1.

Currency Exchange Rates: Determination and Forecasting

a. Calculate and interpret the bid-ask spread on a spot or forward foreign currency
quotation and describe the factors that affect the bid-offer spread.
i. Exchange Rates – the price of one currency in terms of another.
1. E.g. 1.4126 USD/EUR means each euro costs $1.4126.
a. The euro is the base currency
b. The USD is the price currency
2. Spot exchange rate – rate for immediate delivery, usually settled within
2 days after the trade.
3. Forward exchange rate – rate to exchange a certain amount of one
currency for a set amount of another at a specified future date.
4. Rates often include the foreign exchange spread, the lower number is
that they’ll buy at and the higher is what they’ll sell at.
ii. Foreign exchange spread – difference between the bid and offer price. Often
quoted as ‘pips’, which are 1/10,000 when quoted to 4 decimal places. Dealers
manage their currency inventories on the interbank market, which is basically
the wholesale market for currencies.
1. The spread quote by the dealer depends on
a. The spread in the interbank market for the same currency pair
b. The size of the transaction – larger transactions usually have
larger spreads due to liquidity
c. The relationship between the dealer and the client
2. The interbank spread depends on
a. Currencies involved – high-volume pairs have lower spreads
b. Time of day – when both NY and London are open is the most
liquid window
c. Market volatility – higher volatility, higher spreads
3. Forward spreads depend in part on
a. Spreads are higher for longer maturities, more counter-party
risk, less liquid, more interest rate risk
b. Identify a triangular arbitrage opportunity and calculate its profit, given the bid-offer
quotations for three currencies.
i. Warm-up: working with foreign currencies
1. Converting foreign currencies – if given AUD/GBP 1.5060 - 1.5067
a. Up-the-bid-and-multiply – if converting 1m GBP we do
1m*1.5060 = 1,506,000 AUD
b. Down-the-ask-and-divide – if converting 1m AUD we do
1m/1.5067 = 663,702.13 GBP
2. Cross Rate – exchange rate between two currencies implied by their
exchange rates with a common third currency. Sometimes there is no
direct pair trading so you have to use cross rates.
a. E.g. USD/AUD = 0.60 and MXN/USD = 10.70
 𝑀𝑋𝑁 𝑈𝑆𝐷 𝑀𝑋𝑁
i. = ∗ = 0.60 ∗ 10.70 = 6.42
𝐴𝑈𝐷 𝐴𝑈𝐷 𝑈𝑆𝐷
3. Cross Rates with Bid-Ask Spreads – if we want A/C, but are only given
A/B and C/B, we can do the following
𝐵 1
a. 𝐶 𝑏𝑖𝑑
= 𝐶
( )
𝐵 𝑜𝑓𝑓𝑒𝑟

ii. Triangular Arbitrage – you start with one currency, and then convert it through
all three and back to the original and see if you end up with the same amount
you started with.
1. Make sure to remember up the bid and multiply and down and the ask
and divide.
c. Distinguish between spot and forward rates and calculate the forward premium
/discount for a given currency.
i. Forward premium – when the forward price is greater than the spot price
ii. Forward discount – when the forward price is less than the spot price
iii. E.g. Spot: 1.0511/1.0519 30-day: +3.9/+4.1
1. 1.0511+(3.9/10,000)=1.05149 1.01519+(4.1/10,000)=1.05231
iv. When the rate includes the forward premium or discount it’s called the “all-in
quote”
d. Calculate the mark-to-market value of a forward contract
i. At initiation – if covered interest rate parity holds, the value at initiation to both
parties is 0.
ii. At maturity –
1. 𝑉𝑇 = (𝐹𝑃𝑇 − 𝐹𝑃)(𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑠𝑖𝑧𝑒)
a. FP = forward price locked in at inception to buy base currency
b. 𝐹𝑃𝑇 = forward price to sell the same currency at time T
iii. Prior to expiration
(𝐹𝑃𝑡 −𝐹𝑃)(𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡 𝑠𝑖𝑧𝑒)
1. 𝑉𝑇 = 𝑑𝑎𝑦𝑠
[1+𝑅( )]
360
a. 𝐹𝑃𝑡 = forward price to sell base currency at time t in the market
for a new contract maturating at time T.
b. FP = forward price specified in the contract at inception to buy
base currency
c. Days = number of days remaining (T-t)
d. R = interest rate of price currency
i. Be sure to get this right
e. Explain international parity relations (covered and uncovered interest rate parity,
forward rate parity, purchasing power parity, and the international Fisher effect).
i. Covered Interest Rate Parity – means bound by arbitrage, so any forward
premium or discount exactly offsets the difference in rates. A investor would
earn the same return investing in either currency.
𝑑𝑎𝑦𝑠
[1+𝑅𝐴 ( )]
360
1. 𝐹 = 𝑑𝑎𝑦𝑠 ∗ 𝑆0
[1+𝑅𝐵 ( )]
360
a. Where S is the spot rate as A/B, F is the forward rate of A/B
b. Steps for arbitrage on pg. 262
 ii. Uncovered Interest Rate Parity – if forward currency contracts aren’t available
or capital controls are present, covered interest rate parity may not hold.
Uncovered interest rate parity refers to these situations not bound by arbitrage.
1. If rates in A are 4% and rates in B are 9%, currency B is expected to
depreciate by 5% relative to country A to make investors indifferent. So
the expected value of the change in spot rates is the difference in
interest rates.
2. Covered interest parity derives the expected future spot price, which is
not market traded.
3. Investors are not compensated for foreign currency risk under
uncovered interest parity, so it assumed investors are risk-neutral.
4. If the forward rate is equal to the expected future spot rate, we say the
forward rate is an unbiased predictor of the future spot rate.
a. If uncovered interest rate parity holds, the forward rate is an
unbiased predictor of expected future spot rates.
5. There is no reason this must hold in the short run, and it often doesn’t.
There is evidence that it holds in the long-run though. So longer-term
expected future spot rates based on uncovered interest rate parity are
often used as forecasts of future exchange rates.
iii. Forward rate parity – the forward rate is equal to the expected future spot rate
iv. International Fisher Relation – the fisher equation is that the nominal rate
equals the real rate plus expected inflation.
1. International fisher relation – assumes real interest parity (real rates are
equal across countries because when they aren’t, capital flows until
they are made equal again) and states
a. 𝑅𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐴 − 𝑅𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝐵 = 𝐸(𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝐴 ) − 𝐸(𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝐵 )
v. Purchasing Power Parity – law of one price says the same good should cost the
same in each market adjusted for the exchange rate. This often does not hold
due to transportation costs and tariffs etc.
1. Absolute Purchasing Power Parity – compares the average prices in two
countries based on a basket of representative goods.
a. S(A/B) = CPI(A) / CPI(B)
b. Even if the law of one price did hold, absolute PPP might not
because people in country A eat more of one thing than in
country B so the weights of the goods might be off.
vi. Relative Purchasing Power Parity – changes in exchange rates should exactly
offset the price effects of any inflation differential between the two countries.
1. If country A has 6% inflation and B has 4% inflation, then A should
depreciate by 2% relative to B.
2. %∆𝑆(𝐴⁄𝐵) = 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝐴 − 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛𝐵
3. Even if absolute PPP doesn’t hold, there may still be a relationship
between changes in the exchange rate and differences between the
inflation rates of two countries.
 vii. Ex-Ante Version of PPP – the same as relative PPP except it uses expected
inflation instead of actual inflation.
1. There is no true arbitrage to force relative PPP to hold, so it often
doesn’t in the short run. Since it usually holds in the long-run, it is still a
useful measure.
f. Describe relations among the international parity conditions.
i. Covered interest rate parity holds by arbitrage. If forward rates are unbiased
predictors of future spot rates, uncovered interest rate parity also holds, and
vice versa
ii. Interest rate differentials should mirror inflation differentials. This holds true if
the international Fisher relation holds. If that is true, we can also use inflation
differentials to forecast future exchange rates – which is the premise of the ex-
ante version of PPP.
iii. If the ex-ante version of relative PPP as well as the international Fisher relation
both hold, uncovered interest parity will also hold.
g. Evaluate the use of the current spot rate, the forward rate, purchasing power parity,
and uncovered interest parity to forecast future spot exchange rates.
i. We can use an-ante PPP, uncovered interest rate parity, or forward rates to
forecast future spot rates.
1. Uncovered interest parity and PPP are not bound by arbitrage and often
don’t hold in the short term but can be used for long-term forecasts.
2. The forward rate is not an unbiased predictor of future spot rates
3. PPP holds over long time horizons.
ii. Real exchange rate – includes an adjustment for inflation differences since a
base year
𝐶𝑃𝐼𝐵
1. 𝑟𝑒𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 = 𝑆𝑡 , where S is the spot rate at time t given
𝐶𝑃𝐼𝐴
as (A/B)
a. Note the change in B/A and A/B
2. If relative PPP holds, the real exchange rate would be constant, in
practice it hovers around that long-term equilibrium value.
h. Explain how flows in the balance of payment accounts affect currency exchange rates
i. Balance of Payments – accounting method to keep track of all payments
between a country and its trading partners. Includes government transactions,
consumer transactions, and business transactions.
1. Current account + financial account + official reserve account = 0
a. Capital account – exchange of goods and services, exchange of
investment income, and unilateral transfers (gifts to and from).
Summarizes whether you are selling more goods and services to
the world or buying more (surplus or deficit).
b. Financial account – (aka capital account) measures the flow of
funds for debt and equity investment into and out of the
country.
c. Official reserve – transactions made from the reserves held by
the official monetary authorities of the country. Normally this
 does not change substantially year to year, and people mostly
focus on the first two.
i. When a country has a current account deficit, they must
generate a surplus in the capital account or see its
currency depreciate.
d. Capital flows tend to be the dominant factor in influencing
exchange rates in the short-term, as capital flows tend to be
larger and more rapidly changing than goods flows.
2. Influence of BOP on Exchange Rates
a. Current account influences – current account deficits lead to
depreciation by the following mechanisms
i. Flow mechanism – current account deficits in a country
increase the supply of that currency in the global
market, putting downward pressure on its price. The
decrease in value may restore the balance of payments
depending on
1. The initial deficit – the larger it is the larger the
decrease needs to be
2. The influence of exchange rates on domestic
import and export prices – as the currency
decreases in value, the cost of imports goes up,
some of the increase in cost may not be passed
to consumers
3. Price elasticity of demand for the traded goods
– the larger the elasticity the more the number
of goods imported will change.
ii. Portfolio Composition Mechanism – countries with
current account surpluses also often have capital
account deficits due to investing in other countries.
When their portfolios get dominated by a few
currencies they will have to rebalance now and then,
which can hurt the portfolio currencies.
iii. Debt sustainability mechanism – a country with a
current account deficit could be financing it by
borrowing from abroad. If the debt gets too high and
people think you can’t pay it back your currency value
can drop dramatically.
b. Capital Account Influences – capital flows account for most of
the movements in exchange rates. When capital flows in, it
increases demand for that currency and it appreciates. Excess
capital of what it needed can have problems though
i. Excessive capital inflows can create the following:
1. Excessive real appreciation of the domestic
currency
 2. Financial asset/real estate bubbles
3. Increases in external debt by government or
business
4. Excessive consumption in the domestic market
fueled by credit
ii. Emerging markets often counteract these with capital
controls or intervening in forex markets.
ii. Real Exchange Rate Equation – the real rate fluctuates around the long-term
equilibrium real rate. These fluctuations can be explained as:
1. Real exchange rate (A/B) = equilibrium real exchange rate (A/B) + (real
interest rateB – real interest rateA) – (risk premiumB – risk premiumA)
a. Remember when we talk about currencies we usually refer to
the base currency, when USD/EUR goes from 1.30 to 1.20 we
say the euro depreciated. So, a higher interest rate would make
that currency appreciate, so the A’s and B’s are “backwards”
2. Remember:
a. In the short-run, the real value of a currency fluctuates around
its long-term equilibrium value
b. The real value of a currency is positively related to its real
interest rate and negatively related to its risk premium.
c. The real rate increases when the nominal rate increases
(holding inflation expectations unchanged) or when expected
inflation decreases (keeping nominal rates unchanged).
iii. Taylor rule – central banks usually have a mandate to keep inflation steady and
employment as full as possible. The Taylor rule links the bank’s policy rate to
economic conditions and can be used to forecast exchange rates:
1. 𝑅 = 𝑟𝑛 + 𝜋 + 𝛼(𝜋 − 𝜋 ∗ ) + 𝛽(𝑦 − 𝑦 ∗ ) , where R is the central bank
policy rate implied by the rule, rn is the neutral real policy rate, pi is
current inflation, pi* is the target inflation rate, y is the log of current
output, y* is the log of target sustainable output, and alpha and beta are
coefficients greater than 0, Taylor suggested 0.5 for both.
2. You can subtract pi from both sides to get it as the real interest rate
iv. The Taylor rule can be substituted into the real exchange rate equation,
showing:
1. The real value of a currency is positively related to its neutral real
interest rate, inflation gap, output gap
2. It is negatively related to the risk premium
i. Explain approaches to assessing the long-run fair value of an exchange rate.
i. If the ex-ante version of PPP holds, the real exchange rate will be constant at its
equilibrium level, but this is not usually the case in the short-run. Since it holds
in the long-term, inflation differential is a factor that tends to move the real rate
back towards its equilibrium level in the long-run.
ii. The IMF uses the following to assess long-run exchange rates.
 1. Macroeconomic balance approach – how much current exchange rates
must adjust to equalize a country’s expected current account imbalance
and that country’s sustainable imbalance.
2. External sustainability approach – how much current exchange rates
must move to force a country’s external debt (asset) relative to GDP
towards its sustainable level.
3. Reduced-form economic model approach – estimates the equilibrium
path of exchange rate movements based on patterns in several macro
variables, such as trade balance, net foreign assets/liabilities, and
relative productivity.
iii. A country with excessive inflows may act to limit their effects and avoid the
negative effects of when they inflows leave.
1. One way is to jointly asses a country’s current account deficit/surplus
and its currency’s PPP implied value.
a. E.g. if it’s running a current account deficit and its currency is
overvalued per PPP, the government may intervene to reduce
the value of the currency.
j. Describe the carry trade and its relation to uncovered interest rate parity and calculate
the profit from a carry trade.
i. Uncovered interest rate parity says that a currency with a high interest rate
should depreciate relative to a currency with a lower interest rate, so that an
investor would be indifferent between the two. If A has 3% and B has 1% then A
will depreciate by 2%.
1. However, this is not bound by arbitrage so it may not hold.
ii. In the carry trade, you invest in the higher yielding currency while borrowing in
the lower yielding one.
1. The lower yielding currency is called the funding currency.
2. Return = interest earned on investment – funding cost – currency
depreciation.
iii. Risks of the carry trade – the trade is only profitable if uncovered interest rate
parity does not hold. The main risk is that the funding currency could
appreciate too much.
1. The return exhibits negative skewness and kurtosis, so the probability of
a large loss is greater than would be expected from the normal
distribution. This high chance of a large loss is the crash risk of the carry
trade.
2. The crash risk of the carry trade is mainly due to the fact that the trade
is leveraged. As more investors follow the same strategy, the demand
could cause the value of the high-yielding currency to go up. However,
the herding behavior increases the risk that everyone exits at the same
time. This is especially true if they use stop-losses.
iv. Risk management in the carry trade – two main approaches
1. Volatility filter – whenever implied volatility reaches a certain threshold
(implied from the prices of options), the carry trades are unwound.
 2. Valuation filter – a valuation band is established for each currency
based on PPP or other models. When the value goes above (below) the
band, the trader will underweight (overweight) that currency in their
carry trade portfolio.
k. Explain the potential effects of monetary and fiscal policy on exchange rates
i. High capital mobility – when capital is unrestricted
1. Monetary policy
a. Expansionary – lowers rates, capital flows out, demand for
currency decreases, value of currency decreases
b. Restrictive – opposite effect
2. Fiscal policy
a. Expansionary – increases government borrowing and real rates.
Capital flows in due to higher rates, demand goes up, value goes
up
b. Restrictive – the opposite
ii. Low capital mobility – common in emerging markets, means the effect of a
trade imbalance on exchange rates is greater than the impact of interest rates.
1. Expansionary fiscal or monetary policy leads to increases in net imports,
depreciating the domestic currency.
2. Restrictive monetary or fiscal has the opposite effect.
3. If you have both expansionary fiscal and monetary, the currency
depreciates, if both are restrictive, it appreciates. If one of each, the
effect is uncertain.
iii. Fixed Exchange Rate Regimes – pegs their currency to a benchmark currency.
1. An expansionary (restrictive) policy leads to a depreciation
(appreciation) of the domestic currency. Under a fixed rate regime, the
government would then have to buy (sell) its own currency in the forex
markets, essentially reversing the policy stance.
a. This is why governments cannot manage exchange rates as well
as pursue independent monetary policies. If they want to
manage monetary policy they have to let the currency fluctuate
or restrict capital movements.
iv. Monetary approach to exchange rate determination – under monetary models
we assume output is fixed, so the monetary policy primarily affects inflation,
which affects exchange rates. There are two main approaches:
1. Pure monetary model – The PPP holds at any point in time and output
is held constant. Expansionary policy (monetary or fiscal) increases
prices and decreases the value of the currency. It does not take into
account expectations about future monetary expansion or contraction.
2. Dornbusch overshooting model – assumes prices are sticky in the short-
run and don’t immediately reflect changes in monetary policy.
a. With expansionary monetary policy, prices increase over time,
leading to a decrease in the real interest rate and capital
outflows.
 b. Also, in the short-term, exchange rates overshoot the long-run
PPP implied values, aka under expansionary policy the
depreciation of the currency is greater than the depreciation
implied by PPP and then gradually increase to their implied level
c. The opposite is true for a restrictive monetary policy.
v. Portfolio Balance (Asset Market) Approach to Exchange Rate Determination –
focuses on long-run implications of sustained fiscal policy (deficit or surplus) on
currency values.
1. When a country runs a fiscal deficit, it borrows money from investors,
and investors evaluate these investments in terms of risk and reward. A
sovereign debt investor has two components to their return, the
interest and the currency return.
2. The investor needs to look at the implications of a fiscal deficit on risk
and return (typically the yield should increase due to increased risk). If
they think the risk is too high for the return they will not buy the bonds
and the currency will depreciate.
vi. Wrap-up:
1. In the short term with free capital flows, an expansionary fiscal policy
leads to domestic currency appreciation via higher real interest rates. In
the long term, the government has to reverse course with a tighter
budget, depreciating the currency. If not, it has to print money which
lowers the value of the currency as well.
l. Describe objectives of central bank intervention and capital controls and describe the
effectiveness of intervention and capital controls.
i. Objectives
1. Ensure the domestic currency does not appreciate excessively
2. Allow the pursuit of independent monetary policies without being
hindered by their effect on currency values.
a. An emerging market might pursue a restrictive policy to raise
rates, but not want the large inflows of capital.
3. Reduce excessive inflow of capital.
ii. Effectiveness
1. For developed markets, the size of the forex market is usually much
larger than its central bank’s forex reserves, so their interventions are
mostly ineffective. Emerging markets might be more effective.
2. For capital controls, the effectiveness depends on the size and
persistence. Large and persistence flows are harder to manage than
short small ones.
m. Describe Warning Signs of a Currency Crisis – historically people have not done well
predicting crises and are usually surprised by them.
i. Terms of trade deteriorate
ii. Official forex reserves dramatically decline
iii. Real exchange rate is substantially higher than the mean-reverting level
iv. Inflation increases
 v. Equity markets experience a boom-bust cycle
vi. Money supply relative to bank reserves increases
vii. Nominal private credit grows.
2. Economic Growth and the Investment Decision
a. Compare factors favoring and limiting economic growth in developed and developing
countries.
i. Preconditions for growth
1. Savings and investment – positively correlated with development, if
savings is too low they can use foreign investment.
2. Financial Markets and Intermediaries – efficiently allocate resources.
a. Markets determine who offers the best risk adjusted return
b. Financial instruments are made offering investors liquidity and
reduced risk
c. By pooling small savings, they can finance big projects
d. Can get out of hand and increase risk and not growth
3. Political stability, rule of law, property rights
4. Investments in human capital
5. Tax and regulatory systems – lower the taxes and regulatory burdens,
the higher the growth
6. Free trade and unrestricted capital flows – also positively related
b. Describe the relations between the long-run rate of stock market appreciation and the
sustainable growth rate of the economy.
i. Earnings in aggregate can only grow as fast as GDP, or if corporate earnings’
share of GDP increases.
ii. ∆𝑃 = ∆𝐺𝐷𝑃 + ∆(𝐸 ⁄𝐺𝐷𝑃) + ∆(𝑃⁄𝐸 )
iii. Long run in the other two should be zero, so growth in GDP is all that’s left
c. Explain why potential GDP and its growth rate matter for equity and fixed income
investors.
i. Equity – stated previously, it is the main driver of equity returns
ii. Growth in potential GDP indicates that future income will rise, causing
consumers to increase current spending. To encourage consumers to delay
spending, real rates must rise to attract them back.
iii. In the short term, the relationship between actual GDP and potential GDP can
provide insight into the state of the economy.
1. If actual is above potential, prices rise, so the difference can be used to
estimate inflation.
2. Monetary authorities will develop policy consistent with that gap.
iv. It is more likely for a government to run a fiscal deficit if actual GDP is below
potential
v. Due to credit-risk assumed by fixed income investors, growth in GDP may be
used to gauge credit risk of both corporate and government debt.
1. Higher potential GDP growth rate reduces expected credit risk and
generally increases the credit quality of debt
d. Distinguish between capital deepening investment and technological progress and
explain how each affects economic growth and labor productivity.
i. Factor inputs and economic growth
1. Y, K, L, and T
2. Cobb-Douglas
a. 𝑌 = 𝑇𝐾 𝛼 𝐿1−𝛼
b. Has constant returns to scale (increasing all factors by 10%
increases output by 10%.
3. Output per worker – Cobb-Douglas divided by L
a. 𝑌⁄𝐿 = 𝑇(𝐾 ⁄𝐿)𝛼
ii. Assuming the number of workers and alpha remain constant, you can only
increase output per worker through capital deepening or improving technology.
1. Since alpha < 1, capital deepening has a diminishing effect. Developed
markets typically have a high capital to labor ratio and a low alpha.
iii. In equilibrium, the marginal product and marginal cost of capital are equal
1. 𝛼 𝑌⁄𝐾 = 𝑟
2. 𝛼 = 𝑟 𝐾 ⁄𝑌 , meaning the return of capital times capital is the amount of
income to supplier of capital, divided by Y is the definition of alpha.
iv. Capital deepening is a movement along the productivity curve, technological
progress shifts the curve.
e. Forecast potential GDP based on growth accounting relations
i. ∆𝑌⁄𝑌 = ∆𝐴⁄𝐴 + 𝛼 ∗ (∆𝐾⁄𝐾 ) + (1 − 𝛼)(∆𝐿⁄𝐿)
1. In practice, levels of capital and labor are forecasted from long-term
trends and the shares are determined from national income accounts. T
must be estimated as a residual
ii. Growth rate in potential GDP = long-term growth rate of labor force + long-term
growth rate in labor productivity
f. Explain how natural resources affect economic growth and evaluate the argument that
limited availability of natural resources constrains economic growth
i. Resources can be renewable or non-renewable, but they don’t always help.
ii. Access to resources doesn’t require ownership of resources. As long as you can
access resources through trade, it’s ok.
iii. If you overly rely on your natural resources it can limit innovation and hurt
growth. Also, you can get “Dutch Disease” if demand for your resources drives
your currency up, making other industries not competitive.
g. Explain how demographics, immigration, and labor force participation affect the rate
and sustainability of economic growth.
i. Labor force is the number of working age people available to work
ii. Labor supply factors
1. Demographics – younger populations have higher potential growth
2. Labor force participation – labor force / working age population
3. Immigration – potential source of growth for countries with poor
demographics
4. Average hours worked – general trend is downwards
h. Explain how investment in physical capital, human capital, and technological
development affects economic growth
i. Human capital – a qualitative measure of the work force. Increases via
education and experience show up in T.
ii. Physical capital – generally separated into infrastructure, computers, and
telecommunications (ICT) and non-ICT capital. Strong positive correlation
between investment in physical capital and GDP growth rate.
1. Why does it increase growth if there are diminishing returns?
a. Not all countries have high levels of capital
b. Some capital investment influences technological progress
i. Network externalities
iii. Technological Development – takes many different forms. Developed countries
rely on this the most and hence spend the most on R&D. Increases GDP per
worker.
iv. Public Infrastructure – provide additional benefits to private investment. E.g.
the highway makes your distribution center more useful.
i. Compare classical growth theory, neoclassical growth theory, and endogenous growth
theory.
i. Classical Growth Theory – the idea is once growth rises above subsistence level,
the population increases to drive it back down again, preventing long-term
growth per capita. This is not true.
ii. Neoclassical Growth Theory – focused on estimating the economy’s long-term
steady state growth rate. The economy is at equilibrium when the output-to-
capital ratio is constant, and the labor-to-capital ratio and output per capita also
grow at the equilibrium growth rate, g*.
1. Using the Cobb-Douglas, we see the sustainable growth in output per
capita is equal to the growth in tech (theta) divided by labor’s share of
GDP
𝜃
a. 𝑔∗ = 1−𝛼
2. Sustainable growth rate of output is g* plus the growth in labor
𝜃
a. 𝐺 ∗ = 1−𝛼 + ∆𝐿
3. Under neoclassical growth theory:
a. Capital deepening affects the level of output but not the growth
rate in the long run.
b. An economy will move towards its steady state regardless of the
initial capital to labor ratio or level of technology.
c. In the steady state, growth in productivity (output per worker)
is a function of the level of technological progress and labor’s
share of GDP
d. In the steady state, marginal product of capital is constant but
marginal productivity is diminishing.
 e. An increase in savings will only temporarily raise growth, but
countries will higher savings rates will enjoy higher capital to
labor ratios and higher productivity.
f. Developing countries (with low capital per worker) will be
impacted less by diminishing marginal productivity of capital,
and hence have higher growth rates as compared to developed
countries but will eventually converge.
iii. Endogenous Growth Theory – says that technological progress emerges as a
result of investment in both physical and human capital. There is no steady
state growth rate, so increased investment can permanently increase growth
rates.
1. The main assumption is that certain investments increase TFP from a
societal standpoint. Some R&D benefits are external to the firm doing
the R&D.
2. Theorizes that returns to capital are constant, which means an increase
in savings will permanently increase the growth rate.
3. Main difference between neoclassical and endogenous is that
neoclassical assumes capital investment will expand as technology
improves (i.e. growth comes from increases in TFP not related to the
investment in capital from within the model), while endogenous theory
assumes that capital investment may improve TFP.
j. Explain and evaluate convergence hypotheses
i. There are large differences in productivity between countries, with less
developed ones having much lower productivity.
ii. Absolute Convergence Theory – less developed economies will achieve equal
living standards over time.
iii. Conditional Convergence Theory – countries will only attain equal living
standards if they have the same savings rate, population growth rate, and
production function.
1. Less developed countries will grow faster until they catch up
iv. Club Convergence – countries with similar features can be said to be part of a
club and will converge to their club’s standard of living. Countries can join a
new club by changing their characteristics.
v. Empirical evidence shows that developing countries can reach higher standards
of living.
k. Describe the economic rationale for governments to provide incentives to private
investment in technology and knowledge.
i. Under endogenous theory, R&D can have positive externalities that benefit all
of society. These benefits might be worth the cost, but the benefit to the
company isn’t worth it so it never happens. The government can fix this.
l. Describe the expected impact of removing trade barriers on capital investment and
profits, employment and wages, and growth in the economies involved.
i. None of the theories discussed earlier account for potential trade and capital
flows, but removing trade barriers can have the following benefits:
 1. Increased investment from foreign savings
2. Allows focus on industries with a comparative advantage
3. Increased markets for domestic products, resulting in economies of
scale
4. Increased sharing of technology and higher TFP growth
5. Increased competition leading to inefficient firms closing and capital
being used efficiently
ii. The neoclassical model’s predictions in an open economy focus on convergence.
1. Developing countries have high returns to capital, but as they grow it
will diminish and approach developed countries.
iii. The endogenous growth model also predicts greater growth with free trade and
capital mobility since open markets foster innovation. As competition increases,
only the efficient survive and those firms permanently increase the growth rate
by providing positive externalities. Economies of scale also increase output.
iv. Removing barriers may speed convergence.
3. Economics of Regulation
a. Describe classifications of regulations and regulators
i. Regulations – can be either statutes (laws made by a legislative body),
administrative regulations (rules issued by government bodies or bodies
authorized by the government), or judicial law (findings of the court).
ii. Regulators – can be government agencies or independent regulators.
1. Independent regulators – given power to create rules and enforce them
by the government but are usually not funded by the government and
are thus politically independent.
2. Some independent regulators are self-regulating organizations (SROs)
that regulate as well as represent their members.
a. SROs may have inherent conflicts of interest and they may not
be the best solution.
b. They are good in that they increase the overall level of
regulatory resources, use industry insiders with expertise, and
allow regulators to divert resources to better uses.
3. Outside bodies aren’t regulators themselves but their products are
referenced by regulators, like IASB and FASB
b. Describe uses of self-regulation in financial markets
i. SROs without government recognition aren’t regulators
ii. SROs may be immune from political pressure, but can be influenced by their
own members
iii. When properly supervised, SROs have been shown to be effective
iv. SROs are not common in civil law countries, government agencies fill those
roles, they are more common in common law countries like the UK and US.
c. Describe the economic rationale for regulatory intervention
i. Regulations are needed when there is
 1. Informational frictions – when information is not equally distributed.
When only some have access to information it’s called information
asymmetry.
2. Externalities – mostly deal with the consumption of public goods,
people share in the benefits but don’t bear the cost so you need
regulators
d. Describe regulatory interdependencies and their effects
i. Regulatory Capture – the idea that eventually the regulator will be composed of
industry insiders and will eventually be controlled by the industry
ii. Regulatory competition – regulators in charge of different jurisdictions try to
attract business with more favorable conditions.
1. Regulatory arbitrage – when businesses shop around for a market that
allows a certain behavior. Can be solved by a cohesive framework.
e. Describe tools of regulatory intervention
i. Price mechanisms – such as taxes and subsidies can shape behavior
ii. Restricting/requiring certain activities
iii. Provision of public goods or financing of private projects
iv. The effectiveness depends on their ability to enforce, but the actions must hit
the right people, like managers doing the bad thing vs unknowing shareholders
f. Explain purposes in regulating commerce and financial markets
i. Regulating commerce – e.g. company laws, tax laws, bankruptcy laws etc.
1. may help or hinder commerce
ii. Regulating financial markets
1. Regulation of securities markets
a. Disclosure requirements are a key element
b. Many securities regulations are about mitigating agency issues
c. Regulators have historically focused on protecting retail
investors, with less regulation for qualified investors
2. Regulation of financial institutions
a. Prudential supervision – monitoring and regulation of financial
institutions to reduce system-wide risks. When one institution
fails it can have a domino effect.
3. Goals are to prevent failures in the financial system, protect investors,
create confidence in the markets, and enhance capital formation.
g. Describe anticompetitive behaviors targeted by antitrust laws globally and evaluate the
antitrust risk associated with a given business strategy.
i. Most regulators protect domestic businesses while also encouraging
competition among domestic businesses. Antitrust laws promote competition
by restricting certain activities like mergers resulting in too much market share,
bundling, discriminatory pricing etc.
ii. Internationally, companies need to deal with many different antitrust regulators
iii. When evaluating a proposed merger, this of the regulatory response
h. Describe the benefits and costs of regulation
i. US agencies are required to conduct cost-benefit analysis for new regulations
 ii. Costs can be easy to view but hard to quantify, remember to include the cost to
the private sector, not just the cost of the agency.
iii. Regulatory burden – the cost of compliance for the regulated entity
1. Regulatory burden minus the private benefits of regulation gives the net
regulatory burden
iv. Look for unintended consequences, like higher gas mileage requirements
causing people to just drive more
v. Since costs can be hard to anticipate, many regulations have a sunset clause
that requires a new cost-benefit analysis with the actual data before renewing
them
i. Evaluate how a specific regulation affects an industry, company, or security.
i. Regulations can hurt or help an industry
ii. Regulations may introduce inefficiencies in the market