Lvl2: Economics

covered interest rate parity

The domestic currency will trade at a forward premium (F_f/d > S_f/d) if, and only if, the foreign risk-free interest rate exceeds the domestic risk-free interest rate (i_f > i_d).

uncovered interest rate parity

• change in spot rate over the investment horizon should, on average, equal the differential in interest rates between the two countries

• return can be approximated by

• country with the higher interest rate or money market yield will see its currency depreciate

• evidence that uncovered interest rate parity works better over very long-term horizons

forward rate parity - covered rate parity + uncovered rate parity

• forward exchange rate will be an unbiased predictor of the future spot exchange rate

• relies on risk neutral speculators

• forward exchange rates are typically poor predictors of future spot exchange rates in the short run. Over the longer term, uncovered interest rate parity and forward rate parity have more empirical support.

purchasing power parity (PPP)

• law of one price - identical goods should trade at the same price across countries

• over shorter horizons nominal exchange rate movements may appear random, over longer time horizons nominal exchange rates tend to gravitate toward their long-run PPP equilibrium values.

absolute PPP

• P_f = (S_f/d)(P_d)

• equilibrium exchange rate between two countries is determined entirely by the ratio of their national price levels

relative PPP

• percentage change in the spot exchange rate (%ΔS_f/d) will be completely determined by the difference between the foreign and domestic inflation rates (π_f − π_d)

• currency of the high-inflation country should depreciate relative to the currency of the low-inflation country.

Fisher effect

• foreign–domestic nominal yield spread is determined solely by the foreign–domestic expected inflation differential

• assume that currency risk is the same throughout the world

• emerging country’s investors will require a risk premium for holding the currency

real interest rate parity

• The real yield spread between the domestic and foreign countries (r_f − r_d) will be zero, and the level of real interest rates in the domestic country will be identical to the level of real interest rates in the foreign country

carry trade

• taking long positions in high-yield currencies and short positions in low-yield currencies

• carry trade strategies have generated positive returns over extended periods

• during periods of low volatility, carry trades tend to generate positive returns, but they are prone to significant crash risk in turbulent times

• Assume uncovered interest rate parity does not hold

The Flow Supply/Demand Channel

• if a country sold more goods and services than it purchased then the demand for its currency should rise > exert upward pressure on the value of the surplus nation’s currency > currencies appreciate over time

• limited pass-through effects of exchange rate changes on traded goods prices

The Portfolio Balance Channel

• Countries with trade deficits will finance their trade with increased borrowing > increase their dollar holdings

The Debt Sustainability Channel

• If a country runs a large and persistent current account deficit > experience an untenable rise in debt owed to foreign investors > investors expect a major depreciation of the deficit country’s currency

Mundell–Fleming Model

• expansionary monetary policy affects growth, in part, by reducing interest rates and thereby increasing investment and consumption spending > induce capital to flow to higher-yielding markets, putting downward pressure on the domestic currency > more responsive capital flows are to interest rate differentials, the greater the depreciation of the currency

• Expansionary fiscal policy > upward pressure on interest rates because larger budget deficits must be financed > attract capital from lower-yielding markets, putting upward pressure on the domestic currency > appreciate substantially

Monetary Models of Exchange Rate Determination

• Output is fixed and monetary policy affects exchange rates primarily through the price level and the rate of inflation

• X percent rise in the domestic money supply will produce an X percent rise in the domestic price level > proportional decrease in the domestic currency’s value - PPP

Portfolio Balance Approach

• assumed to hold a diversified portfolio of domestic and foreign assets, including bonds

• government budget deficit leads to a steady increase in the supply of domestic bonds outstanding > investors expect to be compensated with (1) higher interest rates (2) immediate depreciation of the currency

• in the long run, governments that run large budget deficits on a sustained basis could eventually see their currencies decline in value

currency crisis

• capital markets have been liberalized to allow the free flow of capital

• large inflows of foreign capital

• preceded by (and often coincide with) banking crises

• fixed or partially fixed exchange rates are more susceptible

• Foreign exchange reserves tend to decline precipitously

• currency has risen substantially relative to its historical mean

• ratio of exports to imports deteriorates

• Inflation tends to be significantly higher

Factors limiting growth

• Low rates of saving and investment

• Poorly developed financial markets

• Weak, or even corrupt, legal systems and failure to enforce laws

• Lack of property rights and political instability

• Poor public education and health services

• Tax and regulatory policies discouraging entrepreneurship

• Restrictions on international trade and flows of capital

Return on equity

E(R_e) = dividend yield + expected repricing + inflation rate + real economic growth – change in shares outstanding

= dy + Δ(P/E) + i + g – ΔS

• Earnings growth per share is the primary channel through which economic growth can impact equity returns.

ΔS dilution effect term

ΔS = nbb + rd

net buy backs + relative dynamism (small- and medium-sized entrepreneurial firms that are not traded publicly on the stock market)

Production Function

Y = AF(K,L),

Y= aggregate output in the economy

A = total factor productivity (TFP) - level of “technology”

K = stock of equipment and structures

L = quantity of labor

Cobb–Douglas production function

F(K,L) = K^αL^1−α

α determines the shares of output (factor shares) paid by companies to capital and labor

• constant returns to scale - if all the inputs into the production process are increased by the same percentage, then output rises by that percentage

• diminishing marginal productivity -

growth accounting equation

ΔY/Y = ΔA/A + αΔK/K + (1 − α)ΔL/L

• growth in TFP as a residual

• quantify the contribution of each factor

• to measure potential output

labor productivity growth accounting equation

Capital deepening

• increase in the capital-to-labor ratio,

• at point B, further additions to capital have relatively little impact

labor force participation rate

percentage of the working age population in the labor force

network externalities

The more people in the network, the greater the potential productivity gains

captured in TFP

Classical growth theory

• population growth accelerates when the level of per capita income rises above the subsistence income

• labor input faces diminishing marginal returns, the additional output produced by the growing workforce eventually declines to zero

• population grows so much that labor productivity falls and per capita income returns back to the subsistence level

• in the long run, the adoption of new technology results in a larger but not richer population

In reality

• growth of per capita income increased, population growth slowed

• technological progress more than offset the impact of diminishing marginal returns

Neoclassical Model

determine the long-run growth rate of output per capita and relate it to (a) the savings/investment rate, (b) the rate of technological change, and (c) population growth

steady state growth rate - neoclassical

θ denote the growth rate of TFP

n is the growth rate of the labor force

equilibrium output-to-capital ratio

savings/investment equation

plant and equipment wearing out at rate δ,

deepen the physical capital stock at the rate θ/(1 − α)

capital for new workers entering the workforce at rate n,

capital-to-labor ratio (k)

Impact on the Steady State

• Labor force growth (n) - increase > increases the slope of the required investment line > shifts the steady-state equilibrium to lower capital-to-labor and output per worker ratios

• Depreciation rate (δ) - increases the slope of the required investment line > reduces the equilibrium capital-to-labor and output per worker ratios

• Growth in TFP (θ) - same -

Conclusions from neoclasical

• Capital Accumulation - level of output but not the LT growth rate - move to steady state

• Capital Deepening vs. Technology - Rapid growth that is above the steady-state rate but slows LT - technological change or growth required because of diminishing marginal returns to capital

• Convergence - growth rates of developing countries should exceed those of developed countries - convergence over time

• Effect of Savings on Growth - initial impact temporarily raise the rate of growth - economy moves to a higher level of per capita output and productivity

endogenous growth theory

• explaining technological progress rather than treating it as exogenous

• self-sustaining growth - not steady state

• no diminishing marginal returns to capital

• increasing the saving rate permanently increases the rate of economic growth

• no reason why the incomes of developed and developing countries should converge

endogenous growth rate of output per capita

∆y_e/y_e = ∆k_e/k_e = sc − δ − n

s = savings rate

Absolute convergence

developing countries, regardless of their particular characteristics, will eventually catch up with the developed countries and match them in per capita output + per capita income growth (not level) - neoclasical

Conditional convergence

conditional on the countries having the same saving rate, population growth rate, and production function

same level of per capita output as well as the same steady-state growth rate

club convergence

only rich and middle-income countries that are members of the club are converging to the income level of the world’s richest countries

appropriate institutional changes - otherwise non-convergence trap

open economies

• neoclassical model, convergence should occur more quickly if economies are open and there is free trade

• endogenous growth models predict that a more open trade policy will permanently raise the rate of economic growth