Advanced Economics - master

Balance of payments (BoP)

The balance of payments is the record of all international financial transactions made by a country's residents. A country's balance of payments tells you whether it saves enough to pay for its imports.

BOP components

They are the financial account, the capital account and the current account.

Financial Account

The financial account describes the change in international ownership of assets.

Capital account

The capital account includes any financial transactions that don't affect economic output.

Current account

The current account measures international trade, the net income on investments and direct payments.

Balance of payments’ implications for the exchange rate market

A change in a country's balance of payments can cause fluctuations in the exchange rate between its currency and foreign currencies. The reverse is also true when a fluctuation in relative currency strength can alter the balance of payments.

Balance of payments’ implications for exchange rate market part 2

There are two different and interrelated markets at work: the market for all financial transactions on the international market (balance of payments) and the supply and demand for a specific currency (exchange rate).

Balance of payments’ implications for exchange rate market part 2

These conditions only exist under a free or floating exchange rate regime. The balance of payments does not impact the exchange rate in a fixed-rate system because central banks adjust currency flows to offset the international exchange of funds.

Saving and Investment - Close economy

GDP Y= C + I+ G

Saving and Investment - Close economy part 2

A closed economy does not engage in international trade in goods and services. Investment must equal saving (S=I).

Investment Saving Open economy

GDP Y= C + I + G + NX, investment equals saving + capital inflow

IS Without government

we do not include government expenditure.

is With government

: Government expenditure refers to government purchases of goods and services; Taxes includes transfer payments.

The foreign exchange market (Forex, FX, or currency market

is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines the foreign exchange rate. It includes all aspects of buying, selling and exchanging currencies at current or determined prices.

Forex actors

Actors: At the top is the interbank foreign exchange market, which is made up of the largest commercial banks and securities dealers. Commercial companies, central banks, investment management firms, retails foreign exchange traders,

Forex INSTRUMENTS

A spot transaction is a two-day delivery transaction (except of trades between the US dollar, Canadian dollar, Turkish lira, euro and Russian ruble, which are next business day), as opposed to the futures contracts, which are three usually months.

(INSTRUMENT) FORWARD TRANSACTION

. In this transaction, money does not actually change hands until some agreed upon future date. Non Deliverable forward: Forex banks, ECNs, and prime brokers offer NDF contracts, which are derivatives that have no real deliver-ability.

SWAP:

The most common type of forward transaction is the foreign exchange swap. In a swap, two parties exchange currencies for a certain length of time and agree to reverse the transaction at a later date.

Futures

are standardized forward contracts and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures contracts are usually inclusive of any interest amounts.

foreign exchange option (or FX option)

is a derivative where the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date.

The nominal effective exchange rate (NEER)

is an unadjusted weighted average rate at which one country's currency exchanges for a basket of multiple foreign currencies. In economics, the NEER is an indicator of a country's international competitiveness in terms of the foreign exchange market.

The real effective exchange rate (REER)

weighted average of a country's currency in relation to an index or basket of other major currencies, adjusted for the effects of inflation.

REER part 2

This exchange rate is used to determine an individual country's currency value relative to the other major currencies in the index, such as the U.S. dollar, Japanese yen and the euro.

Purchasing Power Parity

(law of one price – Big Mac or Starbuck’s Latte parities)

PPP

compares different countries' currencies through a market "basket of goods" approach. Exchange rate between one currency and another is in equilibrium when their domestic purchasing powers= exchange. Cost of good in one currency/cost of good in second cur

Absolute ppp:

A country with a relatively high inflation rate will have a depreciating currency and vice versa. Q=1

Relative ppp

changes in the nominal exchange rates equals the difference in the inflation rates between two countries. An increase in prices decreases competitivity of a country and leads to a depreciation of its currency.

The Big Mac index

suggests that changes in exchange rates between currencies should affect the price that consumers pay for a Big Mac in a particular nation, replacing the "basket" with the famous hamburger.

The law of one price

says that the same good in different competitive markets must sell for the same price. Transportation costs and barriers between markets are not important.

net international investment position (NIIP)

(NIIP) measures the gap between a nation’s stock of foreign assets and a foreigner's stock of that nation's assets. Essentially, it can be viewed as a nation’s balance sheet with the rest of the world at a specific point in time.

Absorption

absorption is the total demand for all final marketed goods and services by all economic agents, regardless of the origin of the goods and services themselves. absorption = consumption + imports

Main endogeneous variables and links between them

Y, P, Pe, S, Se, R, r, Q

Real exchange rates

(REER) is the weighted average of a country's currency in relation to an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country's currency against that of each country in the index.

Real interest rate

A real interest rate is an interest rate that has been adjusted to remove the effects of inflation to reflect the real cost of funds to the borrower and the real yield to the lender or to an investor.

Real interest rate formula

Real Interest Rate = Nominal Interest Rate minus Inflation (Expected or Actual)

Exogenous and pre-determined variables

all foreign variables, Total financial wealth of the domestic private sector (WP), Stock of domestic government bonds outstanding (B)

Policy variables

T, G, M

The Gold Standard

was a system under which nearly all countries fixed the value of their currencies in terms of a specified amount of gold, or linked their currency to that of a country which did so.

The Gold Standard part 2

Domestic currencies were freely convertible into gold at the fixed price and there was no restriction on the import or export of gold. Gold coins circulated as domestic currency alongside coins of other metals and notes with the composition vary bycountry

The Gold Standard part 3

As each currency was fixed in terms of gold, exchange rates between participating currencies were also fixed.

Central banks had two overriding monetary policy functions under the classical Gold Standard:

1. Maintaining convertibility of fiat currency into gold at the fixed price and defending the exchange rate. 2. Speeding up the adjustment process to a balance of payments imbalance, although this was often violated.

A central bank could manipulate the gold points

using so-called ‘gold devices’ in order to increase or decrease the profitability of exporting gold and therefore the flow of gold.

Form of the UIP under (credible) fixed exchange rate model

Uncovered interest rate parity theory states the difference in interest rates between two countries will equal the relative change in currency foreign exchange rates over the same period.

Form of the UIP under (credible) fixed exchange rate model part 2

If the uncovered interest rate parity relationship does not hold, then there is an opportunity to make a risk-free profit using currency arbitrage or Forex arbitrage.

Efficiency of monetary vs. fiscal policy under fixed exchange rates

In the Mundell-Fleming framework, the two versions (fixed and float) produce diametrically opposed results concerning the effectiveness of fiscal and monetary policies

Efficiency of monetary vs. fiscal policy under fixed exchange rates part 2

As we recall, under a floating rate, fiscal policy was ineffective and monetary policy was very effective. Under a fixed rate, monetary policy is ineffective and fiscal policy is very effective.

Consequences of an increase / decrease of foreign interest rates

Generally, higher interest rates increase the value of a country's currency. Higher interest rates tend to attract foreign investment, increasing the demand for and value of the home country's currency.

Permanent shock

is a shock whose effects on current values of a variable never die out in absolute terms.

Transitory shock

is a shock whose effects gradually die out.

rules of thumb (when to choose which type regime)

A rule of thumb is a guideline that provides simplified advice regarding a particular subject. It is a general principle that gives practical instructions for accomplishing or approaching a certain task.

Balassa-Samuelson effect

Balassa-Samuelson effect is a phrase that describes the result when countries with high productivity growth also experience high wage growth, which leads to higher real exchange rates.

Gravity Model

The gravity model suggests that relative economic size attracts countries to trade with each other while greater distances weaken the attractiveness

gravity theory

an economy will gravitate towards trading with its closest neighbours and economies which are similar in terms of size, cultural preferences and stage of development.

Fiat Money

Fiat money is a government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. Most modern paper currencies are fiat currencies,U. S dollar, euro, and some major currencies

Comparative Advantage

is an economy's ability to produce a particular good or service at a lower opportunity cost than its trading partners. Comparative advantage is used to explain why companies, countries, or individuals can benefit from trade.

Classical theories (Ricardo vs. Heckscher-Ohlin) part 1

1. No difference among internal and international trade

According to the Classical economists, there is a need for a separate theory of international trade because of the differences between internal and international trade.

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Classical theories (Ricardo vs. Heckscher-Ohlin)

1. No difference among internal and international trade

According to the Classical economists, there is a need for a separate theory of international trade because of the differences between internal and international trade.

But according to Ohlin, there is no need for a separate theory of international trade, as fundamental principle of both is same.

As against Ricardian Theory which is based on two countries, two commodities and one factor

Ohlin's Modern theory incorporates two countries two commodities and two factors.

Concavity of production possibility frontier (diseconomies of scale)

Most of the PPF curves are concave due to the inadaptability of the resources. The law of increasing opportunity cost states: as the production of one good rises, the opportunity cost of producing that good increases.