Endogenous growth theory of economic growth:

(1) investment in knowledge capital

(2) increase in savings rate ->

(3) R&D expenditures

(1) No diminishing returns to (knowledge) capital is uniquely associated with endogenous growth theory

(2) -> permanent increase in growth rate

(3) increase technological progress

Given currency quotes in DC/FC, if: 1 + r_DC < (1 +r_FC)(forward rate)/ spot rate funds will flow _______

out of the domestic currency

This equation is Interest Rate Parity rearranged! If the term on the left (1 + r_DC), is less than the term on the right, it means that the domestic rate is low relative to the hedged foreign rate. Therefore, there is a profitable arbitrage from borrowing the domestic currency and lending at the foreign interest rate. Because we lend in the foreign market, we say that the funds flow out of the domestic economy.
(Study Session 4, LOS 14.e) 

Growth rate in potential GDP = long-term growth rate of technology + α*(long-term growth rate of capital) + (1 − α)*(long-term growth rate of labor)

Where α = Factor cost/% capital

Under the Mundell-Fleming model and the asset market approach to exchange rate determination, a country following sustained expansionary fiscal policy would see its currency: (short-run & long-run against other currencies)

Under Mundell-Fleming model, a country running expansionary fiscal policy (i.e., running fiscal deficits) would attract foreign capital due to high interest rates and will see its currency appreciate in the short-run. Under the asset market approach, in the long-run sustained deficits will increase the risk of the country’s debt and lead to a currency depreciation.

Forward rate (DC/FC); given spot rate & interest rates

Spot Rate (DC/FC) ×

[(1 + domestic rate) / (1 + foreign rate)]

Economic income (2 formulas)

EI = cash flow - (beginning market value - ending market value)

EI = cash flow + change in market value.

The appreciation of aggregate stock market depends on:

(1) GDP growth rate

(2) Growth of share of capital in GDP

(3) Growth in P/E multiples

Labor productivity can be enhanced by (2 things):

(1) capital deepening and/or

(2) improvement in technology

The endogenous growth theory contends that economic growth is a function of (2 variables):

The endogenous growth theory holds that productivity growth is a function of society’s ability to:

(1) create knowledge capital--discover new products and methods

(2) real interest rates

Improvement in potential GDP growth in developed countries is largely driven by:

In developing countries, by:

technological progress

technological progress and capital deepening

Developing countries have the potential to grow through both (2 things):

capital deepening and technological progress

The neoclassical growth theory:

Sustainable growth rate of economy is a fxn of population growth, labor's share of income and rate of technological advancement. Growth from other means, such as increased savings, are only temporary.

when the output to capital ratio is constant, both the labor to capital ratio and output per capita grow at the same equilibrium rate

FX carry trade return distribution exhibits (positive/negative) skewness and (positive/negative) excess kurtosis.

Negative skewness

Positive excess kurtosis

External sustainability approach

The assessment of sustainable levels of debt relative to GDP

Dutch disease refers to situation where a country with large endowments of natural resources finds its currency appreciating driven by foreign demand for those resources. This increase in currency value may render other domestic industries uncompetitive globally.

Countries with abundant natural resources may devote disproportionate amount of its economic energy in pursuing those resource industries at the expense of other industries.

will change to reflect differences in inflation between countries.

price mechanism regulatory tools

Calculate the one-year forward USD/EUR rate that would preclude profits from covered interest arbitrage between the U.S. dollar and the Euro

=(USD/EUR)_Spot(0) *

[(1 + USD(R)_{1-yr nominal}) / (1 + EUR(R)_{1-yr nominal})

The Mundell-Fleming model to determine exchange rate focuses on the impact of:

interest rates

Mundell-Fleming approach focuses on the role of interest rate in exchange rate determination. Mundell-Fleming model does not explicitly take into account the role of inflation. 

Uncovered interest-rate parity is the concept that exchange rates must change so that the return on investments with identical risk will be the same in any currency. Suzaken’s statement reflects uncovered interest rate parity. Covered interest rate parity would be applicable if the investor hedges the foreign exchange risk via a forward exchange rate contract.

In steady state, the rental price of capital is equal to _________ under ________ theory

In steady state, the rental price of capital is equal to capital's share of total output divided by total capital. 

Neoclassical theory of economic growth

Step 1: Determine whether an arbitrage opportunity exists.

We can arrange the formula for covered interest rate parity (CIP) to look like: (1 + r_domestic) − [((1 + r_foreign) × Forward_DC/FC) / Spot_DC/FC] = 0 

If this condition holds with the financial data above, there are no arbitrage opportunities: (1 + 0.06500) − [((1 + 0.05200) × 31.5000) / 30.73000] = 1.06500 − 1.07836 = -0.01336 

Since the no arbitrage condition does not hold, we move on to: 

Step 2: Borrow Domestic or Foreign?

Rule 1: If the sign on the result of Step 1 is negative, borrow domestic. If the sign is positive, borrow foreign. Here, the sign is negative, so borrow domestic. 

Rule 2: See table below. (Rule 2 is an alternative to Rule 1). 

Here, (0.06500 – 0.05200) compared to (31.5000 – 30.73000) / 30.73000 0.013000 < 0.02506, borrow domestic.

Step 3: Conduct Arbitrage and Calculate Profits.

Note: ¹ This is the amount you will have available to repay the loan. ² This is the amount you need to repay.

=LTGR(technology) + (alpha)(LTGRcapital) + (1-alpha)(LTGRlabor)

=LTGR(labor force) + LTGR(labor productivity)

Classical theory of economic growth -- what concept is uniquely associated w/ it?

Classical growth theory contends that there is a subsistence real wage, defined as the minimum real wage necessary to support life. Whenever real wages are greater than the subsistence real wage, the population will increase, leading to diminishing returns to labor, and eventually, decreased labor productivity. The key to classical growth theory is the population explosion that occurs whenever real GDP per labor hour increases above the subsistence level, which will eventually eliminate any gains from increased labor productivity. 

Convergence theory

Reasons for failure of convergence

Developing countries should have higher rates of growth of productivity and GDP, which should lead to the per capita GDP, and the gap narrowing between developing and developed economies over time.

low rates of investment, low rates of savings, political instability, a lack of property rights, poor education and health, taxes and regulations that discourage working and investing, and restrictions on trade.

economic income = cash flow − economic depreciation

economic depreciation = (beginning market value − ending market value)

Interest rate parity states that exchange rates must change so that:

risk-adjusted returns on investments in any currency will be equal

(1) prevention of excessive appreciation of domestic currency

(2) reduction of excessive foreign capital inflows

(3) pursuit of independent monetary policy

Characteristics of countries that will see their current account deficits quickly restored to sustainable level due to depreciation of their currency (3):

(1) Countries with lower initial current account deficits

(2) Import and export prices sensitive to exchange rate movements

(3) Imports and exports with high price elasticity of demand

FX Carry Trade problem:

(1) determine "investment" and "funding" currencies

(2) calculate expected return on FX CT

Refer to question Question ID#: 147211

(1) Indian Rupee has higher interest rate and hence would be the investment currency. USD, the counter currency, would be the funding currency. INR is expected to depreciate by [(1/53.88 – 1/54.12)]/(1/53.88) =0.44%

(2) Potential Return on FX carry trade = interest earned – funding cost – depreciation of investment currency.
= (IR_{Invest Curr})(d/360) – (IR_{Fund Curr})(d/360) – 0.44 = 1.22%

(note: 90-day holding period – hence divide the annual interest rates by 4). (Study Session 4, LOS 14.i)

V_t = (FP_t - FP)(Contract Size) / [1+R*(days/360)]

FP = price specified in forward

(1) If contract calls for purchase of X EUR in 30 days, compute mark-to-market value on 30-day forward to SELL EUR. 

FP_t: Spot Bid + (30-day forward bid rate)/10000

R = Interest rate of price currency (days til mature)

Differentiate between:

(1) Portfolio balance approach

(2) Monetary approach

(3) Mundell-Fleming approach

(1) Portfolio balance approach focuses on long-term implications of fiscal policy on exchange rate.

(2) Monetary approach focuses on implications of monetary policy

(3) Mundell-Fleming model focuses on short-term implications of monetary/fiscal policies.

=(Real Interest Rate - Risk Premium)

Highest # = appreciates the most

Question ID#: 87077

Make notecards

E(S_t) = Expected spot rate at time t

=S₀ * [(1+R_A)/(1+R_B)]^t 

[(1 + R_nominal-A)/(1 + R_nominal-B)] = 

[(1 + ExpInflation(A))/(1 + ExpInflation(B))]

Relative Purchasing Power Parity (rPPP)

+ Real exchange rate (formulas):

rPPP: S_t = S₀ * [(1+Inflation_A)/(1+Inflation_B)]^t

Real exchange rate:

S_t * [(CPI_B/CPI_A)]

Mundell-Fleming model:

(1) Under high capital mobility--monetary policy/fiscal policy -> interest rates -> currency ____?

(2) Low capital mobility--monetary/fiscal -> current account status -> currency ____?

(1) expansionary monetary policy/restrictive fiscal policy -> low interest rates -> currency depreciation

(2) expansionary monetary/expansionary fiscal policy -> current account deficits -> currency depreciation

Restrictive monetary policy -> short-term appreciation of currency -> then slow depreciation to long-term PPP value

Expansionary monetary -> depreciation of domestic currency in short term -> slow appreciation toward long-term PPP value

-terms of trade deteriorate

-official foreign exchange reserves dramatically decline

-real exchange rate substantially higher than mean-reverting level

-inflation increases

-equity markets experience boom-bust cycle

-money supply relative to bank reserves increases

-nominal private credit grows

-level of savings/investment

-developed financial markets and intermediaries

-political stability, rule of law, property rights

-investment in human capital (education, HC)

-favorable tax and regulatory systems

-free trade and unrestricted capital flows

Y = TK^AlphaL^(1-Alpha)

Y = aggregate output

Alpha = share of output allocated to (K)

T = Total factor productivity (TFP) which represents technological progress of economy

Output per worker (derived from Cobb-Douglas)

What is capital deepening?

Output/worker = Y/L = T(K/L)^Alpha

CD is an increase in the capital stock and capital-to-labor ratio. Because of diminishing MPC, increases in capital stock can lead to only limited increases in output and labor productivity if capital-to-labor ratio is already high

In equilibrium:

(1) marginal product of capital (MPK)

(2) marginal cost/rental price of capital (r)

(1) MPK = (alpha)(Y/K)

(2) r = (alpha)(Y/K)

Under neoclassic growth theory, sustainable growth of output per capita (g*) (formula):

and G* = ?

g* = (Theta) / (1 - alpha)

 Theta = O w/ horizontal line = growth rate in technology

1- alpha = labor's share of GDP

G* = g* + DELTA(L)

G* = sustainable growth rate of output

DELTA(L) = growth of labor

(1) Absolute convergence theory

(2) Conditional convergence hypothesis

(3) Club convergence hypothesis

(1) less-developed countries willl converge to SOL of developed countries

(2) convergence in living standards will occur for Cs with same savings rate, pop growth and production fxns

(3) some less developed countries may converge to developed standards if they are in "club" of countries--similar institutional structures, such as property rights, and political stability. Outside club--no convergence

Classification of regulations:

(1) Statutes

(2) Administrative regulations

(3) Judicial law

(1) Laws made by legislative bodies

(2) Issued by government

(3) Findings of the court

(1) price mechanisms

(2) restricting or requiring certain activities

(3) provision of public goods

(4) financing of private projects

(1) company law

(2) tax law

(3) contract law

(4) competition law

(5) banking law

(6) bankruptcy law

(7) dispute resolution system

(1) Financial market regulations seek to:

(2) Securities M R include (3):

(3) Prudential supervision:

(1) protect investors and to ensure stability of financial system

(2) disclosure requirements, regulations to mitigate agency conflicts, regulations to protect small investors

(3) monitoring instructions to reduce system-wide risks and protect investors

(1) Net regulatory burden

(2) Sunset clauses

(1) Costs to the regulated entities minus the private benefits of regulation

(2) Require a cost-benefit analysis to be revisited before the regulation is renewed