Economics

Buy bid or ask for FOREX?

use the up or down the same quote you see given.
AUD/GBP example

Transaction	Direction	Rule	Rate Used	Proceeds
GBP → AUD	Down the quote	Ask ÷	1.5067	AUD 663,394.57
AUD → GBP	Up the quote	Bid ×	1.5060	GBP 1,506,000

triangular arbitrage

In triangular arbitrage, we begin with three pairs of currencies, each with bid and ask quotes, and construct a triangle where each node in the triangle represents one currency. To check for arbitrage opportunities, we go around the triangle clockwise (and later, counterclockwise) until we reach our starting point. As before, we follow the up-the-bid-and-multiply, down-the-ask-and-divide rule.

Covered Interest Rate Parity

What does "covered" mean? Bound by arbitrage.

What does it state? Any forward premium or discount exactly offsets the interest rate differential between two countries — so an investor earns the same return in either currency.

What does it derive? The no-arbitrage forward rate.

What enforces it? Arbitrage — if the forward rate drifts, traders will exploit it and force it back.

What is required for it to hold? Forward currency contracts must be available and capital flows must be unrestricted.

Uncovered Interest Rate Parity

What does "uncovered" mean? NOT bound by arbitrage.

What does it state? The expected change in the spot rate offsets interest rate differentials — but this is just an expectation, not enforced by trading.

What does it derive? The expected future spot rate (which is not market traded).

What enforces it? Nothing — it relies on expectations, not arbitrage. It need not hold if capital flows are restricted or forward contracts are unavailable.

PPP vs law of 1 price

Does it hold in practice? No — even if law of one price held for every good, absolute PPP can still fail because consumption patterns differ across countries (e.g. more rice in Japan, more potatoes in Russia), so the basket weights are different.

relative purchasing power parity

relative purchasing power parity (relative PPP) states that changes in exchange rates should exactly offset the price effects of any inflation differential between two countries. Simply put, if (over a 1-year period) Country A has a 6% inflation rate and Country B has a 4% inflation rate, then Country A's currency should depreciate by approximately 2% relative to Country B's currency over the period.

Parities relationships

FX Carry Trade

FX carry trade, an investor invests in a higher yielding currency using funds borrowed in a lower yielding currency. The lower yielding currency is called the funding currency.

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 probability implied under a normal distribution. We call this high probability of a large loss the crash risk of the carry trade.

BOP

Balance-of-payments (BOP) accounting is a method used to keep track of transactions between a country and its international trading partners. It includes government transactions, consumer transactions, and business transactions. The BOP accounts reflect all payments and liabilities to foreigners as well as all payments and obligations received from foreigners.

Current Account

The current account measures the exchange of goods, the exchange of services, the exchange of investment income, and unilateral transfers (gifts to and from other nations). The current account balance summarizes whether we are selling more goods and services to the rest of the world than we are buying from them (a current account surplus) or buying more from the rest of the world than we are selling to them (a current account deficit).

Financial Account

The financial account (also known as the capital account) measures the flow of funds for debt and equity investment into and out of the country.

CA deficit

Currency Depreciation May Restore Balance Depending On:

1. Size of initial deficit

   • Larger deficit → larger depreciation needed.

2. Exchange-rate pass-through

   • Depreciation raises import prices, but firms may absorb some costs instead of fully passing them to consumers.

3. Price elasticity of imports/exports

   • If imports are price inelastic (e.g. oil), quantity demanded changes little → deficit may persist.

4. Portfolio balance mechanism

   • Surplus countries invest in deficit countries.

   • If investors rebalance away from concentrated holdings, investee currency may fall sharply.

5. Debt sustainability mechanism

   • Deficit countries often borrow from abroad.

   • Excessive debt/GDP can reduce investor confidence → rapid currency depreciation.

Pure Monetary/ Dornbusch Overshooting

• PPP holds
  PPP hold long term

MF, Monetary and Portfolio Balance

Model	Focuses On	Key Driver
Mundell-Fleming	Interest rates & trade	Policy changes → rates change → capital/trade flows → currency moves
Monetary	Money supply & inflation	More money printed → prices rise → currency falls
Portfolio Balance	Asset holdings & wealth	Surplus nations accumulate too many foreign assets → rebalance → currency moves

What is potential GDP growth

growth rate than GDP can grow before inflation kicks in

Situation	Equity Investors	Fixed Income Investors	Central Bank
Actual > Potential	Cautious — late cycle	Worry about inflation	Raise rates
Actual < Potential	Opportunity — early cycle	Less inflation risk	Cut rates

"Dutch disease"

The so-called "Dutch disease" refers to a situation where global demand for a country's natural resources drives up the country's currency values, making all exports more expensive and rendering other domestic industries uncompetitive in the global markets.

Labor force

Labor force is defined as the number of working age (ages 16–64) people available to work, both employed and unemployed.

Labor Supply Factors

Factor	Impact on Growth	Key Point
Demographics	Older population = lower growth	Low fertility → future labor decline
Labor Force Participation	More participants = higher growth	Women entering workforce boosts it
Immigration	Offsets labor decline	Key solution for aging developed countries
Average Hours Worked	Declining trend = lower growth	Caused by legislation, wealth effect, high taxes

classical growth theory

Classical growth theory argues that per capita income cannot permanently rise above subsistence level: any gains trigger population growth, which causes diminishing returns to labor and pushes income back down. This self-correcting mechanism, however, is not supported by real-world evidence.

Subsistence level is the minimum income a person needs to survive — just enough to cover basic necessities like food, shelter, and clothing.

growth per person

1. Growth per person (g*):

g∗=θ1−αg^* = \frac{\theta}{1-\alpha}g∗=1−αθ​

• θ (theta) = how fast technology is improving

• 1 - α = labor's share of GDP (how much of the economy's output comes from labor)

• So growth per person is basically driven by technology, scaled by how important labor is in production

total output growth

. Total output growth (G*):

G∗=g∗+ΔLG^* = g^* + \Delta LG∗=g∗+ΔL

• Just take growth per person and add population/labor growth

• More workers = more total output, even if each worker isn't more productive

What is Neoclassical Growth Theory?

Long-run growth in per capita income is driven only by technological progress. Capital deepening and higher savings only temporarily boost growth due to diminishing returns. Every economy converges to a steady state growth rate, and developing countries grow faster than developed ones until growth rates converge.

What is Endogenous Growth Theory?

Technological progress comes from within the economy through investment in R&D, physical, and human capital. Returns to capital are constant (not diminishing), so there is no steady state — increased savings and investment can permanently raise the growth rate. Knowledge spillovers from R&D benefit the entire economy.

What are the three convergence hypotheses?

• Absolute: All countries converge to the same per capita output — not supported by neoclassical theory

• Conditional: Countries converge only if they share similar savings rates, population growth, and production functions — supported by neoclassical theory

• Club: Countries with similar institutions converge with each other — poorer countries outside the club may never catch up without institutional reform

Corr between FX and stock

correlation is not stable and tends to converge toward zero in the long run

Mundell Fleming high low cap mobility monetary + fiscal

Monetary	Fiscal	High capital mobility	Low capital mobility
Expansionary	Expansionary	Uncertain	Depreciation
Expansionary	Restrictive	Depreciation	Uncertain
Restrictive	Expansionary	Appreciation	Uncertain
Restrictive	Restrictive	Uncertain	Appreciation

Currency Warning Signs

The following conditions have been identified as warning signs in the period leading up to a currency crisis:

• Terms of trade (i.e., ratio of exports to imports) deteriorate.

• Fixed or partially-fixed exchange rates (versus floating exchange rates).

• Official foreign exchange reserves dramatically decline.

• Currency value that has risen above its historical mean.

• Inflation increases.

• Liberalized capital markets, that allow for the free flow of capital.

• Money supply relative to bank reserves increases.

• Banking crises (may also be coincident).

GDP growth with interest rates

higher growth → higher real rates

Club vs Conditional Convergence

• Club

  • join an institution

• Conditional

  • Savings Rate, population growth, production function