic Growth

  • Rule of 70
Approximate years to double GDP = 70 / growth rate
  • Sources of economic growth(factors of production)
    • Land: all natural resources available for production.
    • Capital goods: manufactured goods that are used in production.
    • Labor: physical and mental talents of workers that are used in production.
    • Entrepreneurial ability: the act of combining the other three factors, making the decisions, and bearing the risk, in the hope of generating an economic profit.
  • Critical social institutions for suitable incentive system
    • Markets: facilitate the exchange of information between buyers and sellers
    • Property rights: laws and regulations that govern the ownership, use, and sale of goods, services, and factors of production
    • Monetary exchange: provides for the efficient exchange of goods and services
  • One-Third Rule: 1% increase in capital per labor hour -> 1/3% increase in real GDP per labor hour
  • Improving labor productivity
    • Investment in new capital -> increasing the level of capital per worker
    • Investment in human capital: investment in people’s skills and knowledge
    • Discovery of new technologies -> human capital and physical capital more productive. Research and development is the primary driver of the discovery of new technologies.
  • Classical growth theory growth in real GDP is temporary
Real GDP per person rises above the subsistence level -> population explosion -> GDP per person driven back to the subsistence level.
  • Neoclassical growth theory without technological change, no growth in real GDP; population growth is independent of economic growth
Technology -> increased saving and investment -> capital per labor hour grows -> real rate of return fall.
Real return falls to the target rate of return -> economic growth stops
  • New growth theory economic growth continues indefinitely as technology advances.
Decreases in the real rate intensify the incentive to discover up -> technology growth -> real interest rate increase above the target rate of return


Economic regulation includes the regulation of natural monopolies and the regulation of competitive industries.

  • Dual purpose: to prevent both excessive monopoly profits and predatory competitive practices.
  • Prevalent methods of economic regulation of natural monopolies
    • Cost-of-service regulation: establishment of a pricing policy (maximum price)
    • Rate-of-return regulation: limits excessive returns to the producers

Social regulation: qualitative applicable to all industries; based upon a wide variety of goals such as product quality, product safety, and the safety of employees in the workplace.

Negative side effects

  • Creative response: a firm conforms to the letter, but not the intent
  • Feedback effect: a type of creative response which occurs when consumers’ behavior is changed as a result of the new regulation

Regulator's behavior

  • Capture hypothesis: regulatory body will eventually be influenced by the industry that is being regulated
  • Share-the-gains, share-the-pains theory: assumption that regulators will strive to satisfy all three interested parties: the legislators, the customers, and the regulated firms themselves; regulators consider the consequences of their decisions from the standpoint of each of the three affected parties

Deregulation: removal of existing regulations

  • short-run effects: typically negative; higher-cost producers may exit, workers may be laid off, a decrease in product quality may occur, and product prices may increase.
  • long-run benefits: typically positive; include better service, more product variety, and lower costs.

World Trade

  • Comparative advantage: the lowest opportunity cost to produce a product.
  • Law of comparative advantage: trading partners can be made better off if they specialize in the production of goods for which they are the low-opportunity-cost producer (have a comparative advantage) and trade for those goods for which they are the high-opportunity-cost producer. A country gains (i.e., it realizes expanded consumption possibilities) from international trade when it exports those goods for which it has a comparative advantage and imports those goods for which it does not.
  • Tariff: a tax imposed on imported goods; benefits domestic producers and government; a loss in consumer surplus
  • Quota: a limitation on the quantity of goods imported. Importers are given licenses to import specific amounts of foreign goods. Importers gain for high price sale domestic producers benefit because of limited competition, a loss in consumer surplus
  • Voluntary export restraints (VER): agreements by exporting countries to voluntarily limit the quantity of goods they will export to an importing country

Arguments for trade restrictions

  • Most economists agree that trade restrictions benefit specific groups at the expense of the whole economy.
  • Arguments made to support trade restrictions with some validity:
    • Developing industries (infant industries) should be protected.
    • Exporters should be prohibited from selling goods abroad at less than production cost (anti-dumping argument).
    • Protect industries associated with national defense.
  • Arguments made to support trade restrictions with little validity:
    • Trade barriers protect jobs.
    • Trade restrictions create jobs.
    • Trade with low-wage countries depresses wage rates in high-wage countries.

Currency Exchange

  • Nominal exchange rate: price of one currency in terms of another
  • Real exchange rate: rate in terms of what is required to purchase an equivalent amount of goods based on the relative price levels
RER = E x (P/P*)

  • Export effect: demand for exports from that area increases -> currency value increases
  • Expected profit effect: Expected future value of a currency -> currency value increases
  • Currency value decrease -> Quantity demanded increases
  • Demand for a currency is a downward-sloping and supply is an upward sloping of its exchange rate
Since factors that increase currency demand also decrease currency supply, exchange rates can be quite volatile even with relatively stable trading volume.

  • Purchasing power parity: same goods should cost the same in different countries; requires that the exchange rate adjust so that exchange-rate adjusted goods prices return to the same level, reflecting differences in inflation
  • Interest rate parity: exchange rates must change so that the return on investments with identical risk will be the same in any currency

Balance-of-payments (BOP) accounting: method used to keep track of transactions between a country and its international trading partners

current account + capital account + official reserve account = 0
  • current account ∋ net exports, net income from asset ownership, net gifts
    • does not reflect economic health
  • capital account ∋ international payments for the purchase and sales of debt and equity securities and real assets
  • official reserve account ∈ government-held foreign currencies
  • The impact of borrowing to finance a deficit in the current account is dependent on its use. If the deficit is to finance consumption, future consumption must be reduced to repay the money. If the borrowing is to finance investment, then future growth will repay the borrowings.

Central bank intervention in currency markets (buying or selling their country’s currency) can reduce short-term exchange rate volatility but cannot prevent real long-term changes in equilibrium exchange rates.

  • Flexible exchange rate policy: supply and demand without direct intervention in the foreign exchange market.
  • Fixed exchange rate policy: value of a currency at a level set by the government; requires active government intervention
  • Crawling peg exchange rate policy: sets a target path for the exchange rate and supports this range through government intervention in the foreign exchange markets.

Foreign exchange quotations

  • Direct quotations: domestic currency per unit of foreign currency, from the perspective of the counter currency
  • Indirect quotations: foreign currency per unit of the domestic currency, from the perspective of the base currency
  • Bid-ask spread: difference between the price a dealer is willing to pay(bid) and the price a dealer is willing to take to sell a currency(ask); generally no commissions charged on transactions
  • Factors of influence
    1. Market conditions bid-ask spread on foreign currency quotations increases as exchange rate volatility (uncertainty) increases.
    2. Bank and currency dealer positions affects the mid-point of the spread
    3. Greater trading volume leads to narrower spreads
  • Currency cross rates
an arbitrage profit exists if profits observed by going around the triangular arbitrage
  • Spot markets: transactions that call for immediate delivery of the currency
  • Forward markets: both parties to the transaction agree to exchange one currency for another at a specific future date; spreads typically greater for further forward trade
Forward premium.gif
  • Interest rate parity: forward premiums or discounts to interest rate differentials between countries
Interest rate parity.gif
  • Covered interest arbitrage: trading strategy that exploits currency positions when the interest rate parity equation is not satisfied

Foreign Exchange Parity

Flexible exchange rate system foreign exchange rate determined by supply and demand; currency appreciates in value with increased demand

Currency appreciation ⇐ ➘income growth + ➘inflationary rate + ➚real interest rate + ➚investment climate(political stability)

Policy Currency Current account Financial account
Monetary policy Depreciation - -
Fiscal policy Mixed - +

Fixed exchange rate system exchange rate fixed against one of the major currencies

  • - independence of monetary policy
  • + relative stability
  • e.g. HKD to USD

Pegged exchange rate system commitment to use fiscal & monetary policy to maintain exchange rate within a narrow band relative to another currency

Absolute PPP (purchasing power parity) price of a similar consumption basket should be the same across borders

Relative PPP exchange rate adjustment to offset inflation rate differentials, proportional to price indices


International Fisher relation interest rate differential = expected inflation differential, resulting stable and equal real interest rate

(1 + real r) = (1 + r)/[1 + E(I)]
linear approximation real r ≈ r - E(I)

Uncovered interest rate parity combination of PPP + international Fisher relation expected spot exchange rate adjustment to nominal interest rate differences

Uncovered interest rate parity.gif

Foreign exchange expectation relation forward rate is an unbiased predictor of the expected future spot rate

(F − S0) / S0 = E(%ΔS)
  • if the relation holds, no reward for bearing foreign currency exposure

Economic Activity Measurement

  • Gross Domestic Product (GDP) total market value of all final goods & services produced in a country
  • Gross National Income (GNI) total goods & services produced by the citizens of a country; GDP + net property income from abroad
  • Net National Income (NNI) GNI - depreciation(decline in resources)

GDP@market prices - indirect taxes + subsidies = GDP@factor prices

  • Output data collected in both current and constant prices; converted to equivalent prices from a designated base year
  • Expenditure data measured in current prices and then adjusted; consumer spending
  • Income data gathered in current prices & converted into constant prices using the price index.
  • GDP deflator: inflation trends estimator(price index) calculated by expenditure data; not accurate in a volatile economic environment; affected by GDP composition