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Macroeconomics
Aggregate output, price & economic growth
It is the study of aggregate activities of households, companies and markets, that
focus on national aggregates like investments, total consumption, rate of change in
prices and the overall level of interest rates, Macroeconomic analysis examines a
nation’s aggregate output and income, its competitive and comparative advantages,
the productivity of its labor force, its price level and inflation rate, and the actions of
its national government and central bank.

Important definitions:

Aggregate output: is the market value of all goods and services produced in a country
during a specific period

Aggregate income: is the value of income received by the suppliers of factors used in
the production of goods and services during a specific period

There are four boards of income:

 Compensation of employees: wages and benefits

 Rent: payment for the use of property
 Interest: payments for lending funds
 Business Profits: returns that received by companies’ owners for the use of their
capital

Aggregate expenditure: the total amount spent on goods and services that produced
in the economy during the period

Aggregate output = aggregate income = aggregate expenditure

Gross domestic product

GDP: is the market value of all final goods and services produced within economy in a
given period of time

GDP can be measured by:

 Income approach: calculated by summing the amounts earned by households,

companies and government
 Expenditure approach: calculated by summing the amounts spent on the goods
and services produced

Two methods can be used to calculate GDP based on expenditures: either the final
price or the sum of the value added to each stage

Below criteria is used to ensure that GDP is measured consistently over time and
across countries:

 All goods and services included in the calculation of GDP must be produced
during the measurement period
 The only goods and services included in the calculation of GDP are those whose
value can be determined by being sold in the market, Note that owner occupied
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housing and government services are examples of services that cannot be sold
in market but included in GDP
 Only the market value of final goods and services is included in GDP. Final
goods and services are those that are not resold

Nominal and real GDP:

Nominal GDP: value of goods measured at current prices

Real GDP: value of goods measured at a year based prices

Per capita real GDP: real GDP divided by the size of population and it measures the
average standard of living in a country

Inflation: the difference between real and nominal GDP

GDP deflator: a gauge of prices and inflation that measures the aggregate changes in
prices across the overall economy

GDP deflator = (nominal GDP / real GDP) x 100

Increase in nominal GDP will be (Nominal GDP / nominal GDP base year )-1

The components of GDP under expenditure approach

GDP = C + I + G + (X-M)

 C: consumer spending
 I: gross private domestic investment
 G: Government spending
 X – M: exports – imports

Statistical discrepancy: is the difference between measuring GDP by the 2 approaches

Market analysis uses expenditures approach because data are more timely and
reliable

Expenditures approach: GDP =

 Consumer spending
 Government spending
 Business gross fixed investment
 Exports – imports
 Government gross fixed investment (not all countries)
 Change in inventories (must be counted for goods produced and not sold yet)
 statistical discrepancy

Income approach: GDP =

 National income
 Capital consumption allowance
 Statistical discrepancy
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National income =

 Compensation of employees (wages and benefits)

 Government enterprises profits before taxes
 Corporate profits before taxes
 Interest income
 Unincorporated business net income (business owner’s income)
 Rent
 Indirect business taxes minus subsides

Capital consumption allowance (CCA): A measure of depreciation of the capital stock

that occurs in the production of goods and services, loosely speaking, profit + CCA as
the total amount earned by capital

Personal income:

A broad measure of pretax income received by household, whether earned or not

earned; it is a useful determinant of consumer purchasing power & consumption

Personal income =

 National income
 Transfer payments to households
 Indirect business taxes
 Corporate income taxes
 Undistributed corporate profits

Personal disposable income (PDI):

Equals to personal income minus personal taxes

PDI = consumption + Savings

IS & LM curve

Represents the quantity of goods and services that households, businesses,

government, and foreign customers want to buy at any given level of prices

Fundamental relationship between savings & investment, trade balance & fiscal
balance by Balancing aggregate income & expenditures:

GDP expenditure C + I + G + (X – M) = GDP Income =C+S+T

By solving for S: S = I + (G – T) + (X – M)

Domestic private saving are used in three ways:

1. Investment
2. Fiscal balance (negative is surplus, positive is deficit)
3. Trade balance (positive is surplus, negative is deficit)

To derive aggregate demand curve, we must understand factors under the two
approaches

GDP expenditure C + I + G + (X – M) = GDP Income =C+S+T

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C, Consumption is an increasing function of disposable income: either an increase in
real income or a decrease in taxes will increase consumption and savings, the
proportional of additional disposable income that is consumed or spend is Marginal
propensity to consume (MPC) while the proportional of additional disposable income
that is saved is Marginal propensity to save (MPS)

MPS + MPC = 100%

I, investment is an increasing function of expected profitability & decreasing function

of real interest rate

G, government spending on goods and services is an exogenous policy variable

determined outside the macroeconomic model.

T, Net taxes is an increasing function of Economic activity: Tax policy may also be
viewed as an exogenous policy tool but the actual amount of net taxes collected is
closely tied to the level of economic activity

(M – X), trade balance is a function of domestic disposable incomes that affects

imports, foreign disposable incomes that affect exports, and relative price in domestic
and foreign markets

The IS curve:

The IS curve illustrates the negative relationship between interest rates and real
income for equilibrium in goods market

S – I = (G – T) + (X – M)

Interest rates affect components of income

Lower interest rates tend to:

 Decrease savings by households in favor of consumption

 Increase investment by firms as cost of capital decreases
 And so decrease (S – I)

In order to satisfy the above equation, income must increase to restore equilibrium by
increase savings, decrease fiscal or trade balances

Note that:

At higher levels of income or low interest rates, S – I < (G – T) + (X – M), implying

insufficient expenditure.

At lower levels of income or higher interest rates, S – I > (G – T) + (X – M), implying

planned expenditure exceeds output

The LM curve

The LM curve illustrates the positive relationship between interest rates and real
income for equilibrium in money market

The quantitative theory of money equation provide a straight forward connection

between nominal money supply (M), price level (P), real income/expenditures (Y) and
velocity of money (V)
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The demand for real money balances is an increasing function of income and
decreasing function of interest rates

An increase in real income must be accompanied by an increase in the interest rate in

order to keep the demand for real money balances equal to the supply. This
relationship, which economists refer to as the LM curve

For overall equilibrium, the values of real interest rates and income must be
consistent with equilibrium in both the goods and money markets. This simultaneous
equilibrium is the intersection of the IS curve & LM curve

As we will see that aggregate demand curve looks like the ordinary curves in
microeconomics but lower prices allows us to buy more of a good within a given level
of income doesn’t apply here as income is variable, instead aggregate
income/expenditure to be determined in the model with the price level, aggregate
income/expenditures will replace quantity

The aggregate demand curve will represent the combination of aggregate income and
prices under tow conditions:

 First condition: the IS curve, the equality of planned expenditures and actual
income
 Second condition: the LM curve, equilibrium in money market

The aggregate demand curve: an inverse relationship between price level and real
income

If price level declines real income increases, real money supply increases and interest
rates decreases

If price level increases real income decreases, real money supply decreases and
interest rates increases

It should be clear that many interesting and important aspects of the economy are
subsumed into the AD curve: saving, investment, trade and capital flows, interest
rates, asset prices, fiscal and monetary policy, and more. All of these disappear
behind a deceptively simple relationship between price and output/income.

Aggregate supply

Represents the relationship between price level & real GDP

Represents the level of domestic output producers are willing to provide at various
prices

Supply curve has three phases:

VSRAS (very short run aggregate supply): very elastic curve as firms will adjust output
without changing price managing current inputs aggressively

SRAS: an upward curve as some inputs prices will change as production increase or
decrease
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LRAS: A vertical inelastic curve and price levels has no long run effect on aggregate
supply, this level of output is called potential GDP or full employment GDP

Aggregate supply is a function of capital & Labor, The position of the LRAS curve is
determined by the potential output of the economy. The amount of output produced
depends on the fixed amount of capital and labor and the available technology.

The long-run equilibrium is referred to the full employment level of output, at this
level of output, the economy’s resources are deemed to be fully employed and (labor)
unemployment is at its natural rate.

This concept of a natural rate of unemployment assumes the macro economy is

currently operating at an efficient and unconstrained level of production. Companies
have enough spare capacity to avoid bottlenecks, and there is a modest, stable pool
of unemployed workers looking for and transitioning into new jobs.

Shifts in aggregate demand and supply

Shifts in aggregate demand:

A change in price levels is represented as a movement along the AD curve

The factors that influence the level of expenditures will cause AD to shift

Remember GDP = C + I + G + (M – X)

Factors that directly or indirectly influence aggregate demand are:

 Household wealth, increase, shifts right

 Consumer and business confidence, increase, shifts right
 Capacity utilization, increase, shifts right
 Fiscal policy (Government spending), increase, shift right
 Expansionary fiscal policy, shift right
 Expansionary monetary policy, shift right
 Growth in global economy, increase, shift right

Shift in short-run supply curve:

Factors that change cost of production or expected profit margins will cause SRAS to
shift

Factors that directly or indirectly influence SRAS are:

 Productivity increases, shift right

 Nominal wages, decreases, shift right
 Input prices, decrease, shift right
 Expectations about future output prices, increase, shift right
 Business taxes, decrease, shift right
 Subsidies, increase, shift right

Shift in long-run aggregate supply curve:

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Potential GDP: measure the productive capacity of the economy and is the level of
real GDP that can be produced at full employment, potential GDP is not static, it can
increase every year

The position of LRAS curve is determined by potential output of the economy, any
factor that increases the resource base will influence LRAS

Factors that directly and indirectly influence LRAS are:

 Supply of human capital, increase, shift right

 Supply of natural resources, increase, shift right
 Supply of physical capital, increase, shift right
 Productivity and technology, increase, shift right

NB, all factors that shifts LRAS are obviously shifting SRAS, but not all factors that
shift SRAS has an impact on LRAS

Equilibrium GDP & prices

Equilibrium occurs by intersection of AD & AS, at this point aggregate output

demanded equal aggregate output supplied

If the price level is above equilibrium, then the quantity of output supplied exceeds
the amount demanded. This situation would result in unsold inventories and would
require a reduction in production and in prices.

If the price level is below equilibrium, then the quantity of aggregate output
demanded exceeds the quantity of aggregate output supplied. This situation would
result in a shortage of goods that would put upward pressure on prices.

It’s important to know that short-run equilibrium may occur at a level above or below
the full employment

AD & AS cases:

 Long-run full employment

 Short-run recessionary gap
 Short-run inflationary gap
 Short-run stagflation

Long-run equilibrium: occurs when AD curve intersects SRAS curve at a point on LRAS
curve

GDP = potential GDP, both labour and capital are fully employed

Recessionary gap: occurs when AD curve decreases and shifts to left to intersects
SRAS curve at a point below LRAS curve

GDP < potential GDP, both labour and capital unemployment rates rise

Inflationary gap: occurs when AD curve shift to the right to intersects SRAS curve at a
point above LRAS curve

GDP > potential GDP, result an upward price level pressure

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Stagflation: occurs when AS curve shift to the left to intersects AD curve at a point
below LRAS curve

GDP < potential GDP, result unemployment and increase inflation

If both curves shifts: just know it by graphs

Economic growth & sustainability

Economic growth is calculated as the annual percentage change in real GDP or the
annual percentage in real per capita GDP

 Growth in real GDP measures how rapidly the total economy is expanding.
 Per capita GDP, defined as real GDP divided by population, determines the
standard of living in each country and the ability of the average person to buy
goods and services.

Sustainable rate of economic growth: the rate of increase in the economy’s productive
capacity or potential GDP

Global investors need to address questions like:

 What are the underlying determinants or sources of growth for the country?
 Are these sources of growth likely to remain stable or change over time?
 How can we measure and forecast sustainable growth for different countries?

Production function and potential GDP:

The neoclassical or Solow growth model shows that the economy’s productive
capacity and potential GDP increases by:

 Accumulation of such inputs as capital, labor, and raw materials used in

production, and
 Discovery and application of new technologies that make the inputs in the
production process more productive—that is, able to produce more goods and
services for the same amount of input.

This model based on production function that provides the quantitative link between
the level of output that economy can produce and the inputs used in the production
process

Y = AF (L, K)

Where A represents total factor productivity (TFP) which is a scale factor that reflects
the portion of growth that is not accounted by capital or labor, the main factor
influence TFP is technological knowledge, it’s not observed and must be estimated

Thomas Malthus in his 1798 publication, Essay on the Principle of Population. Malthus
argued that as the population and labor force grew, the additional output produced by
an additional worker would decline essentially to zero and there would be no long-
term economic growth. This gloomy forecast caused others to label economics the
“dismal science.”

Because of diminishing returns to both labor and capital, economists found that the
only way to sustain growth in potential GDP per capita is through growth in TFP, this
result an upward shift for production function
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Growth in potential GDP = growth in TFP + W C (growth in capital) + WL (growth in
labor)

Growth in per capita potential GDP = growth in TFP + W C (growth in capital-to-labor

ratio)

Sources of economic growth:

Five important sources for economy growth are:

 Labor supply;
 Human capital;
 Physical capital;
 Technology; and
 Natural resources.

Measures of sustainable growth:

We can focus on the productivity of the labor force:

Labor productivity: the quantity of goods and services that a worker can produce in
one hour of work

Labor productivity = real GDP / aggregate hours

By dividing production function by L we get

Y/L = AF (1, K/L), where Y/L is the labor function

Because both output and labor input can be observed, labor productivity can be
measured directly

Level of labor productivity is much higher in the developed countries while growth
rate of labor productivity is much higher in developing countries

If productivity growth is rapid, it means the same number of workers can produce
more and more goods and services. In this case, companies can afford to pay higher
wages and still make a profit. Thus, high rates of productivity growth will translate
into rising profits and higher stock prices.

In contrast, persistently low productivity growth suggests the economy is in bad

shape. Without productivity gains, businesses have to either cut wages or boost prices
in order to increase profit margins. Low rates of productivity growth should be
associated with slow growth in profits and flat or declining stock prices.

Measuring sustainable growth:

By rearranging labor productivity: potential GDP = labor productivity x aggregate

hours

Potential growth rate = long-term labor productivity growth rate + long-term labor
force growth rate
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Business cycles
Overview of Business cycles
Defined in five steps:

1. Business cycles are typical of economies that rely mainly on business

enterprises
2. A cycle has an expected sequence of phases representing alternation between
expansion and contraction.
3. Such phases occur at about the same time throughout the economy
4. Cycles are recurrent but they do not all have the exact same intensity and/or
duration.
5. Cycles typically last between 1 and 12 years.

Business cycles characterized by fluctuations in economic activities where real GDP &
unemployment rate are the key variables used to determine the current phase of the
cycle

Phases of business cycles:

1. Expansion
2. Peak
3. Contraction
4. Trough

A boom is an expansionary phase when economic growth is testing the limits of the
economy

A simple common rule of starting expansion/recession is when economy experience

two consecutive quarters of positive/negative real GDP growth

Fluctuations of the economy

 Resources use through business cycles

 Capital spending
 Inventory levels
 Consumer behaviour
 Housing sector behaviour
 External trade sector behaviour

Typical business cycle characteristics may be summarized as follows

Expansion:

 GDP growth rates is positive

 Unemployment rate decreases as hiring accelerates
 Investment increases
 Consumer spending and home construction increases
 Inflation rate may increase
 Inventory levels is normal
 Imports increase as domestic income growth increases

Peak:
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 GDP growth rates decreases but still positive
 Unemployment rate decreases but hiring slow
 Investment grow but in a slower rate
 Consumer spending and home construction increase but in a slower rate
 Inflation rate increase
 Inventory levels is high

Contraction:

 GDP growth rates is negative

 Unemployment rate increases and working hours decrease
 Investment decrease
 Consumer spending and home construction decreases
 Inflation rate decreases with a lag
 Inventory levels is normal
 Imports decrease as domestic income growth increases

Trough:

 GDP growth rates increase, become positive again

 Unemployment rate is high but increasing in overtime & temp workers
 Investment increases
 Consumer spending and home construction may
 Inflation rate moderate
 Inventory levels is low

Theories of business cycles

1. Neoclassical schools:
Neoclassical analysis believed that business cycles results are primary driven by
changes in technology over time and these are temporary deviations from long-run
equilibrium and their

They relied on the concept of general equilibrium that all markets will reach
equilibrium because of the invisible hand or free market

2. Keynesian theory

Keynes believed that business cycles result from changes in expectations

Keynes believes that governmental intervention is a must to keep capital and labour
employed & limit the damage after major recessions

He famously quipped that, “in the long run, we are all dead”

3. Monetarist school

Monetarists believed that business cycles results from external shocks or the
inappropriate decisions by the monetary authority that impact money supply
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Monetarists believed that central banks should follow a policy of steady & predictable
increases in money supply

4. The Austrian school

The Austrian school believed that business cycles result from government intervention
in the economy

5. The new classical school

They introduced the real business cycle theory (RBC)

They believe that policy makers shouldn’t try to counteract business cycles because
expansion and contraction are efficient markets response for external shocks

Menu cost

Another possibility that some economists suggested in the 1980s is called the “menu
costs” explanation: It is costly for companies to continuously adjust prices to make
markets clear, just like it would be costly for a restaurant to print new menus daily
with updated prices. Another explanation is that every time an economic shock hits a
company, the company will need some time to reorganize its production.

Unemployment
Many governments’ state economic policy objectives related to limiting
unemployment and containing price inflation

Unemployment is at its highest at end of trough as recovery starts, and its lowest just
at the peak of economy

Important definitions:

 Employed: number of people with a job, normally does not include informal
workers
 Labour force: people who either have a job or actively seeking a job
 Activity ratio: labour force to population of working age that is from 16 to 64
 Unemployed: people who are actively seeking a job but currently can’t find one
 Long-term unemployment: people who have been out of work for more than 3 to
4 months but are still looking for one
 Frictionally unemployment: people that just left one job and are about to start
another one
 Hidden unemployment:
o Underemployed: person that have a job that is below his qualifications
o Discouraged worker: person that given up seeking employment,
discouraged workers are statistically outside labour force
 Voluntary unemployed: person voluntary outside labour force
 The unemployment rate: ratio of unemployment to labour force, generally
stated as a percent of the overall workforce
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Although these various unemployment measures provide insight to the state of the
economy, unemployment is a lagging economic indicator of the business cycle
because:

1. The labor force expands and declines in response to economy environment and
so unemployment rates tends to point in a past economic condition
2. The reluctance of business to lay off people affects unemployment rates which
gives false signals to business cycles

Straight forward indicators such as:

1. Payroll employment: by measuring the size of payrolls, it’s a clear indication of

economic weakness when payroll shrinks and a clear indicator of recovery when
payroll rise
2. Cut back working hours and overtime following by cutting temporary and part-
time workers is a good indicator of economy weakness, increase overtime and
working hours followed by increase in temporary and part-time workers is a
good indicator of economy recovery
3. Productivity decrease is an early indicator of falling output and economy
weakness even payroll still the same, and productivity also responds quickly
when business condition improve as it begins to utilize its unemployed workers,
productivity occurs earlier than any upturn in full-time employment payrolls

Inflation
The overall price level changes at varying rates during different phases of a business
cycles, it’s pro-cyclical, as it goes up and down with the cycle but with a lag of a year
or more

Important definitions:

 Inflation: is a sustained rise in the aggregate price levels, economists use

various prices indices to measure the overall price level
 Stagflation: high inflation combined with high unemployment, no short term
policies is thought to be effective
 Deflation: a sustained decrease in aggregate price levels, which corresponds to
negative inflation rate less than 0%
 Hyperinflation: an extremely fast increase in aggregate price levels
 Disinflation: a decline in the inflation rate but still positive

Inflation is measured by the percentage change in price index

Price index: represents the average prices of a basket of goods and services, and
various methods can be used to calculate the average of different prices such as:

1. Laspeyres index: an index created by holding composition of consumption

basket constant using a base index, because most price indices are created to
measure the cost of living, simply using a fixed basket of goods and services
has three biases: The substitute bias, the quality bias and new product bias
2. Paasche index: is an index using the current composition of the basket
3. Fisher index: is the geometric mean of the Laspeyres index & Paasche index

Types of indexes:
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1. PCE (personal consumption expenditures): price index covers all personal
consumptions using business surveys
2. PPI (Producer price index): reflects price changes experiences by domestic
producers in a country, PPI can influence future CPI because price increases can
eventually passes through to consumers, scopes and weights also vary among
countries in a more dramatic ways because different countries specialized in
different industries, in some countries it called wholesale price index

Causes of inflation:

Cost-push: in which rising costs, usually wages, compel business to raise prices

Low unemployment rates means shortage in labor market which tends to force cost-
push inflation

A complete picture only emerges when examine such trends along with productive
indicators

Labor cost per unit (ULC): the average labor cost to produce one unit of output

ULC = total cost of labor per worker per hour / output per worker per hour

Practitioners look for this relationship in this mix of indicators to identify cost- or
wage-push inflationary pressure.

Demand-pull: in which increasing demand raises prices

The higher the rate of capacity utilization or the closer actual GDP to potential GDP,
the more likely an economy will suffer shortages, bottlenecks, a general inability to
satisfy demand, and hence, price increases,

The lower the rate of capacity utilization or the more an economy operates below its
potential, the less such supply pressure will exist and the greater likelihood of a
slowdown in inflation, or outright deflation

Money supply: Monetarists contend that inflation is fundamentally a monetary

phenomenon. A surplus of money will inflate the money price of everything in the
economy. Stated in terms of straightforward supply and demand relationships, a
surplus of money would bring down its value and raises prices

Inflation expectations: Beyond demand-pull, monetary, and cost-push inflation

considerations, practitioners also need to account for the effect of inflation
expectations. Once inflation becomes embedded in an economy, businesses, workers,
consumers, and economic actors of every kind begin to expect it and build those
expectations into their actions. This reaction, in turn, creates an inflationary
momentum of its own in a manner much like the wage-price spiral, expectations give
inflation something of a self-sustaining character and cause it to persist in an
economy even after its initial cause has disappeared
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Economic indicators
Important definitions:

Economic indicator: is a variable that provides information on the state of the overall
economy

Leading economic indicators: They are believed to have value for predicting the
economy’s future state

Coincident economic indicators: They are believed to have value for identifying the
economy’s present state

Lagging economic indicators: They are believed to have value in identifying past
condition of economy

Diffusion index of economic indicators: reflects the proportion of the index’s

components that are moving in a pattern consistent with the overall index. Analysts
often rely on these diffusion indices to provide a measure of the breadth of the
change in a composite index.
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Monetary & fiscal policy

Monetary policy: refers to central bank activity that are directed toward quantity of
money and credit

Fiscal policy: refers to government’s decision about taxation and spending

Both monetary and fiscal policies are used to regulate economic activity over time.
They can be used to accelerate growth when an economy starts to slow or to
moderate growth when an economy starts to overheat. In addition, fiscal policy can be
used to redistribute income and wealth.

Monetary policy
Important definition:

 Money: a generally accepted medium of exchange and unit of account

 Central banks: the dominant bank in a country, usually with official or semi-
official government status
 Barter economy: an economy where everyone pay for goods and services with
another goods and services
 Double coincidence of wants: both economic agents in the transaction wants
what the other is selling
 Medium of exchange: any asset that can be used to purchase goods and
services
 Promissory note: a written promise to pay a certain amount of money in
demand, it was created by goldsmiths that were evolved into banks

Money:

For money to act as this liberating medium of exchange, it must possess some
qualities:

 be readily acceptable,
 have a known value,
 be easily divisible,
 have a high value relative to its weight, and
 be difficult to counterfeit

Money fulfill three important functions:

 Acts as a medium of exchange

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 Provide individuals of a way of storing wealth
 Provides society with a convenient measure of value and unit of account

Money creation process:

The process by which changes in bank reserves translate into changes in money
supply

Fractional reserve banking: banking in which reserves constitute a fraction of

deposits, the practice of lending others customers money to other depending on the
assumption that not all customers will want all their money back at any one time

Reserve requirement: requirements for banks to hold reserves in proportion to the

size of deposits

Money multiplier: describes how a change in reserves is expected to affect the money
supply, in its simplest form equals 1 divided by reserve requirement

Narrow money: the notes and coins in circulation in an economy plus other very highly
liquid deposits

Broad money: encompasses narrow money plus the entire range of liquid assets that
can be used in purchasing

Definitions of money: basically the greater the complex of financial systems, the
harder to define money

Quantity theory of money:

It’s the relationship between money and price levels, which asserts total spending in
proportional to the quantity of money supplied

Quantity theory of money equation: M x V = P x Y

 M: money supply
 V: velocity
 P: price
 Y: real output

Effectively it says that over a given period, the amount of money used to purchase all
goods and services in an economy equal to monetary value of output, if velocity of
money is constant, then it means spending is a proportional of quantity of money

Money neutrality: refers that an increase in money supply will only lead to an increase
in price levels, while leaving real variables like output unaffected

The simple quantity theory gave rise to the equally simple idea that the price level
and the rate of inflation could be controlled by manipulating the rate of growth of the
money supply.

Theories of demand & supply of money

Demand for money: the amount of wealth that households & firms of an economy
choose to hold in the form of money

There is an inverse relationship between demand of money & interest rates

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Three reasons for holding money are:

1- Transactions
2- Precautionary
3- Speculation

Generally speaking, as GDP grows, transactions balances will also tend to grow but
remain stable ratio over time, precautionary balances tend to increase, speculation,
balances will tend to be inversely related to the expected return on other financial
assets and directly related to the perceived risk of other financial assets

Supply of money: the amount of money supplied is determined by the central bank
and is independent of interest rates, perfectly inelastic

Equilibrium: As with most other markets, the supply of money and the demand to hold
it will interact to produce an equilibrium price for money. Where the price of money is
the nominal interest rate that could be earned by lending it to others

Monetary policies: A central bank can affect short-term interest rates by increasing
or decreasing money supply:

1- An increase in money supply will shift supply for the right which will intersect
interest rates at new lower equilibrium
2- A decrease in money supply will shift supply curve to the left which will intersect
interest rates at new higher equilibrium

The Fisher effect:

The real interest rate in an economy is stable over time so that changes in nominal
interest rates are the results of changes in expected inflation

Investors can never be sure about future values of such economic outcomes. To
compensate them for this uncertainty, they require a Risk premium: an extra return
expected by investors for bearing some specific risk

Nominal rates = real rates + expected inflation + risk premium

The roles of central banks:

Central banks plays a number of key roles in modern economies:

1- The monopoly supplier and guardian of their fiat currencies and as an institution
charges with the role of maintaining confidence in their currency
2- The central of economic life, Banker of the government, bank of the banks
3- The lender of last resort
4- The regulator and supervisor of payments system
5- The saver & manager of foreign currency and gold reserve
6- The conductor of monetary policy and the supervisor of banking system

Goals of central banks:

1- The primary goal is maintaining price stability is the association of controlling

inflation
2- Exchange rates stability
3- Full employment
4- Sustainable positive economic growth
19
5- Moderate long-term interest rates

Cost of inflation: really centers on the distinction between

Expected inflation can give rise to:

 Menu costs
 Shoe leather costs.

Unexpected inflation can in addition:

 Lead to inequitable transfers of wealth between borrowers and lenders
 Give rise to risk premium
 Reduce the information content of market prices

Monetary policy tools:

Open market operations: buy or sell of government bonds by central bank to

implement monetary policy

Official interest rate: an interest rate sets and publicly announced by central bank,
normally the rate at which central bank is willing to lend money to the commercial
banks

Reserve requirements: the requirement for banks to hold reserves in proportion to the
size of deposits

The transmission mechanism:

The process whereby a central bank’s interest rate gets transmitted through the
economy and ultimately affects inflation

The central bank’s policy rate works through the economy via any of the following
interconnected channels:
 Short-term interest rates;
 Changes in the values of key asset prices (inflation)
 The exchange rate; and
 The expectations of economic agents

Inflation targeting: Over the 1990s, a consensus began to build among both central
bankers and politicians that the best way to control inflation and thereby maintain
price stability was to target a certain level of inflation and to ensure that this target
was met by monitoring a wide range of monetary, financial, and real economic
variables. Nowadays, inflation-targeting frameworks are the cornerstone of monetary
policy and macroeconomic policy in many economies

Inflation-targeting framework normally has the following set of features:

 An independent and credible central bank;

 A commitment to transparency;

 A decision-making framework that considers a wide range of economic and

financial market indicators
20
 A clear, symmetric and forward-looking medium-term inflation target,
sufficiently above 0 percent to avoid the risk of deflation but low enough to
ensure a significant degree of price stability.

Exchange rates targeting: Such targeting involves setting a fixed level or band of
values for the exchange rate against a major currency by buying and selling the
national currency in foreign exchange markets, it is in this sense that a successful
exchange rate targeting policy imports the inflation of the foreign economy

Limitations of monetary policy:

Included problems in the transmission mechanism and the relative effectiveness of

interest rate adjustment as a policy tool in deflationary environments

Problems in transmission mechanism:

1. Bond market vigilantes: bond market participants who might reduce their
demand for long-term bonds, thus pushing up their yields
2. Liquidity trap: a condition in which demand curve becomes perfectly elastic
(horizontal) so that injections of money will not lower interest rates or affect real
activity
3. Interest rate adjustment in a deflationary environment
4. Quantitative easing: an expansionary monetary policy based on aggressive
open market purchase operations

Limitations summarized that the ultimate problem for monetary authorities as they try
to manipulate the supply of money in order to influence the real economy is that they
cannot control the amount of money that households and corporations put in banks
on deposit, nor can they easily control the willingness of banks to create money by
expanding credit. Taken together, this also means that they cannot always control the
money supply. Therefore, there are definite limits to the power of monetary policy.

Fiscal policy
It is a tool to influence economic activity that involves using government spending
and changing taxes revenue

General rule:

Decreasing taxes & increasing spending, budget deficit, increase overall demand,
economic growth and employment that can fight a recession
21
Increasing taxes & decreasing spending, budget surplus, decrease overall demand,
economic growth & employment that can slow down an expansion

Deficits and national debt:

Deficits: are the difference between government revenues and spending over
calendar period

National debt: government deficits are financed from the private sector

Should we be concerned about the size of a national debt (relative to GDP)?

The arguments of not being concerned about national debt:

 The scale of the problem may be overstated because the debt is owed
internally to fellow citizens.
 A proportion of the money borrowed may have been used for capital
investment projects or enhancing human capital that should lead to raised
future output and tax revenues.
 Large fiscal deficits require tax changes which may actually reduce
distortions caused by existing tax structures.
 Deficits may have no net impact because the private sector may act to
offset fiscal deficits by increasing saving in anticipation of future increased
taxes. This argument is known as “Ricardian equivalence” and is
discussed in more detail later.
 If there is unemployment in an economy, then the debt is not diverting
activity away from productive uses (and indeed the debt could be
associated with an increase in employment).

The arguments of being concerned about national debt:

 High levels of debt to GDP may lead to higher tax rates in the search for
higher tax revenues. This may lead to disincentives to economic activity.
 If markets lose confidence in a government, then the central bank may
have to print money to finance a government deficit. This may lead
ultimately to high inflation, as evidenced by the economic history of
Germany in the 1920s and more recently in Zimbabwe.
 Government borrowing may divert private sector investment from taking
place (crowding out) if there is a limited amount of savings to be spent on
investment, then larger government demands will lead to higher interest
rates and lower private sector investing
 Taxes can be justified both in terms of raising revenue and wealth
redistribution

Ricardian equivalence:

 Increase in current deficit mean greater taxes in the future,

 Tax payers may increase current saving and decrease current consumption in
order to maintain their preferred pattern of consumption over time
 If tax payers reduce increase savings and reduce consumption by an amount
equal to repaying debt
 The aggregate demand will not change

If tax payers underestimate their future liability for servicing and repaying the debt,
so that aggregate demand increased by equal spending and tax increases, Ricardian
does not hold any more
22
Objectives of fiscal policy include:

 Influencing the overall level of economic activity and aggregate demand.

 Redistribution of income and wealth among segments of the population.
 Allocation of resources among economic agents and sectors.

Fiscal policy tools:

Government spending can take a variety of forms:

1. Transfer payments: welfare payments made through the social security system
that exist to provide a basic minimum level of income for low income
households, and also provide a mean that government can change the overall
income distribution in a society, they are considered in the general government
spending on goods and services
2. Current government spending: involves spending on goods and services that
are provided on a regular basis including health, education and defense, this will
have a big impact on country’s skill level and labor productivity
3. Capital expenditure: involves spending that is not regular that include
infrastructure on roads, hospitals and schools, this will have an impact on
potential productivity on nation

Government revenue can take a variety of forms:

1. Direct taxes: taxes levied on income, wealth, and corporate profits and include
capital gains taxes, national insurance (or labor) taxes, and corporate taxes.
They may also include a local income or property tax for both individuals and
businesses. Inheritance tax on a deceased’s estate will have both revenue-
raising and wealth-redistribution aspects.

2. Indirect taxes: taxes on spending on a variety of goods and services in an

economy—such as the excise duties on fuel, alcohol, and tobacco as well as
sales (or value-added tax)—and often exclude health and education products on
social grounds.

Four desirable attributes of tax policy that are Simplicity, efficiency, fairness and
revenue sufficiency

Advantages of using different fiscal policy tools:

 Quick implementation of indirect taxes can influence spending behavior

instantly and generate revenue for the government at little or no cost to the
government.
 Social policies, such as discouraging alcohol or tobacco use, can be
implemented very quickly via indirect taxes

Disadvantages of using different policy tools:

 Direct taxes are more difficult to change without considerable notice often many
months, because payroll computer systems will have to be adjusted, although
the announcement itself may well have a powerful effect on spending behavior
more immediately. The same may be said for welfare and other social transfers.
 Capital spending plans take longer to formulate and implement, typically over a
period of years.
23
The fiscal multiplier: measure the effect of government spending over overall
income

Fiscal multiplier = 1 / (1 – tax rate) (1 – marginal propensity to consume)

The balanced budget multiplier: If government spending increases by the same

amount as it raises taxes, the aggregate output actually rises

Major issues in fiscal policy implementation:

Fiscal policy cannot stabilize aggregate demand completely because the difficulties in
executing fiscal policy cannot be completely overcome.

1- Due to recognition lag, action lag and impact lag

2- A second aspect is the uncertainty of where the economy is heading

independently of these policy changes

There are wider macroeconomic issues also involved here.

 If the government is concerned with both unemployment and inflation in an

economy, then raising aggregate demand toward the full employment level may
also lead to inflation.
 If the budget deficit is already large relative to GDP and further fiscal stimulus is
required, then the necessary increase in the deficit may be considered
unacceptable by the financial markets leading to higher interest rates on
government debt and political pressure to tackle the deficit.
 Fiscal expansion raises demand, but what if we are already at full employment
 If unused resources reflect a low supply of labor or other factors rather than a
shortage of demand
 If the government borrows from a limited pool of savings, the competition for
funds with the private sector may crowd out private firms with subsequent less
investing and economic growth. In addition, the cost of borrowing may rise,
leading to the cancellation of potentially profitable opportunities.

The relationship between fiscal and monetary policies

In their detailed research paper using the IMF’S Global Integrated Monetary and Fiscal
Model (IMF 2009), IMF researchers examined four forms of coordinated global fiscal
loosening over a two-year period, which will be reversed gradually after the two years
are completed. These are:

 An increase in social transfers to all households,

 A decrease in tax on labor income,

 A rise in government investment expenditure, and

 A rise in transfers to the poorest in society.

The two types of monetary policy responses considered are:

24
 No monetary accommodation, so rising aggregate demand leads to higher
interest rates immediately

 Monetary accommodation, interest rates are kept unchanged for the two years.

The following important policy conclusions from this study emphasize the role of
policy interactions:

 No monetary accommodation: Government spending increases have a much

bigger effect (six times bigger) on GDP than similar size social transfers because
the latter are not considered permanent, although real interest rates rise as
monetary authorities react to rises in aggregate demand and inflation. Targeted
social transfers to the poorest citizens have double the effect of the non-
targeted transfers, while labor tax reductions have a slightly bigger impact than
the latter.

 Monetary accommodation: Except for the case of the cut in labor taxes, fiscal
multipliers are now much larger than when there is no monetary
accommodation. The cumulative multiplier (i.e., the cumulative effect on real
GDP over the two years divided by the percentage of GDP, which is a fiscal
stimulus) is now 3.9 for government expenditure compared to 1.6 with no
monetary accommodation. The corresponding numbers for targeted social
transfer payments are 0.5 without monetary accommodation and 1.7 with it.
The larger multiplier effects with monetary accommodation result from rises in
aggregate demand and inflation, leading to falls in real interest rates and
additional private sector spending (e.g., on investment goods). Labor tax cuts
are less positive.

Quantitative easing and policy inter action: What about the scenario of zero interest
rates and deflation? Fiscal stimulus should still raise demand and inflation, lowering
real interest rates and stimulating private sector demand
25
International trade & capital flows
Basic terminology:

 GDP: measures the market value of all final goods and services produced by
factors of production located within a country/economy during a given period of
time including production of goods and services by foreigners within the county
and excluding production of goods and services by its citizens outside the country,
it means gross product by country
 GNP: measures the market value of all final goods and services produced by
factors of production located within a country/economy during a given period of
time excluding production of goods and services by foreigners within the county
and including production of goods and services by its citizens outside the country,
it means gross product by nationality
 Imports: are goods and services that a domestic economy purchases from other
countries
 Exports: are goods and services that a domestic economy sell for other countries
 Net exports: the difference between value of exports and imports
 Trade surplus: if exports excess imports
 Trade deficit: if imports excess exports
 Terms of trade: the ratio of the price of exports to the price of imports
 Autarky: is a state in which country doesn’t trade with other countries and also
known as closed economy
 Autarkic price: price of goods and services inside an autarky country
 Open economy: is a state in which country is trading with other countries
 World price: price of goods and services in an open economy country if there is no
restrictions on trade
 Free trade: occurs when there is no government restrictions on country’s ability to
trade, under free trade intersection of global aggregate demand and aggregate
supply determine the equilibrium quantity and price of exports and imports
 Trade protection: governmental restrictions of import and export like tariffs and
quotas
 Globalization: refer to the increasing worldwide integration of markets
 Foreign direct investment FDI: refers to direct investment by a firm in productive
assets in a foreign country
 Multinational Corporation MNC: when a firm engaged in FDI, operating in more than
one country or having subsidiary firms in more than one country
 Foreign portfolio investment FPI: refers to short-term investment by a firm,
institution or individuals in foreign financial instruments

Patterns and trends in international trade and capital flows:

(World Bank 2009) When exports are concentrated in labor-intensive manufacturing,

trade increase wages for unskilled workers, benefiting poor people. It also encourages
macroeconomic stability, again benefiting the poor, who are more likely to be hurt by
inflation. And through innovation and factor accumulation, it enhances productivity
and thus growth. There may be some empirical uncertainty about the strength of
trade’s relationship with growth. But essentially all rich and emerging economies have
a strong trade orientation.

(World Trade Organization 2008) of course, trade is not the only factor that influences
economic growth. Research has also identified such factors as the quality of
26
institutions, infrastructure, and education; economic systems; the degree of
development; and global market conditions.

Benefits and costs of international trade:

The most compelling arguments supporting international trade are: countries gain
from exchange and specialization, industries experience greater economies of scale,
households and firms have greater product variety, competition is increased, and
resources are allocated more efficiently

It is critical for analysts to be able to examine a country’s comparative and absolute

advantages and to analyze changes in them. It is also important to understand
changes in government policy and regulations, demographics, human capital, demand
conditions, and other factors that may influence comparative advantage and
production and trade patterns. This information can then be used to identify sectors,
industries within those sectors, and companies within those industries that will benefit

Absolute & comparative advantages:

Absolute advantage: if a country is able to produce a good or service at a lower cost

or with a fewer resources than its trading partner

Comparative advantage: if a country’s opportunity cost of producing a good is lower

than its trading partner

Adam smith argued that a country could gain from trade if it has an absolute
advantage in the production of that good

Ricardian model: argued that even a country do not have an absolute advantage of
producing a good, it still could still gain from trade if it had a comparative advantage
in the production of that good, labor is the only variable factor of the production
where difference in labor productivity reflecting underlying differences in technology

Heckscher-ohlin model: both capital and labor are the variable factors of the
production, differences in in the relative endowment of these factors are the source of
country’s comparative advantage, this model assumes that technology in each
industry is the same among countries, but it varies between industries, according to
this model, a country has a comparative advantage of producing a good whose
production is intensive in the factor with which it is abundant endowed and would
tend to specialize in and export that good

It is important to note that technological differences, as emphasized in the Ricardian

trade model, and differences in factor abundance, as emphasized in the Heckscher–
Ohlin model, are both important drivers of trade. They are complementary, not
mutually exclusive. Tastes and preferences can also vary among countries and can
change over time, leading to changes in trade patterns and trade flows.

Restrictions & agreements

Trade restrictions or protection are government policies that limit the ability of
domestic households and firms to trade freely with other countries

The primary objective of restrictions is to protect domestic industries that produce the
same or similar goods. They may also aim to reduce a trade deficit. Tariffs reduce the
demand for imported goods by increasing their price above the free trade price.
27
1- Tariffs: Taxes that government levies on imported goods
2- Quotas: limits on amount of imports allowed over sometime
3- Export subsidies: It is a payment by government to a firm for each unit of good
that is exported
4- Voluntary export restrain: is a trade barrier by limiting exports of a good to
trading partner to a specific number of units

An import license: specifies the quantity of a good that can be imported into a country

Quota’s rent: profits that foreign producers can earn by raising the price of their
goods higher than they would without a quota

Countervailing duties: are duties that are levied by the importing country against
subsidized exports entering the country

Effect of tariffs, quotas & subsidies are:

1- Reduce imports
2- Increase price
3- Increase domestic quantity supplied
4- Decrease consumer surplus
5- Increase producer surplus
6- Decrease welfare except for large countries that can influence the global price

Trading blocs & regional trading agreements:

Free trade areas FTA: The most prevalent forms of regional integration, in which all
barriers to the flow of goods and services among members have been eliminated,
NAFTA (USA, Canada and Mexico) is an example

Costume union: Extends FTA by creating a common trade policy against non-members
Benelux is an example (Belgium, Netherland and Luxemburg)

Common market: Extend costume unions by allowing free movement of factors of

production among members, MERCOSUR is an example (the southern cone common
market of Argentina, Brazil, Paraguay and Uruguay)

Economic union: Extends common market by requiring common economic institutions

and coordination of economic policies among members, the EU is an example

Monetary union: extends economic union by adopting a common currency, EU with

Euro is an example

Trade creation: it occurs when higher-cost domestic production replaced by lower-cost

imports from other members

Trade diversion: occurs when low-cost imports from nonmembers replaced by higher-
cost production from members

The benefits from free trade are greater specialization according to comparative
advantage, reduction in monopoly power because of foreign competition, economies
of scale from larger market size, learning by doing, technology transfer, knowledge
spillovers, greater foreign investment, and better quality intermediate inputs at world
prices. Also apply to regional trading blocs. In addition, fostering greater
interdependence among members of the regional trading bloc reduces the potential
28
for conflict. Members of the block also have greater bargaining power and political
clout in the global economy by acting together instead of as individual countries.

Capital restrictions:

There are many reasons for governments to restrict inward and outward flow of
capital. For example, the government may want to meet some objective regarding
employment or regional development, or it may have a strategic or defense-related
objective

Balance of payments (BOP): is a double entry bookkeeping system that reflects

payments for exports and imports with debit represents an increase in country’s
assets and decrease in its liabilities & Credit represents a decrease in country’s assets
and increase in its liabilities

Balance of payments components: is composed of the current account, capital

account and financial account

Current account: measure the flow of goods and services

Decomposed into four sub-accounts

 Merchandise trade consists of all commodities and manufactured goods

bought, sold, or given away.
 Services include tourism, transportation, engineering, and business services,
such as legal services, management consulting, and accounting. Income on
foreign investments, fees from patents and copyrights on new technology,
software, books, and movies are also recorded in the services category.
 Income receipts include income derived from ownership of assets, such as
dividends and interest payments
 Unilateral transfers represent one-way transfers of assets, such as worker
remittances from abroad to their home country and foreign direct aid or gifts.

Capital account: measure transfers of capital

Decomposed into two sub-accounts

 Capital transfers include debt forgiveness and migrants’ transfers (goods and
financial assets belonging to migrants as they leave or enter the country).
Capital transfers also include the transfer of title to fixed assets and the transfer
of funds linked to the sale or acquisition of fixed assets, gift and inheritance
taxes, death duties, uninsured damage to fixed assets, and legacies.
 Sales and purchases of non-produced, non-financial assets, such as the
rights to natural resources, and the sale and purchase of intangible assets, such
as patents, copyrights, trademarks, franchises, and leases.

Financial accounts: records investment flows

Decomposed into two sub-accounts

 A country’s assets abroad are further divided into official reserve assets,
government assets, and private assets. These assets include gold, foreign
currencies, foreign securities, the government’s reserve position in the
29
International Monetary Fund, direct foreign investment, and claims reported by
resident banks.
 Foreign-owned assets in the reporting country are further divided into official
assets and other foreign assets. These assets include securities issued by the
reporting country’s government and private sectors (e.g., bonds, equities and
mortgage-backed securities), direct investment, and foreign liabilities reported
by the reporting country’s banking sector.

Trade organizations

1. International monetary fund

 Provides a forum for cooperation on international monetary problems;
 Facilitates the growth of international trade and promotes employment,
economic growth, and poverty reduction;
 Supports exchange rate stability and an open system of international payments;
and
 Lends foreign exchange to members when needed, on a temporary basis and
under adequate safeguards, to help them address balance of payments
problems.
The global financial crisis of 2007–2009 demonstrated that domestic and
international financial stability cannot be taken for granted, even in the world’s
most developed countries. In light of these events, the IMF has redefined and
deepened its operations by:

 Enhancing its lending facilities

 Improving the monitoring of global, regional, and country economies
 Helping resolve global economic imbalances
 Analyzing capital market developments
 Assessing financial sector vulnerabilities

2. World Bank group

The World Bank’s main objective is to help developing countries fight poverty and
enhance environmentally sound economic growth. For developing countries to grow
and attract business, they have to

 Strengthen their governments and educate their government officials;

 Implement legal and judicial systems that encourage business;
 Protect individual and property rights and honor contracts;
 Develop financial systems robust enough to support endeavors ranging from
micro credit to financing larger corporate ventures; and
 Combat corruption.

The two affiliated entities: international bank for reconstruction and development
IBRD and international development association IDA

3. World trade organization

The WTO provides the legal and institutional foundation of the multinational trading
system. It is the only international organization that regulates cross-border trade
relationships among nations on a global scale
30
The WTO’s most important functions are the implementation, administration, and
operation of individual agreements; acting as a platform for negotiations; and settling
disputes. Moreover, the WTO has the mandate to review and propagate its members’
trade policies and ensure the coherence and transparency of trade policies through
surveillance in a global policy setting. The WTO also provides technical cooperation
and training to developing, least-developed, and low-income countries to assist with
their adjustment to WTO rules. In addition, the WTO is a major source of economic
research and analysis, producing ongoing assessments of global trade in its
publications and research reports on special topics. Finally, the WTO is in close
cooperation with the other two Bretton Woods institutions, the IMF and the World
Bank.

Currency exchange rate

The foreign exchange markets

Exchange rate: refers to the price of one currency in terms of another

The exchange rate is the number of units of one currency (called the price currency)
that one unit of another currency (called the base currency) can buy

USD/EUR = 1.2875 where USD in the price currency and EUR is the base currency,
means that 1 euro can buy 1.2875 dollars

A decline in above exchange rate means that USD is appreciating against EUR, or EUR
is depreciating against USD

Exchange rates described above are referred to as nominal exchange rates

Real exchange rate: which are indices often constructed by economists and other
market analysts to assess changes in the relative purchasing power of one currency
compared with another

Purchasing power parity PPP: which describes the long-term equilibrium of nominal
exchange rates, PPP asserts that nominal exchange rates adjust so that basket of
goods will have the same price in different markets or the purchasing power of
different currencies is equalized for a standardized basket of goods

The real exchange rate that an individual faces is an increasing function of the
nominal exchange rate and the foreign price level and a decreasing function of the
domestic price level. The higher the real exchange rate that this individual faces, the
fewer foreign goods the individual can purchase

It is important to note that real exchange rates are not quoted or traded in global FX
markets: They are only indices created by analysts to understand the international
competitiveness of an economy and the real purchasing power of a currency.

Although real exchange rates can exert some influence on nominal exchange rate
movements, they are only one of many factors; it can be difficult to disentangle all of
31
these inter-relationships in a complex and dynamic FX market. As discussed earlier,
PPP is a poor guide to predicting future movements in nominal exchange rates
because these rates can deviate from PPP equilibrium for years at a time. Hence, it
should not be surprising that real exchange rates, which reflect changes in relative
purchasing power, have a poor track record as a predictor of future nominal exchange
rate movements.

Market functions

FX markets facilitate international trade in goods and services, where companies and
individuals need to make transactions in foreign currencies. This would cover
everything from companies and governments buying and selling products in other
countries, to tourists engaged in cross-border travel

It is important to realize that spot transactions make up only a minority of total daily
turnover in the global FX market: The rest is accounted for by trade in forward
contracts, FX swaps, and FX options

Market participants:

The sell side generally consists of large FX trading banks like Citigroup, UBS, and
Deutsch bank ……

The buy side:

 Corporate accounts
 Real money accounts
 Leveraged accounts
 Retail accounts
 Governments
 Central banks
 Sovereign wealth funds SWF

Market size and composition:

The Bank of international settlements is the umbrella organization of world’s central

banks

The most recent survey in 2010 gives a broad indication of the current size and
distribution of global FX market flows, the daily turnover estimated by BIS was totaled
approximately of USD 3.9 trillion

FX turnover by instruments:

 Spot 36%
 OTC forwards 12%
 Exchange-traded derivatives 4%
 Swaps 44%
 OTC options 4%
32
FX turnover by Counterparty:

 Interbank 39%
 Financial clients 48%
 Non-financial clients 13%

FX turnover by currency pair:

28 
 USD/EUR
%

14 
 JPY/USD
%


 USD/GBP 9%


 USD/AUD 6%


 CAD/USD 5%

The largest hub is London, New York and Tokyo respectively

Currency exchange rate calculations:

Exchange rate quotations:

Currency A/B, A is price currency or quota currency, B is the base currency

The base currency is always set to 1

Direct currency quota: foreign currency is the base

A Paris-based will be EUR/GBP

Indirect currency quota: Domestic currency is the base

A Paris based trader will be GBP/EUR

Exchange rate quota conventions:

1- The three letters code refer to what are considered the major exchange rates
and it’s always in terms of exchange to USD
2- The six letters codes refer to some of the major cross-rates
3- When both currencies mentioned in the code, the base currency always
mentioned first
4- Regardless of where a market participant is located, there is always a mix of
direct and indirect quotes in common market usage
FX Rate Quote Name Convention Actual Ratio
33
(Price currency/Base
Convention
currency)
EUR Euro USD/EUR
JPY Dollar–yen JPY/USD
GBP Sterling USD/GBP
CAD Dollar–Canada CAD/USD
AUD Aussie USD/AUD
NZD Kiwi USD/NZD
CHF Swiss franc CHF/USD
EURJPY Euro–yen JPY/EUR
EURGBP Euro–sterling GBP/EUR
EURCHF Euro–Swiss CHF/EUR
GBPJPY Sterling–yen JPY/GBP
EURCAD Euro–Canada CAD/EUR
CADJPY Canada–yen JPY/CAD

The two-sided price quoted by the dealer is in terms of buying/selling the base
currency. It shows the number of units of the price currency that the client will receive
from the dealer for one unit of the base currency (the bid) and the number of units of
the price currency that the client must sell to the dealer to obtain one unit of the base
currency (the offer). The bid is always smaller than the offer

 Increase in exchange rate means that base currency is appreciating

 Decrease in exchange rate means that base currency is depreciating

Cross rate calculations:

Three currencies calculation:

CAD/USD x USD/EUR = CAN/EUR

JPY/USD x (CAD/USD)-1 = JPY/CAD

Forward calculations:

When the forward rate is higher than the spot rate, the points are positive and the
base currency is said to be trading at a forward premium. Conversely, if the forward
rate is less than the spot rate, the points are negative and the base currency is said to
be trading at a forward discount. Of course, if the base currency is trading at a
forward premium, then the price currency is trading at a forward discount, and vice
versa.

Spot rate is 1.2875 and one year forward rate is 1.28485

Forward rate discounted to spot rate and forward points is equal to

1.28485 – 1.2875 = -0.00265 multiply by 10000, it is -26.5

34
To convert forward points to forward rate. Just add forward rate after dividing it by
10,000 to spot rate

Relationship between spot rates, forward rates and interest rates

Forward exchange rates are based on arbitrage relationship that equates investment
return on two alternative but equivalent investments

(1 + id) = Sf/d (1 + if) (1 / Ff/d)

Formula can be rearranged as of forward rate Ff/d = Sf/d [(1+if) / (1+id)]

Formula can be rearrange as of percentage of forward to spot F f/d / Sf/d = (1+if) / 1+id),
this shows that forward rate is higher than spot rate if foreign interest rate is higher
than domestic interest rate

 The currency with the higher interest rate will be traded at a discounted forward
rate
 The currency with the lower interest rate will be traded at a premium forward
rate

One context in which forward rates are quoted as a percentage of spot rates occurs
when forward rates are interpreted as expected future spot rates:

Ft = S t+1

The equation above indicates that, all else equal, a higher domestic interest rate
implies slower expected appreciation (or greater expected depreciation) of the
domestic currency

Historical data shows that forward rates are poor predictors of future spot rates

Forward rates are based on domestic and foreign interest rates, means that anything
affects that level and shape in the yield curve in either domestic or foreign markets
will also affect the relationship between spot and forward exchange rates

For the purposes of this reading, it is best to understand forward exchange rates
simply as a product of the arbitrage equation outlined earlier and forward points as
being related to the (time-scaled) interest rate differential between the two countries.
Reading any more than that into forward rates or interpreting them as the “market
forecast” can be potentially misleading.

Exchange rate regimes

Exchange rate regime: The policy framework that each central bank adopts to
manage exchange rates

The ideal currency regime:

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1- The exchange rate between any two currencies would be credibly fixed. This
would eliminate uncertainty in prices of goods and services as well as real and
financial assets.
2- All currencies would be fully convertible at any time for any purpose. This
condition ensures unrestricted flow of capital.
3- Each country would be able to undertake fully independent monetary policy in
pursuit of domestic objectives, such as growth and inflation targets.

It should be clear that independent monetary policy is not possible if exchange rates
are credibly fixed and currencies are fully convertible. There can be no ideal currency
regime.

Historical perspective on currency regimes:

The price-spice-flow mechanism: national currency were backed by gold, a country

could only print as much money as its gold reserved, but it was self-adjusting and
inspired confidence. Still, new gold discoveries as well as more efficient methods of
refining gold would enable a country to increase its gold reserves and increase its
money supply apart from the effect of trade flows

The Bretton woods system: in later stages of World War 2, a new system of fixed
exchange rates with periodic realignments was devised by Keynes and Dexter, these
periodic realignments were viewed as a part of standard monetary policies

The Smithsonian agreement: Friedman argued that it’s better to let the market
determine the exchange rate rather than central bank governors and treasury
ministers, Academic economists and financial analysts alike soon realized that the
high degree of exchange rate volatility was the manifestation of a highly liquid,
forward-looking asset market, investment-driven FX transactions—for both long-term
investment and short-term speculation—mattered much more in setting the spot
exchange rate than anyone had previously imagined.

The European exchange rate mechanism: in 1979 the European Union opted for a
system of limited flexibility because there are costs to a high degree of exchange rate
volatility. These include difficulty of planning without hedging exchange rate risks,
domestic price fluctuations, uncertain costs of raw materials, and short-term
interruptions in financing transactions

As of April 2008, the International Monetary Fund (IMF) classified the actual exchange
rate regimes of its members into the eight categories

The important point to be drawn from this discussion is that the prices and flows in
foreign exchange markets will reflect the legal and regulatory framework imposed by
governments, not just “pure” market forces.

1. Arrangements with no legal tender, dollarization: Foreign currency to be used as

its medium of exchange and unit of count
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2. Currency broad system: A simple fixed rate system in which domestic currency
will be issued only against foreign exchange and it remains fully backed by
foreign reserves
3. Fixed parity: A simple fixed-rate system specifies that there is no legislative
commitment to maintaining the specified reserve & the target level of foreign
exchange reserves is discretionary. Although monetary independence is limited
as long as the exchange peg is maintained, the central bank can carry out
traditional functions, such as serving as lender of last resort.
4. Target zone: A fixed parity with fixed horizontal intervention bands that are
somewhat wider (up to ±2 percent around the parity). The wider bands provide
the monetary authority with greater scope for discretionary policy
5. Crawling bands: A fixed parity with crawling bands. Initially, a country may fix
its rates to a foreign currency to anchor expectations about future inflation but
then gradually permit more and more flexibility in the form of a pre-announced
widening band around the central parity. Such a system has the desirable
property of allowing a gradual exit strategy from the fixed parity.
6. Managed float: A country may simply follow an exchange rate policy based on
either internal or external policy targets. Such a policy, often called dirty
floating (EGYPT), invites trading partners to respond likewise with their
exchange rate policy and potentially decreases stability in foreign exchange
markets as a whole
7. Independently floating rate: In this case, the exchange rate is left to market
determination and the monetary authority is able to exercise independent
monetary policy aimed at achieving such objectives as price stability and full
employment.

Exchange rates, international rate and capital flows:

Capital flows—potential and actual—are the primary determinant of exchange rate

movements in the short-to-intermediate term. Trade flows become increasingly
important in the longer term as expenditure/saving decisions and the prices of goods
and services adjust.

The elasticities approach:

The absorption approach: