Economics:

Currency Exchange Rates: Determination and Forecasting

Bid (lower) - Ask/Offer (higher)
1.4126 USD/EUR -> USD is the price currency; EUR is the base currency
Spot Rate -> immediate delivery (two days after trade): Vs Forward Rate (some specified date in future)
Reflected as PIP -> 1/10,000 -> (eg. 4 PIPs is $0.0004)
*Up the Bid and multiply;

*Down the ask and divide

Cross Rates with Bid-Ask Spreads: use all the same (all bids or all spreads) for base currency in all cases.
*Offer = inverse of bid; Bid = Inverse of Offer

Arbitrage can only earn money in one direction.

A currency is at a forward PREMIUM if the Fwd price is greater than the spot price
A currency is at a forward DISCOUNT if the Fwd price is less than the spot price
*Premium/Discount is for base currency (bottom). Eg. Spot price $1.20USD / 1.00EUR and fwd
$1.25/1.00EUR -> Eur trading at Fwd premium.
Fwd Premium (discount) = F So per base unit
Value of a fwd contract (to the base buying party) @ Maturity (t):
VT = (FPt FP) (contract size); VT = value of FWD @ T in Price Currency
FPt : Fwd price to sell base currency @ time t = st;
FP: Fwd price locked in @ inception to buy base currency

*dont forget to
use opposite rates
when converting
back!

Value of Fwd contract prior to expiration? Discount it mofo:

VT = (FPt FP) (contract size)
[1 + R (days/360)]

*R= interest rate of PRICE Currency!

Covered Interest Rate Parity: Any forward premium/discount exactly offsets differences in interest rates;
investor earns the same by investing in either currency. Covered -> Arbitrage Forces forward FX rate.
Eg. If E > $ int -> depreciation of E relative to $ will be equal

Uncovered: not bound by arbitrage [expected future spot]

Good indicator of Future!!!

Country with higher

interest rate depreciates
relative to other

E(Stt) = expected spot rate @ time t = (1+Ra/1+RB)t x So

International Fischer Relation: Nominal rate of return (approx.) equal = real + Expected rate of inflation
Linear:

R nominal = Rreal + E(inflation)

Precise:

1 + R nominal = (1 + R real) x (1 + E(inflation))

PPP -> Purchasing Power Parity: Law of one price; basket of goods.

S(A/B) = CPIA / CPIB

So: Spot exchange today

St: expected spot after t periods
Lower inflation = higher currency
Higher inflation = depreciate currency (like interest)!

Ex-Ante PPP -> same thing but EXPECTED inflation not actual
*Does not necessarily hold in the short run; If it holds -> real exchange rate constant @ equilibrium level

Real Exchange Rate: includes adjustment for inflation differentials.

DO NOT USE THIS ONE -> ??

***exception to usual denominator Rule!!!!! -> notice the B/A instead of A/B
Balance of Payments:
Current Account + Financial Account (Capital Account) + Official Reserve = 0
Current Account:

exchange of goods, services, investment income, unilateral transfers (gifts

to/from other nations); Current Account summarizes trade balance
(surplus/deficit).

Capital Account:

Measures flow of funds for debt and equity investments in to and out of Country
(biggest effect on exchange rates)

Reserve Account:

reserves held by official monetary authorities of a country

Exchange Rates-> Current Account deficit will depreciate domestic currency; Depreciation of domestic
currency if we import more than we export
[Inc. supply of $ abroad, -> devalues currency]
Capital Account -> As capital flows into country, demand for currency increases upward pressure on
currency . Excessive inflows cause problems (excessive appreciation, real estate bubbles, increase in
debt/consumption.
Real Exchange Rate (A/B):
equilibrium real exchange rate (A/B) + (real interest B real Int A) (risk premium B risk premium A)
Risk premium A = risk demanded by investors for investing in assets denominated in currency A
Taylor Rule
Central Banks set policy interest rates to:
- maintain price stability (inflation target); - maintain/achieve maximum sustainable employment

FX Carry Trade -> Uncovered Interest Rate Parity -> high int rate depreciates value

Mundell-Fleming Model: Evaluates impact of Monetary & Fiscal policies on interest/exchange rates.
Flexible Regimes: (Floating) rates determined by supply and demand in foreign exchange markets

High Capital Mobility (unrestricted): Expansionary Monetary Policy and Fiscal policy will have opposite
effects on exchange rates;
Monetary Policy:
EXPANSIONARY will reduce interest; reduce inflow of capital investment; decrease financial inflows;
reduce demand for domestic currency -> DEPRECIATION
Restrictive Monetary Policy will have the opposite effect (demand currency )
Fiscal Policy:
EXPANSIONARY fiscal policy: increase deficit from lower taxes or higher govt. spending. Inc. Govt.
borrowing ; Inc real interest rates. it will attract foreign investors, improve financial account and
INCREASE demand for currency ;
However: will also increase economic activity (growth)
& inflation, leading to deterioration of current account and Decrease in Domestic Currency.
Low Capital Mobility (Restricted):
Impact on Exchange Rates (goods flow effect) is > Greater than on Interest Rates (Financial Flows effect).
Expansionary Fiscal or Monetary leads to increases in Net Imports (DEPRECIATION).
(Monetary Wins from High mobility)
Expansionary Both = depreciation;

Restrictive both = appreciation; Mix = uncertainty:

Fixed Exchange Rate Regimes: Govt. fixes rate of exchange relative to a major currency
In Expansionary (restrictive) Monetary Policy would Depreciate (appreciate) domestic currency in free
regime. Here in Fixed, Govt would have to intervene and purchase (sell) its own currency in FX market.
Essentially, reverses Expansionary (restrictive) stance.

In Mobility Govts. Can manage both exchange rates & pursue independent monetary policy. To manage
MP, either let FX rates float freely or restrict Capital movements.
Expansionary (restrictive) fiscal policy leads to appreciation (Depreciation) of domestic currency of free
regime. Here in Fixed, Govt would sell (buy) its own domestic currency to keep exchange rates stable.

Monetary Models:
Mundell-Fleming: inflation (price levels) play no role in exchange rate determination.
Under monetary models-> assume output fixed, Monetary Policy primarily affects inflation which in turn
affects exchange rates.
Pure Monetary Model: PPP holds, output constant.
Expansionary monetary/fiscal = prices up and currency down (Decrease domestic)
Restrictive monetary/fiscal = prices down and currency up
Dornbusch Overshooting Model: prices are sticky (inflexible) in the short run; no immediate impact by
changes to MP -> decrease in real interest rates -> depreciation of domestic currency due to capital
outflows.
Portfolio Balance; Warning Signs; Trend-Follow; FX dealer orders; options Markets.
Central bank intervention -> ensures domestic currency does not appreciate excessively.
Economic Growth & Investment Decision:
Economic Output = GDP per capita (level)
Preconditions -> savings & investment (domestic or foreign); financial markets -> determine best uses of
capital, provide liquidity, etc; Political Stability: law, property rights, physical and IP; Human Capital:
education [developed -> Post-Secondary to create tech; developing -> secondary to use tech], health
care; Tax & regulatory Systems: lower tax, higher growth, lower regulation, more startups; Free trade
and Unrestricted Capital.
Growth in Aggregate stock prices: function of GDP growth; earnings relative to GDP, and Price-earnings
P = GDP + (E/GDP) + (P/E) ; Long run-> growth in earnings relative to GDP = 0; P/E growth zero
*higher potential GDP [Future income -> higher current spending] = higher interest rates [encourage
saving for the future]

Growth in potential GDP represents the main driver of aggregate equity valuation; Upper limit is real
growth for economy.
Higher potential GDP -> higher real interest rates (to delay consumption). Short run, GDP excess of
potential GDP results in rising prices. Concerns about inflation increase, central bank likely to restrict
MP.
-> causes int ; also may run fiscal surplus;
GDP = Credit risk and improved quality of debt issues

Factor Inputs and Economic Growth

Economies are complex, many inputs. Lets Dumb it down to a 2-factor (labor & capital) aggregate
production function in which output (Y) = factor of labor (L) and capital (K) @ given level of Technology
(T).
Cobb Douglas Production Function
Y = TK L(1-)

k = capital; L = Labour; T = Technology; = share of output allocated (%)

Constant returns to scale: % increase in inputs -> same % inc in output

Divide both sides by L : Output per woker

Y/L = T(K/L)

Labour productivity similar to GDP per capita -> std. of living measure
Developed markets have high Capital to Labor ratio and lower ; Gain less in inc productivity
from capital deepening.
Assuming # of workers and remain constant, in output can be gained by increasing capital per
worker (capital deepening) or improving technology. lower lower marg productivity of inc, capital
per worker -> developed -> less benefit from capital deepening.
Marginal Product of Capital: Additional output for 1 additional unit of capital;

[CD constant]

Marginal Productivity of Capital: inc in output per worker for 1 additional unit of capital per labor. [CD
diminishing]
In steady state, marginal product of capital = marginal cost of capital;
Y/K = r

OR

= rK/Y;

r = rate of return;

MPK = Y/K

Economies will increase investment in Kapital as long as MPK > r; However, as T progress occurs, both
capital and labor can produce higher level of output (despite diminishing marg. Productivity of capital)
Investment in T shifts MP curve Up!

Growth rate in potential GDP = long-term growth rate of technology + (long term growth rate of
capital) + (1-)(long term grown rate of labour)
Or
Growth rate in potential GDP = long term growth rate labor force + l-t growth rate labor productivity
Second part reflects both capital deepening & technological progress
Natural Resources: Renewable and Non-renewable -> Can both foster or hinder economic growth; Lack
of access does not mean ownership; Abundance can hinder as too much focus put on recovering rather
than on other industries. Or currency appreciates so much that is stifles other exports (Dutch Disease)
Demographics: Younger populations have higher potential GDP growth; Labor force = # of working age
people available to work; Labor force participation = labor force / working age population; Immigration:
improves a declining labor force.
Human Capital: knowledge and skills that individuals possess (Qualitative measure); Physical Capital:
Infrastructure, Computers, Telecommunications (ICT); Non-ICT Machinery, Transportation; Construction;
Classical Growth Theory -> Malthusian economics -> long term population growth increases when there
are increases in per capita income beyond subsistence level (min income needed to sustain life). Result,
population explosion -> reduce GDP per capita to subsistence level.[No empirical evidence supports this]
Neo-Classical Growth Theory -> focus on long term steady growth rate; Economy in equilibrium when
output-to-capital ratio is constant; Based on Cobb-Douglas

Capital Deepening affects level of output not growth rate in Labor. CD may temporarily inc growth
rate, but it will revert back to sustainable level without technological improvement.
Endogenous Growth Theory : open markets contributes to higher rate of growth permanently for all
markets. Technological growth emerges as result of investment in physical and human capital; No
Steady state growth, inc investment can permanently increase rate of growth [eg R&D enjoyed by
all]

Convergence Hypothesis: will less developed countries experience growth to match their developed
counterparts? Absolute Convergence -> Yes (over time); Conditional Convergence -> only for some
countries w same savings rates, population growth, etc.; Club Convergence -> some join club.
Economies of Regulation:
Regulation:
Statutes -> laws made by legislative bodies;

Administrative-> rules issued by govt agencies, etc.

Judicial -> Findings of court

Regulators -> Mount-up! Govt Agencies, Indep Regulators, Outside Bodies;

SROs: Self-regulatory

Informational Frictions: occur when information is not equally available or distributed

Externalities: deal with consumption of public goods (eg. Parks, military)
Regulatory Capture Theory -> at some point eventually, regulatory body will be influenced / controlled
by the very industry it is regulating
Regulatory Competition -> differences between jurisdictions
Regulatory Arbitrage -> businesses shop for country that has looser restrictions rather than behavior
[e.g. pollution]
Tools of Regulatory Intervention:
Price Mechanisms -> taxes, subsidies, (Alcohol, green energy)
Restricting/requiring certain activities: R134a; form 10-k reporting, etc
Provision of Public goods or financing of private projects-> National Defence, SME Loans,
Regulatory Commerce: Company laws, tax laws, contract laws, competition laws, banking laws,
bankruptcy laws, etc. ;
Regulatory Financial Markets: securities markets, FIs
Anti-trust regulation: In global context, frameworks can conflict when regulations hinder foreign
competition -> promote domestic competition. Antitrust laws work to promote domestic competition
(eg. HH Index).
Cost-benefit analysis of Regulation (not just implementation cost)
Regulatory Burden: cost of compliance for regulated entity; also, unintended consequences: sunsetclause -> revisit cost-benefit analysis;