Last Revised: 05/15/2023

2024 Level 1 - Economics

Readings Page

Firms and Market Structures 2

Understanding Business Cycles 16

Fiscal Policy 22

Monetary Policy 29

Introduction to Geopolitics 35

International Trade 42

Capital Flows and the FX Market 48

Exchange Rate Calculations 59

This document should be used in conjunction with the corresponding readings in the 2024 Level 1 CFA® Program curriculum.
Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and republished with
permission from CFA Institute. All rights reserved.

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 Last Revised: 05/15/2023

Firms and Market Structures

a. determine and interpret breakeven and shutdown points of production, as

well as how economies and diseconomies of scale affect costs under perfect
and imperfect competition

b. describe characteristics of perfect competition, monopolistic competition,

oligopoly, and pure monopoly

c. explain supply and demand relationships under monopolistic competition,

including the optimal price and output for firms as well as pricing strategy

d. explain supply and demand relationships under oligopoly, including the

optimal price and output for firms as well as pricing strategy

e. identify the type of market structure within which a firm operates and
describe the use and limitations of concentration measures

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Profit
Page 1
- Objective of the firm – maximize profit LOS a
𝛑 = TR - TC economic - calculate
accounting - interpret
P×Q
- compare
accounting profit ⇒ TR – accounting costs (explicit costs)
- includes interest exp.
economic profit ⇒ accounting profit – total implicit opportunity costs

required rate of return on equity

normal profit: economic profit = 0
- economic profit > 0 ⇒ abnormal/supernormal profit
technology
- result of ⇒ firm
efficiency
specific
⇒

gov’t. policy cost advantage

monopoly power Structural competitive advantage
barriers to entry (long-term)

sustainable competitive advantage

Page 2
Economic Rent/ LOS a
Supply - calculate
P fixed in short-run (inelastic supply)
- interpret
∴ demand determines price - compare
P2

D2 at P1 ⇒ normal profit
P1
- demand increases to D2, Price to P2
D1 at P2 ⇒ economic rent = (P2 - P1) × Q1
Q1 Q
d
- any commodity, resource or good that is fixed/nearly–fixed in
supply has the potential to generate economic rent
- the more inelastic supply is, the higher the potential
- Effect on Equity Value:
> 0 positive effect
economic profit = 0 no effect
< 0 negative effect

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Revenue
Page 3
Total Average Marginal LOS b
- calculate
P×Q P×Q ∆(P × Q)
Revenue: - interpret
(TR) Q ∆Q
- compare
(AR) (MR)
➀ Perfect Competition/ firms are price takers, all face horizontal
P P demand curves
TR2

P2 = MR2 = AR2 = D2
TR1
P1 = MR1 = AR1 = D1

Q Q

➁ Imperfect Competition/ individual firms can influence price

smaller number of firms in market
(only one = monopoly)
firms face downward sloping demand
curves

Page 4
LOS b
2. Imperfect Competition/
- calculate
Rev. - interpret
TR peaks when MR = 0 - compare
(P × Q)
curve has a decreasing slope
throughout ⇒ implies that 𝚫TR
Q at each successive increment of Q
Q1 df getting smaller
Rev. is

AR > MR at all points

P = AR = Demand 𝐓𝐑
! = 𝐏'
𝐐
Q
Q1
MR
𝚫𝐓𝐑
% )
𝚫𝐐

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Costs
Page 6
Total Average Marginal LOS d
Fixed 𝐓𝐅𝐂( - calculate
TFC
(explicit + 𝐐 - interpret
implicit) (AFC)

Variable 𝐕𝐂+ × Q 𝐓𝐕𝐂(

𝐯 𝐐
(TVC) (AVC)
𝐓𝐂 ∆𝐓𝐂
Total Costs TFC + TVC
𝐐 ∆𝐐
(TC)
(ATC) (MC)
or AFC + AVC
QAVC – AVC is at
Cost Cost/unit (short-run) a minimum, but
TC ATC since AFC will
X AVC continue to decline,
TVC A
A=B X =Y QATC – represents
TFC total minimum
B AFC
Y cost point
Q Q
QAVC QATC (i.e. min. cost/unit)

Breakeven & Shutdown Points

Cost/u Perfect Page 7
Rev./u Comp. - short-run LOS e
if AVC are - determine
P MC
ATC decreasing, MC < AVC - describe
P3
T if AVC are increasing, MC > AVC
AVC
P2 S
MC intersects both AVC & ATC at
P1
R their minimums

Q at P1 – firm is not covering

Point S – shutdown point (AR < AVC) variable cost/unit
- below S, actg. profit < 0 at P2 – VC/unit covered but
TC/unit is not
S – T: actg. profit < RRR
at P3 – all costs covered
Point T – economic BEP (P = AR = MR
short-run long-run
- TR = TC = ATC)
Below S shutdown leave
- ROE = RRR
- ATC = MR = AR = P S - T produce leave
- above T: actg. profit > RRR Above T produce stay

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Economies/Diseconomies of Scale
Page 10
Define: short-run – at least one of the factors of LOS g
production are fixed technology - describe
plant size
long-run – all are variable
- gives rise to ➀ short-run ATC
it
$/un ➁ long-run ATC
Recall: Perfect Competition
- firm is a price taker
SRATC1 - at P1, firms must
SRATC2 SRATC3
SRATC4dfSRATC5 produce at SRATC4
LRATC or exit
P1
minimum efficient
scale
Q1 Q2 Q3 Q4 Q5

economies of scale diseconomies of scale

increasing returns to - decreasing returns to
scale scale

Page 11
economies of scale LOS g
- describe
- division of labour/mgmt. diseconomies of scale
specialization
- poor mgmt. control/oversight
- productivity enhancing equipment/
technology - overlap/duplication
waste reduction - greater stress on local supply
- efficiency gains
energy reduction markets
unions
- superior market insight - big target antitrust legislation
- volume discounts litigation

- rapid economies - consistent - constant returns

- rapid diseconomies economies to scale

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Short/Long Run Profit Max.

Page 12
LOS h
- distinguish
MC
Recall: Perfect Competition
- firm is a price taker
MR1 = P1
➀ SRATC
A
P = MR
MR2 = P2 B MR = MC – max. profit/min.
➁ loss
in short run

at P1, MR1 = MC at ➀ economic profit = A ⇒ encourages market

⇒ max. profit entry since ROE > RRR
- downward pressure on P1
at P2, MR2 = MC at ➁ economic loss = B ⇒ encourages market
⇒ min. loss exit since ROE < RRR
- upward pressure on P2

Page 13
LOS h
- distinguish
MC1 at P1 , MR1 = MC, on
SRATC1 MC2 SRATC2 LRATC SRATC1 at ➀
P1 ➁
- firm invests and moves
P2 ➀
➂ to SRATC2 at ➁

` MR1 = MC2 ⇒ economic

profit

- encourages firm entry, prices

drop to P2
- at P2 , MR2 = MC2 on SRATC2
at ➂
economic profit = 0

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Market Structure
Page 1
- significant determinant of long-term profitability LOS a
- describe
- factors that Perfect Monopolistic
determine Competition Competition Oligopoly Monopoly
market structure
➀ number and
relative size of many many few one
firms
➁ degree of product homogeneous ` homogeneous
differentiated unique
differentiation standardized standardized
➂ seller power over some or
none some considerable
pricing decisions considerable
➃ Barriers to
very low low high very high
entry/exit
➄ Degree of Advertising/ Advertising/
none Advertising
non-price Product Product
competition Differentiation Differentiation

Page 2
LOS b-f
Perfect Competition
- explain
P Demand Analysis
TR P Monopolistic Competition

differentiated TR
product
Q +
non-price Q
P competition
` P
= some
infinitely pricing
elastic power AR = demand
P = MR = AR curve
= demand curve
MR
Q Q
downward sloping demand
price taker
curve since prices are firm
prices are industry determined
determined

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Proof: 𝐐 = 𝐚 − 𝐛𝐏

𝐏 = 𝐚(𝐛 − 𝐐(𝐛 𝐌𝐑 =
𝐝𝐓𝐑
= 𝐚(𝐛 − 𝟐𝐐
𝐝𝐐
𝐦 = −𝟏(𝐛 𝐛

𝐓𝐑 = 𝐏 × 𝐐 𝐦 = −𝟐(𝐛

= 1𝐚(𝐛 − 𝐐(𝐛2 𝐐 `
𝟐 ∴ Slope of MR curve
= 𝐚(𝐛 𝐐 − 𝐐 (𝐛
= 2× slope of the
demand curve

Page 3
LOS b-f
Perfect Competition
Supply Analysis - describe
cost/unit
Monopolistic Competition
P ROE > RRR P
* no well-defined
MC supply curve
differentiated
economic
BEP product
+ MC
ATC
non-price
AVC P
competition ATC
shutdown = some`
point
pricing
power MR
Q Q
Q*
level of output is
level of output determined by
determined by the
MR = MC
MC schedule
but price determined by
(MR = MC)
demand curve

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Page 4
Perfect Competition LOS b-f
Optimal - describe
Price/Output Monopolistic Competition

economic MC
differentiated
profit < 0 ATC1 MC
product
ATC + P ATC
non-price
P MR = AR competition C
`
ATC2
= some
economic
profit > 0 pricing MR D
Q - optimal output power Q
optimal output
𝛑 = TR – TC = economic TR = P × Q
profit TC = 𝐂𝟏 × Q
𝛑 = TR – TC = economic
profit > 0

Page 5
LOS b-f
Perfect Competition
Long-run - describe
Equilibrium Monopolistic Competition
economic profit > 0
encourages firm entry
- drives down demand for
differentiated
MC all firms
product
ATC1 + MC
non-price ATC
P MR = MC competition
` P
minimum = AC minimum
efficient = some efficient
scale pricing scale
Q power D
Q MR
- horizontal demand curve
1) MR = MC ⇒ max. profit
- profit max. when
2) P = AC ⇒ economic
MR = MC (= P = AC) profit = 0

- downward sloping demand

curve

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Page 6
Oligopoly/ LOS b-f
- explain
Demand Analysis
➀ High barriers to entry = few firms selling close substitutes

➁ Some non-price competition = some pricing power = downward

sloping
But// pricing decisions are interdependent demand curve

- market demand characteristics depend

` on the pricing strategy
adopted
➀ Pricing Interdependence
➁ Cournot assumption non-collusion
➂ Nash equilibrium

Collusion ⇒ cartels - all members divide up the AD curve

Page 7
➀ Pricing Interdependence LOS b-f
- explain
Raise prices, competitors Lower prices,
do not competitors follow suit
highly elastic demand - highly inelastic demand
curve kinked curve
demand curve

MC3
P P
P MC2
` MC1

MR D MR D
Q
Shortfall: cannot - prices above P will be
determine what P is much more elastic
at the outset, only - prices below P will be
what happens much more inelastic
after P. MC1 - MC3 ⇒ potentially many more
⇒ do not affect E(P,Q)

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Page 8
2. Cournot assumption (non-cooperative) LOS b-f
- explain
- firms set output simultaneously and let the market
determine price (market price depends on total output)
assumption: each firm chooses it’s profit maximizing output
assuming the output of other firms will not change
assume only 2 firms (duopoly) that sell identical products.
` firm 1
q
monopoly price QPC
Pm firm 2’s best response
Pcour. Cournot equilibrium
Cournot equilibrium
Qm
perfect comp. price firm 1’s best
PPC
D response
Qm Qcour. QPC Qm QPC firm 2
q

Page 9
2. Cournot assumption LOS b-f
- explain
e.g./ QD = 450 - P MC = 30 Firm 1 Firm 2
P = 450 - QD QD = q1 + q2 450 - 2q1 - q2 = 30 450 - q1 - 2q2 = 30
∴ P = 450 - q1 - q2 450 - 2q1 - q2 = 450 - q1 - 2q2
Max. Profit: MC = MR -2q1 - q2 = -q1 - 2q2

𝐝𝐓𝐑 -q1 = -q2

𝐝𝐐 q1 = q2
TR1 = P × Q = (450 - q1 - q2)q1 `
monopoly
450 - 2q1 - q1 = 30
= 450q1 - 𝐪𝟐𝟏 - q1q2 𝐓𝐑 = 𝟒𝟓𝟎𝐐𝐃 − 𝐐𝟐𝐃
450 - 3q1 = 30
MR1 = 𝐝𝐓𝐑 𝟏 = 450 - 2q1 - q2 𝐌𝐑 = 𝟒𝟓𝟎 − 𝟐𝐐𝐃
𝐝𝐪𝟏 3q1 = 420 𝟐𝐐𝐃 = 𝟒𝟐𝟎
TR2 = P × Q = (450 - q1 - q2)q2 q1 = 140 𝐐𝐃 = 𝟐𝟏𝟎
= 450q2 - q1q2 - 𝐪𝟐𝟐 ∴ QD = q1 + q2 = 140 + 140 = 280 PC
MR2 = 𝐝𝐓𝐑 𝟐 = 450 - q1 - 2q2 p = 450 - QD = 170 MR = 450 – QD
𝐝𝐪𝟐

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Page 10
3. Nash Equilibrium - no firm can obtain a higher LOS b-f
- explain
payoff, holding all other firm’s strategies
constant, by choosing a different strategy

Bat-Co.
Low High

50 80
Low
70 ` 0
Arc-Co.
300 500
High
350 300

Payoff Matrix
Nash equilibrium - neither
have an incentive to switch

Page 11
Supply/ LOS b-f
- explain
- level of output determined
by MR = MC Output/
- price determined by demand - no single optimal price and
curve output analysis
- even if 1 firm is dominant - pricing interdependence ⇒ at the
and sets price kink

` - Cournot ⇒ Cournot equilibrium

ΣMCF - Nash ⇒ Nash equilibrium
MC no single - Dominant firm as price leader
PL supply MRL = MCL - all others follow PL
relationship Long-Run equilibrium/ long-run
DF
DL economic profits for differentiation
QL MR QT
L

QF

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Page 12
Monopoly/ LOS b-f
- explain
Demand analysis Single supplier + high barriers
to entry = considerable pricing power
patents, copyrights
control over critical resources
MC gov’t. authorization (natural monopoly)
PE network effects
AC `
- monopolist’s demand schedule = AD curve
in that relevant
market
D
QE MR Supply analysis/ - no well-defined supply
economic function
profit
- profit-maximizing level of output MR = MC

- more like a supply point

Page 13
Monopoly/ LOS b-f
- explain
Long-run equilibrium/
PR - regulated price
QR - regulated output

PM unregulated monopoly
PR LRAC
` EL = (PM, QM)
PC LRMC

MR D regulated monopoly
QM QR QC 1. P = LRMC + subsidy up to
LRAC
2. P = LRAC (authorized
monopoly)

3. National ownership

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Identification of Market Structure

Page 14
Concentration Ratio: LOS g, h
0% - perf. comp. - describe
Σ (market share of N largest firms) - identify
100% - oligopoly/monopoly
quantifies size, but not market power
may be unaffected by M&A among the top N firms

Herfindahl-Hirschman Index (HHI) - does not take

` possibility of entry
Σ [(market share) of N largest firms]
2
into account
= 1 ⇒ monopoly - does not consider
elasticity of
= 𝟏+𝐌 ⇒ M firms with equal market share demand

e.g./ 10 suppliers each with 10% market share

(.1)2 + (.1)2 + (.1)2 + (.1)2 = .04

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Understanding Business Cycles

a. describe the business cycle and its phases

b. describe credit cycles

c. describe how resource use, consumer and business activity, housing sector
activity, and external trade sector activity vary over the business cycle and
describe their measurement using economic indicators

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Understanding Business Cycles

Page 1
Types of cycles
1/ Classical cycle
- not very useful

short long

2/ Growth cycle
- fluctuations in
output around a
long-term trend
vs. classical view
- peaks are
earlier, troughs
are later

Page 2
Types of cycles 3/ Growth rate cycle

potential growth rate

growth above
trend

growth below trend

(growth recession)

- economists and practitioners generally use

cycle #2 ➞ growth cycle

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Page 3

gap Peak
between
actual and Recovery Slowdown
potential Contraction
Expansion
GDP
Trough

Page 4
strong economy ➞ high credit availability on favourable
terms
- often leads to asset price and real estate bubbles
- amplifies business cycles (financial leverage) - more
extensive expansions, deeper recessions
weak economy ➞ tight credit market, higher rates
- Credit cycles tend to be longer, deeper, and sharper than business cycles
growth or contraction in credit (i.e. stage of credit cycle):
determine direction in housing and construction markets
affect the extent of expansions and contractions
- credit cycle contraction + business cycle contraction
= more severe recession
foreshadow policy actions

- Strong peaks in credit cycles are closely associated with systemic banking
crises

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Page 5

average
hours
worked

bearish
bullish big theme

bearish

bullish

Page 6

capacity this
utilization
determines
rates

move into
high operating
- bullish for capital
leverage sectors
equipment
this

keeps
demand for
employment
low

preserve
cash flow

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Page 7

Consumer
Spending
- less cyclical
than
investment
spending

economic data ➞ Consumer confidence, ISM Services, Retail Sales

Page 8

Household Incomes ➞ 𝐘𝐝 - disposable income positively related

to spending on durable goods
- permanent income: excludes temporary income
and unsustainable losses and gains ➞ correlates well
with non-discretionary spending

Household Savings ➞ ↑ 𝐒 may indicate future caution

stock of 𝐒 may indicate future consumption
potential without a need for ↑ Incomes

Housing Sector Behavior

New/Existing Home Sales (Demand)
Building Permits (Supply - construction activity)
HPI - Housing Price Index (median home prices)

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Page 9
Housing Sector Behavior 𝐈
% ) − 𝐥𝐨𝐰
𝐀𝐯𝐠. $

𝐫↓
𝐫↑ low ratio begins to
work against higher
HPI
housing prices
low rates support prices rising incomes
rates rise
𝐈 rates still supportive
% ) − 𝐡𝐢𝐠𝐡
𝐀𝐯𝐠. $ housing prices rising
construction rises construction drops

- late buyers (momentum and

rate of family formation
speculation)
a key influencer
- encourages overbuilding
- inventories rise

Page 10
External Trade Sector Behavior
imports peak imports
increase domestic economy
imports
drop below average

ROW (primary trading partners)

exports drop
exports rise

FX-rate short-term fluctuations

high rate have minimal effect
encourages imports low rates
need to move in one
discourages exports ↓ imports
↑ exports direction for some time

Trade Balance data.

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Fiscal Policy

a. compare monetary and fiscal policy

b. describe roles and objectives of fiscal policy as well as arguments as to

whether the size of a national debt relative to GDP matters

c. describe tools of fiscal policy, including their advantages and disadvantages

d. explain the implementation of fiscal policy and difficulties of

implementation as well as whether a fiscal policy is expansionary or
contractionary

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Fiscal Policy
Page 1
fiscal (gov’t.) monetary (central banks)
taxation activities related to the levels
spending of money supply and credit
- typically act independently of gov’t.

both used to regulate/influence

economic activity over time - to accelerate
or slow down the economy
- goal of both: create an economic environment where
growth is stable and positive and inflation is
low and stable
- attempt to avoid boom/bust scenarios
Gov’t. large employers
large component of aggregate demand (AD)
largest bond issuer (debt)
policy also used to redistribute wealth and income

Page 2

fiscal policy and AD disposable incomes (YD)

taxation affects consumption (sales tax)
CAPEX - bus. investment all affect
employment AD
spending affects
consumption (G)
Keynesians - fiscal policy can have a significant effect on AD, Y, &
employment when there is an output gap
recession - increase spending to raise employment and Y
Rev. < Exp. ➞ budget deficit ➞ issue debt
expansions - lower spending, raise taxes
Rev. > Exp. ➞ budget surplus ➞ pay down debt

➞ surplus = contractionary, deficit = expansionary fiscal policy

Monetarists - fiscal changes have only a temporary effect on AD

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Page 3

automatic stabilizers (non-discretionary policy)

economic slowdown ➞ transfer PMTs ↑ , revenue ↓
expansions ➞ ↓ ↑

reduce output fluctuations

Debt - accumulation of deficits ➞ issue bonds (held by banks, ins. cos.,

pension funds)
𝐃𝐞𝐛𝐭(
𝐧𝐆𝐃𝐏 ➞ if denominator grows, given a constant %’age of 𝐑𝐞𝐯.( ➞ Rev. ↑
𝐆𝐃𝐏
𝐈𝐧𝐭. 𝐏𝐌𝐓𝐬(
𝐧𝐆𝐃𝐏 ➞ servicing ability improves

if rGDP < real 𝐫𝐝 ➞ 𝐃+𝐆𝐃𝐏 worsens since 𝐫𝐝 × D grows faster

than rGDP
but/ higher inflation = higher nGDP , but not higher D (does not
∴ 𝐃$ gets better but worsens with deflation inflate)
𝐆𝐃𝐏

Page 4
Concerns/
No: if debt is owed internally
if debt was used for CAPEX ➞ ↑ economic productivity
require tax changes that may correct existing distortions
no net impact ➞ Ricardian equivalence
- higher spending today = higher taxes tomorrow
➞ results in higher savings today
if an output gap exists - debt is not competing with more
productive uses of savings
Yes: higher D ➞ higher tax rates ➞ may lead to disincentives to
economic activity
loss of confidence in gov’t. ➞ central bank will have to print money
- inflationary
may crowd-out private investment ➞ S = I ➞ if gov’t. is taking
more S ➞ less private I

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Page 5
Policy tools/ outflows:
1/ transfer payments (B) welfare, pensions, housing benefits, tax credits,
child benefits, unemployment
- not included in GDP as it is not considered spending by G
2/ Spending - health, education, defense - justified on both
economic and social grounds
3/ CAPEX - infrastructure (roads, ports, schools)
- affects productive potential
Inflows/ income - wages, cap gains, int., div.
1/ Direct taxes
wealth - estate, property
inflation corporate profits
helps
2/ Indirect taxes - excise duties (fuel, alcohol, tobacco)
both
- sales tax, lotteries

Page 6

taxation is justified on revenue and income/wealth redistribution

desirable attributes of a tax policy grounds
1/ Simplicity
2/ Efficiency - taxes should interfere as little as possible in choices
- should discourage work and investment as little as possible
- often broken ➞ alcohol and tobacco
3/ Fairness - horizontal equity - people in similar situations should
pay the same tax
- vertical equity - those who earn more should pay more
4/ Revenue sufficiency - may conflict with other attributes

Issues/ may reduce incentives to work/save, including flight

tax Rev.
fairness-subjective - depends on your position
Laffer curve
tax reform vs. spending reform
tax rate

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Page 7
+/
policies (some) can be adjusted very quickly
-/ some are inflexible in the short-run (direct taxes, some spending,
entitlements)
∴ not effective in supressing
the effects of a recession

Fiscal Multiplier/ how much output changes for a change in taxation

transfer payments or spending
G - T + B = budget deficit
spending revenue

YD = Y - NT = (1 - 𝐭 )Y +Y = total tax revenue

tax
disposable taxes less rate
income transfer PMTs
(net taxes)

Page 8
-𝐭
limits to
-𝐭 MPC
𝐏𝟑 etc. 𝟏
-𝐭 MPC without (1 - 𝐭)
𝐏𝟐 MPS 𝟏 − 𝐌𝐏𝐂
MPC
G 𝐏𝟏 MPS and
MPS 𝟏
1(1 - .2).9 1(1 - .2).9(1 - .2).9 with tax
𝟏 − (𝟏 − 𝐭)𝐌𝐏𝐂
etc.
$1 C = .72 C = .5184 fiscal multiplier
MPC = .9 S = .08 S = .0576
e.g./ 𝐭 = 20% MPC = .9
𝐭 = 20%
𝟏
C = MPC CYD = C(Y - NT) = C(1 - 𝐭)Y = 𝟏
𝟏 − . 𝟖(. 𝟗) = 𝟑. 𝟓𝟕𝟏
. 𝟐𝟖
MPC in the
𝐭 = 22% : 𝟏+
presence of tax . 𝟐𝟗𝟖 = 3.356

↓ of .2157 in spending

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Page 9
Balanced budget multiplier:
if G ↑ by $1 and tax revenue ↑ by $1 ➞ spending increases

e.g./ MPC = .9 1000

C = 900 I = 100 - assumption - fixed and not related to

income (not defensible)
1000(.8)(.9)
𝐭 = 20%
1080
G = 200 - total spending 920 vs. 900
C = 720 I = 180

Page 10

structural deficit/surplus - what would exist if the economy

was at full employment (or full potential output)

- automatic stabilizers - affect deficit/surplus unrelated to fiscal policy

- what may then appear to be expansionary/contractionary
policy may only be the result of non-discretionary reactions
∴ the level of surplus/deficit may not be a good indicator of
fiscal policy stance

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Page 11
problem problem action effect on
originates detected implemented economy
×
recognition lag action lag impact lag

action decided upon under uncertainty

households
other units - businesses effect effect
- changing behavior
announced changing behavior

target employment - may accelerate inflation

target inflation - may increase unemployment
crowding out requires Debt - may be difficult if Debt levels are
- competes for savings already elevated
for private investment
raises AD - only useful if spare capacity exists
- if spare capacity but labour shortage,
spending will not ↑AD but will ↑ inflation

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Monetary Policy

a. describe the roles and objectives of central banks

b. describe tools used to implement monetary policy tools and the monetary
transmission mechanism, and explain the relationships between monetary
policy and economic growth, inflation, interest, and exchange rates

c. describe qualities of effective central banks; contrast their use of inflation,

interest rate, and exchange rate targeting in expansionary or contractionary
monetary policy; and describe the limitations of monetary policy

d. explain the interaction of monetary and fiscal policy

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Monetary Policy
Page 1

Roles/ sole supplier of the domestic currency

- fiat currency - not convertible into any commodity
- derives its value through gov’t. decree
- acts as a medium of exchange as long as it holds its value
∴ confidence in currency is critical
Banker to the government
Banker’s bank ➞ lender of last resort
- Stands ready to provide funds (liquidity) to any of the banks
under its jurisdiction
regulator/supervisor of the payment system
banking system supervisor
manage the country’s foreign currency reserves and gold reserves
conduct monetary policy
- activities that influence the quantity of money and credit
in an economy

Page 2

Objectives/ maintain the stability of the financial system

- dual (Fed.) promote full employment
single promote price stability (most common mandate)
mandate (ECB)
Tools/ 1 Open Market Operations
- purchase/sale of gov’t. bonds from/to commercial banks
and designated market makers
(overnight to 2 weeks)
secured repo - repurchase agreement - buy, then sell back
loans
reverse repo - sell, then buy back
2 Policy rate (federal funds rate ➞ U.S.)
range: upper bound - rate willing to lend at
lower bound - rate willing to borrow at
- hike in policy rate meant to increase lending rates
and constrict credit growth

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Page 3

Tools/ 3 Reserve Requirements

- to ↑ or ↓ the supply of money
lower RR higher RR
- not used very much in developed economies, more common
in emerging economies
Transmission Mechanism/

Page 4

Inflation Targeting/ gained prominence during 1990s

- began in NZ - targeted range of 0 - 2%
- target a specific range of inflation - make it public so it
finds its way into expectations (self-fulfilling)
- 2% most common target 0% may result in deflation - bad outcomes,
especially for debt
- higher targets = higher inflation volatility
- not consistent with price stability
- requires 3 elements:
1/ Central Bank Independence - from gov’t.
- can make decisions without government approval
- non-partisan, non-elected, ∴ won’t use MP to get re-elected
- operational vs. target independence
set level of rates set inflation target and definition of inflation
they target and the horizon over which it is
to be achieved

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Page 5

2/ Credibility - market must believe CB will stick to its targets

- can be measured by inflation expectations
3/ Transparency - minutes of meetings, press conferences, economic
forecasts (Fed.-SEP), etc...
- should consider a wide range of economic and financial
market indicators

Exception to inflation targeting/

1/ Bank of Japan (BOJ)
- no explicit measure of inflation
- deflation a larger threat, mostly due to demographics
- may not even be credible if it did announce a target
2/ Fed. - no target, but uses PCE ~ 2% (compatible with stable
prices)

Page 6

MP in developing economies/
more challenging in terms of price stability
- rather illiquid/small gov’t. bond market making
open market operations challenging
- rapidly changing economy making it difficult to estimate
a neutral rate
- no clear and stable definition of money supply
- lack of credibility
- lack of independence
Exchange Rate Targeting/ - a fixed level (a peg) or a bond around
a major currency managed exchange
- by tying the domestic currency to that of rate policy
an economy with a credible policy for price stability can
‘import’ price stability

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Page 7
Exchange Rate Targeting/
- sell foreign fx., buy domestic fx. - reduces domestic money
supply ➞ reduce inflationary pressure
- interest rates would adjust ↑
developed ➞ set rate, fx. adjusts
more volatile
developing ➞ set fx., rates adjust
Dollarization - a country adopts the USD as its functional currency
Limitations of MP/
high = contractionary
policy rates neutral rate - the rate that neither
low = expansionary ↑ nor ↓ the rate of economic
growth (and the rate of inflation)

rGDP growth rate + 𝛑𝐞 (long-run) - level of stable infl.

- rate of growth that results in price stability

Page 8

Limitations of MP/
- changes in rates work well for demand shocks but not for supply
shocks
e.g. labor shortages - higher rates will not create more supply

- problems in transmission ➞ inverted yield curves - market lowers

long-term yields
- short rates > long rates ➞ works against contractionary policy
- curve steepeners when rates ↓ - market believes infl. will ↑
- long rates ↑ working against expansionary policy

- liquidity traps - more money into the system is just held by banks
- common when deflation is expected
- loans become risky
- real rates ↑ rapidly

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Page 9

Limitations of MP/
policy rate limited with deflation
fall in general price level
- interest rates would have to be negative

- deflation increases the real value of debt

- lowers revenues as prices drop
- consumers delay big ticket purchases
- quantitative easing can be used - large scale bond buying
- lowers longer-term rates
- flood the economy with money

Page 10

Interactions of FP and MP/ - both influence AD, but through

different channels
- assuming wages and prices are rigid:
- S has higher impact than T with low rates, effect
- TR to poorest 2× better than TR to all is almost 2×
e
mor
lly
Fiscal Policy ol itica
-p t
icul
infrastructure diff
easy - skills develop. tight

easy - highly expansionary T ↑ or S ↓ , rates low

AD ↑ , rates ↓ C↑ , G↓
less crowding
monetary C+G ↑ ∴ 𝐂$𝐆𝐃𝐏 ↑ out
- will encourage inflation - will ↑ Private
policy I which ↑ pot.
rGDP
tight T ↓ or S ↑ ∴ G↑ - rates high
- rates high ∴ C ↓ - higher taxes/lower spending

𝐆$ C↓ G↓
𝐆𝐃𝐏 ↑
AD ↓

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Introduction to Geopolitics

a. describe geopolitics from a cooperation versus competition perspective

b. describe geopolitics and its relationship with globalization

c. describe functions and objectives of the international organizations that

facilitate trade, including the World Bank, the International Monetary Fund,
and the World Trade Organization

d. describe geopolitical risk

e. describe tools of geopolitics and their impact on regions and economies

f. describe the impact of geopolitical risk on investments

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Introduction to Geopolitics
Page 1/
Geopolitics - study of how geography affects political and international
relations
Geopolitical risk - risk associated with tensions or actions
between actors that affect the normal and peaceful
course of international relations
(individuals, organizations, companies, national governments)

impacts
economic growth interest rates access to key resources
supply channels access to markets

affects
risk premiums
asset allocation
geographic exposure

* Describe geopolitics from a cooperation versus competition perspective

* Describe geopolitics and its relationship with globalization

Page 2/
State actors: national governments, political organizations, and country
leaders that exert authority over a country’s national
security and resources
Non-state actors: do not directly control national security or country resources
e.g./ NGOs, multinational companies, charities, influential individuals

Features of Political Co-operation/ · co-operative countries work together

toward some shared goal or purpose (Military, economic, cultural)

* Describe geopolitics from a cooperation versus competition perspective

* Describe geopolitics and its relationship with globalization

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Page 3/
Motivations for Co-operation/
1/ National security or military interest
2/ Economic interest access to key resources
ability of domestic firms to operate on
a global scale
Resource Endowment/
unequal distribution across Standardization/ process of creating
countries creates the need (desire) protocols for the production, sale,
for co-operation transport, or use of products/services
- may also create power imbalances “rules of engagement”
(inter & intra-country) regulatory co-operation - Basel Committee
on Banking Supervision
process standardization - SWIFT
operational synchronization - containerization

* Describe geopolitics from a cooperation versus competition perspective

* Describe geopolitics and its relationship with globalization

Page 4/
Motivations for Co-operation/
Soft Power/ a means of influence without force or coercion
Cultural Considerations/ cultural similarities, immigration patterns

Role of Institutions/
an established organization or practice in a society or culture
formal structure custom or behavioral pattern

strong institutions contribute to more stable internal and

external political force
e.g. rule of law provide more opportunity to
property rights develop co-operative relationships
human rights (more durable)

* Describe geopolitics from a cooperation versus competition perspective

* Describe geopolitics and its relationship with globalization

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Page 5/
Hierarchy of interests and costs of co-operation/

national interests ➞ country’s goals/ambitions - may conflict with or

support co-operation
US vs. China West vs. Russia
promote democracy & human rights wants to spread democracy and
but// extend NATO
want access to cheap labour
but// needs Russian energy supplies
Power of decision maker/
political party or individual
Congress/Parliament Autocrat/Dictator
Short political cycles psychology
changing priorities possible non-predictability

Non-Co-operation Co-operation
spectrum ➞ degrees of Co-op./Non-Co-op.
* Describe geopolitics from a cooperation versus competition perspective
* Describe geopolitics and its relationship with globalization

Page 6/

Globalization/ process of interaction and integration among people,

companies, and governments worldwide (mainly economic and
financial but has cultural spillovers)
headwinds: financial contagion
nationalism (domestic interests first)
supply channel risk
Features: economic and financial co-operation, mainly by non-state actors
(trade in g/s, capital flows, currency exchange, cultural and information
exchange)
nationalism ➞ opposite ➞ domestic economic and
financial activity dominant to the exclusion of
the interests of other nations
globalization and co-operation tend to be correlated

* Describe geopolitics from a cooperation versus competition perspective

* Describe geopolitics and its relationship with globalization

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Page 7/
Motivations for globalization/
1/ Increasing profits
new markets ➞ increased sales - may involve foreign direct investment
lower costs - cheaper labour, lower tax operating environments,
supply chain efficiencies
2/ Access to resources and markets - talent or raw materials
3/ Intrinsic gain - information exchange, knowledge spillovers
Costs of globalization and threats of rollbacks/
Unequal accrual of economic and financial gains - winners and losers
Lower environmental, social, and governance standards - will operate to
local standards
Political consequences - loser countries ➞ net job losses, out migration,
capital outflows
Interdependence - over-reliance on the resources, or a key resource, from
another, potentially, non-co-operative country
* Describe geopolitics from a cooperation versus competition perspective
* Describe geopolitics and its relationship with globalization

Page 8/
Threats of rollback exposed vulnerabilities - supply chain issues
reshoring essential production
country sourcing diversification
owning foreign production
Archetypes/ political, economic, military mutually beneficial
domination trade among a group regionalism

regional/global leaders extensive rules

harmonization

between 2 countries
trade may be
limited to key
self sufficiency, limited trade
national security
can result from isolation
concerns
(food, water, energy)

* Describe geopolitics from a cooperation versus competition perspective

* Describe geopolitics and its relationship with globalization

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Page 9/
National security tools
used to influence/coerce a state actor through direct/indirect
impact on the country’s resources/people/borders
may be actively used or just threatened
Economic tools
Financial tools
free exchange of
currencies, allowing
foreign direct investment

tools can be used to improve

co-operation or escalate
conflict
more tools of collaboration
used, less likely to initiate
conflict or use non-co-op. tools

* Describe tools of geopolitics and their impact on regions and economies

Page 10/
Types of geopolitical risk:
1/ Event risk - date specific e.g. elections, new legislation
2/ Exogenous risk - unanticipated risk that impacts either a country’s
co-operative stance, ability of non-state actors to
globalize, or both
e.g. invasions, natural disasters
3/ Thematic risk - evolve and expand over a long period of time
e.g. climate change, immigration patterns, populism

Assessing Threats/ Likelihood - probability that it will occur

- mostly subjective
Velocity - pace at which geopolitical risk impacts on
investor’s portfolios
Impact - high or low, discrete or broad (economy/market)
(company/sector)

* Describe geopolitical risk and its impacts on investments

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Page 11/
Assessing Threats/

Short-term Medium term Long-term

Russ./Ukr. Pandemic EV
Terrorist attack spillovers spillovers Autonomous vehicles
Metaverse
CB digital currencies

Events Trends
high market volatility
upside
changes in
Base Case portfolio
risk exposures
signposts downside
e.g./ levels, indicators

* Describe geopolitical risk and its impacts on investments

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International Trade

a. describe the benefits and costs of international trade

b. compare types of trade restrictions, such a tariffs, quotas, and export

subsidies, and their economic implications

c. explain motivations for and advantages of trading blocs, common markets,

and economic unions

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International Trade
Page 1
Benefits/
countries gain from exchange and specialization
- higher price for exports (existing domestic surplus)
- lower prices from imports (existing domestic shortage)
- or less efficient domestic production
- specialization is based on comparative advantage arising
from differences in technology and factor endowments
industries experience greater economies of scale
households and firms have greater product variety
increased competition - reduces monopoly power of domestic firms and
forces them to become more efficient
resources are allocated more efficiently
increased exchange of ideas, freer flow of technical expertise
- knowledge spillovers
- general consensus ➞ trade increases overall welfare (gains > costs)

Page 2

Costs/ potential for greater income inequality

loss of jobs in developed countries
greater competition may lead to the decline of some domestic
industries
Trade Restrictions/ gov’t. policies that limit trade
- protect domestic industries or new industries
- protect domestic employment
- protect strategic industries (national security reasons)
- gain revenue from tariffs
- retaliation
1/ Tariffs - taxes a gov’t. levies on imported goods
- primary objective is to protect domestic industries or
reduce a trade deficit for an imported good/service
- reduces demand by raising the price above the free trade
price

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Page 3
1/ Tariffs
- effect of tariff on ‘Small Country’ ➞ price taker (cannot influence world price)
Large Country = large importer
world price inefficiencies in - can influence price
+ production
tariff exporters into a large country may
loss of
exchange reduce price to keep market share
if large country imposes tariff
world
price - redistribution of income from exporting
country to importing country

domestic imports consumers lose A B C D

supply (𝐐𝟏 − 𝐐𝟒 ) local producers gain A (producer surplus)
(𝐐𝟏 )
gov’t. revenue = C
- tariff: dom. prod. = 𝐐𝟐
Dead weight loss = B + D (net welfare effect)
dom. cons. = 𝐐𝟑
imports = 𝐐𝟐 - 𝐐𝟑 B ➞ higher cost producers fill increase in
domestic demand

Page 4
1/ Tariffs
example:
dom. D = 𝐐𝟒 = 200,000 units
dom. S = 𝐐𝟏 = 110,000 units
imports = 90,000
world price = 5/unit
tariff ➞ 1/unit (20%)
new dom. D = 130,000, new dom. S = 170,000

1/ loss in consumer surplus? ABCD

= 1 × 170,000 + 𝟏$𝟐(1)(30,000) = 185,000
(𝐏𝐭 − 𝐏∗ ) 𝐐𝟑 𝐐𝟒 − 𝐐𝟑
2/ gain in producer surplus A = 1 × 130,000 - 𝟏(𝟐(1)(20,000) = 120,000
3/ gov’t. revenue C = 1 × (170,000 - 130,000) = 40,000
4/ dead weight loss = B D = 𝟏$𝟐(1)(130,000 - 110,000) + 𝟏$𝟐(1)(200,000 - 170,000) = 25,000

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Page 5

2/ Quotas - restricts the quantity of a good that can be

imported (generally for a period of time)
- raises domestic price
- same effect as a tariff, but: C is not
gov’t. revenue, it is now called a
‘quota rent’
- captured by exporting country

- dead weight loss = B + C + D

- if importing country auctions ‘import licenses’,
may be able to capture C

3/ Voluntary Export Restraint (VER) - imposed by the exporting country

- quota rent now captured by exporting country

Page 6

4/ Export subsidies - a payment by the government to a

firm for each unit exported
- Shifts sales from the domestic market to the export market
- raises the price in the domestic market by the amount
of the subsidy (small country case)
- large country case - world price declines
countervailing duties - levied by importing country against
subsidized exports entering the country
5/ Domestic content provisions - some %’age of the value-added or
components used in production should be of domestic origin

Capital Restrictions - controls placed on foreigner’s ability to own

domestic assets or on domestic resident’s ability to own
foreign assets

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Page 7
Trading Blocs/
1/ Free trade areas - all barriers to the flow of goods/services
among members have been eliminated
- each country maintains its own policies against non-members
2/ Customs union - FTA + common trade policy against non-members
3/ common market - customs union + free movement of factors of
production among members
4/ Economic union - common market + common economic institutions
+ co-ordination of economic policy among members
5/ Monetary union - economic union + common currency
Regional Integration/ - typically faster/easier than multi-lateral
trade negotiations under WTO
- results in preferential treatment for members - reduce
or eliminate trade barriers

Page 8

Regional Integration/ - can shift trade and production from

lower-cost non-members to higher-cost members
- leads to a less efficient allocation of resources

trade creation - when higher-cost domestic production is

replaced by lower-cost imports from other members
- overall consumption increases since price drops
trade diversion - when lower-cost imports from non-member
countries are replaced with higher-cost imports from
members
- if trade creation > trade diversion, net welfare effect is positive
Costs/Benefits/ same benefits as free trade
- reduces potential for conflict among members
- long-run growth of integrated countries is interconnected
since they have access to each other’s markets

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Page 9
Costs/Benefits/
- leads to convergence in living standards
- consumers gain choice
- competitive firms gain in productivity
but//
may hurt low-skilled workers in wealthier countries
may cause firm failure due to a lack of cost competitiveness

Challenges/
1/ Cultural differences and historical considerations
- past wars and conflicts

2/ a high degree of economic integration limits the

extent to which member countries can pursue independent
economic and social policies
- mobility of labor may thwart policies aimed at
raising low-wage incomes

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Capital Flows and the FX Market

a. define the foreign exchange market, including its functions and participants,
distinguish between nominal and real exchange rates, and calculate and
interpret the percentage change in a currency relative to another currency

b. describe exchange rate regimes and explain the effects of exchange rates on
countries’ international trade and capital flows

c. describe common objectives of capital restrictions imposed by governments

48
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FX - Market
Page 1
USD AUD RUB EUR.USD
EUR NZD SGD USD.CAD EUR.USD = 1.0950
GBP NOK etc... GBP.USD
JPY SEK USD.JPY
CAD CHF USD.CAD = 1.3925
exchange
individual rates
currencies
in terms of 𝐀E𝐁
So… EUR.USD = 𝐔𝐒𝐃+𝐄𝐔𝐑 price
𝐔𝐒𝐃
= 1.0950
𝐄𝐔𝐑
if 𝐔𝐒𝐃+𝐄𝐔𝐑 @ 𝐭 𝟏 = 1.0950 (1) buys
base
need
@ 𝐭 𝟐 = 1.0900 𝐂𝐀𝐃
= 1.3925
𝐔𝐒𝐃
USD appreciated (1) to get
or
EUR depreciated

Page 2
Nominal exchange rate EUR.USD or 𝐔𝐒𝐃+
𝐄𝐔𝐑 1𝐒𝐝' 2
spot rates 𝐟
Now, let’s assume d - domestic
1) a world of homogenous g/s f - foreign
2) no market frictions
3) no trade barriers (i.e. capital restrictions)

if an iPad cost £ 500 or $750, we would expect

𝐔𝐒𝐃E [GBP.USD = 1.5000]
𝐆𝐁𝐏 = 1.5000

called Purchasing Power Parity (theory)

rarely satisfied (if ever) for ∀ goods/baskets

Reality Check: nominal exchange rates exhibit persistent

deviations from PPP

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Page 3
Real Exchange Rates
if 𝐀+𝐁 ↑ (B.A)

A B or if 𝐂𝐏𝐈𝐁 ↑
you live in A-lander will suffer a
A-land ... and want to buy loss of PP in terms of
from B-land B-land g/s

① foreign price But: if 𝐂𝐏𝐈𝐀 ↑ (and I & CPI

level in domestic = 𝐒𝐀$𝐁 × 𝐂𝐏𝐈𝐁 move together)
currency
A-lander will gain PP
and if CPIA = price level in
in terms of B-land g/s
A - land
real exchange 𝐂𝐏𝐈𝐁
= 𝐒𝐀' ×
rate 𝐁 𝐂𝐏𝐈𝐀

Page 4
Real Exchange Rates
want to
Example/ GBP buy g/s EUR

𝐂𝐏𝐈𝐄𝐔𝐑
real fx-rate = 𝐒𝐆𝐁𝐏' ×
𝐄𝐔𝐑 𝐂𝐏𝐈𝐆𝐁𝐏

so, if 𝐒𝐆𝐁𝐏' ↑ 10% , 𝐂𝐏𝐈𝐄𝐔𝐑 ↑ 5% , 𝐂𝐏𝐈𝐆𝐁𝐏 ↑ 2%

𝐄𝐔𝐑

- what is the change in the real fx-rate?

𝟏 + %𝚫𝐂𝐏𝐈𝐄𝐔𝐑 𝟏. 𝟎𝟓
@1𝟏 + %𝚫𝐒𝐆𝐁𝐏' 2× E − 𝟏 = F𝟏. 𝟏𝟎 × J = 𝟏𝟑. 𝟐𝟑
𝐄𝐔𝐑 𝟏 + %𝚫𝐂𝐏𝐈𝐆𝐁𝐏 𝟏. 𝟎𝟐
shortcut ∼ 10% + 5% - 2%
∴ real fx-rate is 13.23% higher = 13%

- means ⇒ need 13.23% more £ to buy same g/s in

€

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Page 5
Real Exchange Rates real
Example/ CNY fx-rate USD
of to get 1
𝐂𝐍𝐘+ so, CNY
𝐔𝐒𝐃 ↓ 3% USD.CNY ↓ 3% appreciated
(1) buys needs against USD.

CPIUSD = 1.5% CPICNY = 4.5%

𝟏. 𝟎𝟏𝟓 𝟏. 𝟎𝟏𝟓
real fx. rate @𝟏 + (−. 𝟎𝟑) × E − 𝟏 = F. 𝟗𝟕 × J − 𝟏 = −𝟓. 𝟕𝟖%
𝟏. 𝟎𝟒𝟓 𝟏. 𝟎𝟒𝟓
(Short cut -3% + 1.5% - 4.5% = -6%)
means ⇒ need 6% less CNY to
buy same g/s in USD

Page 6

e.g./ Setup: hold bonds in HKD , live in AUD J𝐒𝐀𝐔𝐃* K = J𝐒𝐝* K

𝐇𝐊𝐃 𝐟

1) if 𝐒𝐀𝐔𝐃' ↑ , HKD bonds ↑ in AUD terms?

𝐇𝐊𝐃
yes, if 𝐒𝐀𝐔𝐃' ↑ , HKD buys more AUD.
𝐇𝐊𝐃

2) if 𝐒𝐀𝐔𝐃' ↑ , relative purchasing power in HKD ↑

𝐇𝐊𝐃
no, HKD buy more AUD, but they do not buy
more g/s denominated in HKD
① ②
3) if CPIAUD ↑ , then 𝐫𝐞𝐚𝐥𝐀𝐔𝐃' ↑ ⇒ implies that relative
𝐇𝐊𝐃
purchasing power of AUD income is higher
𝐂𝐏𝐈𝐇𝐊𝐃
① no 𝐒𝐀𝐔𝐃* × (if CPI ↑, 𝐂𝐏𝐈𝐇𝐊𝐃 ↓ , 𝐫𝐞𝐚𝐥𝐀𝐔𝐃' ↓)
𝐇𝐊𝐃 𝐂𝐏𝐈𝐀𝐔𝐃 𝐂𝐏𝐈𝐀𝐔𝐃 𝐇𝐊𝐃

② no if 𝐫𝐞𝐚𝐥𝐀𝐔𝐃' ↑ , purchasing power of AUD ↓

𝐇𝐊𝐃

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Page 7
e.g./ Setup: hold bonds in HKD , live in AUD J𝐒𝐀𝐔𝐃* K = J𝐒𝐝* K
𝐇𝐊𝐃 𝐟

4) if 𝐒𝐀𝐔𝐃' ↓ , then 𝐫𝐞𝐚𝐥𝐀𝐔𝐃' ↓ & increase the

𝐇𝐊𝐃 𝐇𝐊𝐃

relative purchasing power of AUD income

𝐂𝐏𝐈𝐇𝐊𝐃
yes: F 𝐒𝐀𝐔𝐃' × J = 𝐫𝐞𝐚𝐥𝐀𝐔𝐃' - implies AUD is
𝐇𝐊𝐃 𝐂𝐏𝐈𝐀𝐔𝐃 𝐇𝐊𝐃
strengthening
against HKD
5) 𝐒𝐀𝐔𝐃' ↑ 5% , CPIHKD ↑ 5% , CPIAUD ↑ 2%
𝐇𝐊𝐃
( HKD bonds in AUD ↑ or ↓ ? ) ↑ 5%

6) change in relative purchasing power of AUD income

𝟏. 𝟎𝟓
𝐫𝐞𝐚𝐥𝐀𝐔𝐃' = TU(𝟏 + . 𝟎𝟓) × VW − 𝟏 = 𝟖. 𝟎𝟖𝟗%
𝐇𝐊𝐃 𝟏. 𝟎𝟐

Page 8

Participants/ Buy side:

1/ Corporate accounts - Revenues/expenses in a for. currency
- borrowing in a for. currency
- primarily hedging
2/ Real money accounts - institutional funds - pensions, endowments, etc.
- hedging of, or unhedged, for currency positions,
limited active trading
3/ Leveraged accounts - hedge funds, proprietary trading desks, etc.
- forex as an asset class, active trading

4/ Retail accounts - non-professional, typically spot market transactions

5/ Governments - transactional to policy goals

6/ Central Banks - intervention, managing foreign currency reserves

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Page 9
Participants/ Buy side:
7/ Sovereign wealth funds - countries with large current account surpluses
- investment mandate - hedging & some active positions
Sell side: FX dealing banks - only the largest, first-tier global banks
- given the wide variety of participants and motives, it is difficult to
predict movements in fx-rates
Market Composition/
33% spot market
14% forward/futures market
FX swaps - combines a spot and forward transaction
53% currency swaps - generally fixed/fixed or floating/floating

- largest proportion occurs in London followed by New York

- forex markets (esp. spot) most active between
8:00 am - 11:30 am New York time

FX - Rate Calculations
Page 10
price
𝐀( ➞ 𝐝( e.g./
Direct 𝐂𝐀𝐃(
𝐁 𝐟
base
𝐔𝐒𝐃 = 1.3300

Indirect 𝐁( ➞ 𝐟( 𝐔𝐒𝐃( 𝟏
𝐀 𝐝 𝐂𝐀𝐃 = 𝟏. 𝟑𝟑𝟎𝟎 = 𝟎. 𝟕𝟓𝟏𝟗
Quote Conventions
EUR euro 𝐔𝐒𝐃$
𝐄𝐔𝐑 EUR.USD
JPY dollar-yen 𝐉𝐏𝐘$ USD.JPY
𝐔𝐒𝐃
GBP sterling 𝐔𝐒𝐃$
𝐆𝐁𝐏 GBP.USD
CAD loonie 𝐂𝐀𝐃$
𝐔𝐒𝐃 USD.CAD Major
AUD aussie 𝐔𝐒𝐃$ AUD.USD Pairs
𝐀𝐔𝐃
NZD kiwi 𝐔𝐒𝐃$
𝐍𝐙𝐃 NZD.USD
CHF Swissie 𝐂𝐇𝐅$
𝐔𝐒𝐃 USD.CHF

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Page 11
Quote Conventions
EURJPY euro-yen 𝐉𝐏𝐘$ EUR.JPY
𝐄𝐔𝐑
EURGBP euro-sterling 𝐆𝐁𝐏$
𝐄𝐔𝐑 EUR.GBP
EURCHF euro-swiss 𝐂𝐇𝐅$ EUR.CHF
𝐄𝐔𝐑 cross pairs
GBPJPY sterling-yen 𝐉𝐏𝐘$ GBP.JPY
𝐆𝐁𝐏
EURCAD euro-cad 𝐂𝐀𝐃$
𝐄𝐔𝐑 EUR.CAD
CADJPY cad-yen 𝐉𝐏𝐘$ CAD.JPY
𝐂𝐀𝐃

USD.CAD some quotes

Sell Buy 1.39025
dollar pips 100 pips = 1 cent
𝟏. 𝟑𝟗𝟎𝟐 𝟏. 𝟑𝟗𝟎𝟔 cents
16.8M 19.2M
Yen 110.63
Bid offer
Sell USD Buy USD
(Buy CAD) (Sell CAD)

Page 12
𝐔𝐒𝐃+ 𝐔𝐒𝐃+
𝐭𝟎 𝐄𝐔𝐑 = 1.2500 𝐭𝟏 𝐄𝐔𝐑 = 1.3000

𝟏. 𝟑𝟎 − 𝟏. 𝟐𝟓
= 𝟒% ⇒ interpreted from the point of
𝟏. 𝟐𝟓
view of the base
∴ the EUR has appreciated relative
to the USD by 4%
Inverse/ Identical
𝐄𝐔𝐑E 𝟏 𝐄𝐔𝐑E 𝟏 Statements
𝐔𝐒𝐃 = 𝟏.𝟐𝟓𝟎𝟎
= 𝟎. 𝟖𝟎𝟎𝟎 𝐔𝐒𝐃 = E𝟏. 𝟑𝟎𝟎𝟎 = 𝟎. 𝟕𝟔𝟗𝟐

. 𝟕𝟔𝟗𝟐 − . 𝟖𝟎𝟎𝟎
. 𝟖𝟎𝟎𝟎
= −𝟑. 𝟖𝟓% ∴ the USD has
depreciated 3.85%
relative to the EUR

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Page 13
𝟏
USD.CAD = 1.3900 CAD.USD = 𝟏.𝟑𝟗𝟎𝟎
= 0.7194

USD.CAD as this CAD.USD

rises
Sell Buy Buy Sell

𝟏. 𝟑𝟖𝟗𝟖 𝟏. 𝟑𝟗𝟎𝟐 . 𝟕𝟏𝟗𝟔 . 𝟕𝟏𝟗𝟐

Bid Ask Ask Bid this falls

⇒
⇒

Buy USD Sell CAD

Sell CAD Buy USD

Payoff: in CAD in USD

(gains/losses)

FX - Market
Page 14
Fx-regimes/

fx-rates will affect capital flows and trade

movements
➞ based on economic stability of the trading country
and volatility
influences the type of exchange rate
regime adopted
Ideal Currency Regime:
3 properties 1/ rate between any 2 countries would be credibly fixed
- eliminates uncertainty
2/ all currencies would be freely convertible
- freely exchanged for any purpose in any amount
3/ each country would be able to undertake fully
independent monetary policy
- cannot have all 3 ➞ 1 + 2 negates 3
3 negates 1 or 2

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Page 15
e.g./ Country A raises interest rates
- because of (I), no uncertainty exists ➞ money flows into A
- increase in m would crowd into investment, pushing
price up, lowering yield (and rates)
now/ if fx-rate was freely floating: forex uncertainty
- flows in drive up fx-rate, making investment costly
for inflows
∴ the more freely floating the currency and the more tightly
convertibility is controlled ➞ the more effective monetary policy
Gold Bretton Smithsonian
Standard Woods Agreement (1973)

m limited by system of fixed parities BW abandoned for

supply of gold for fx-rates with periodic freely-floating currencies
limited ability to real alignments once trade but FX volatility
stimulate growth but imbalances built-up increased
low inflation - build-up of inflations

Page 16
ERM-European
Exchange Rate common currency (1999)
Mechanism
European currencies allowed
fell apart after
to fluctuate within a narrow
end of Cold War
band called the snake
Taxonomy of Currency Regimes/
1/ Dollarization - country uses currency of another nation
- no ability over monetary policy
- inherits currency credibility but not creditworthiness
2/ Monetary Union - a group of countries share a common currency
- each country loses ability for independent monetary policy
3/ Currency Board - a fixed fx-rate with the domestic currency
fully backed by foreign assets
- expansion/contraction of the monetary base directly
linked to trade and capital flows
- outflows result in increasing interest rates

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Page 17
Central Bank
A L
inflow outflow
𝐫𝐔𝐒𝐃 USD domestic 𝐫𝐝
currency

𝐫𝐔𝐒𝐃 - 𝐫𝐝 = seigniorage
4/ Fixed Parity - no legislative commitment as with (3)-CB
- level of fx reserves is discretionary
usually - may be pegged to a single currency or to a
+⁄− 1% band basket of currencies
trade-weighted
- credibility is key

Page 18
Target Zones:
5/ active or passive crawling pegs

pre-announce react to changes in

fx-rate to manipulate domestic inflation
inflation expectations
6/ Fixed parity with crawling bands
- begin with a peg to anchor inflation expectations
- gradually widen a band over time and allow for gradual
exit from the peg
7/ managed float - use a policy target ➞ trade balance, price stability, etc.

8/ independent floating rates - market determined

- central bank has full control of monetary policy

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Page 19
FX and Trade Balance/
trade deficit - must borrow or sell assets to finance
surplus - lend or buy foreign assets
current account capital account

trade flows capital flows

both affect fx-rates and ∆fx-rates affect both
(X - M) = (S - I) + (T - G) - surplus reflected in
trade net fiscal ↑ private S or ↑ gov’t. S.
balance savings balance
financial claims on rest of world
- deficit ➞ ↓ in S ➞ sell foreign assets of foreign build-up of
financial claims against domestic economy
- since trade adjusts slowly, any ∆fx-rate is met by ∆asset prices
∴ capital flows are the primary determinants of fx-rate
movements in the short to intermediate term
- for fixed rate regimes - adjustment happens with interest rates

Page 20

Capital Restrictions/ both inward and outward

- any policy designed to limit or redirect capital flows
- meet policy objectives e.g. employment, regional development,
national security, etc.
inward
limit how much can be invested
restrict/limit investment in certain industries
prevent hot money flows but perhaps not FDI
protect domestic financial markets
outward
limits on repatriation of capital or income
facilitates restrict/limit outflows of wealth
taxation
prevent capital flight ➞ results in purchase of domestic
of wealth
and Income assets

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Exchange Rate Calculations

a. calculate and interpret currency cross-rates

b. explain the arbitrage relationship between spot and forward exchange rates
and interest rates, calculate a forward rate using points or in percentage
terms, and interpret a forward discount or premium

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FX Cross-Rate Calculations
Page 12
e.g. 1/
𝐂𝐀𝐃E 𝐔𝐒𝐃E
𝐔𝐒𝐃 = 1.3980 𝐄𝐔𝐑 = 1.0950

Find 𝐂𝐀𝐃E
𝐄𝐔𝐑
𝐂𝐀𝐃E 𝐔𝐒𝐃E 𝐂𝐀𝐃E
𝐔𝐒𝐃 × 𝐄𝐔𝐑 = 𝐄𝐔𝐑

1.3980 × 1.0950 = 1.5308 (corrected from video)

e.g. 2/ 𝐂𝐀𝐃E 𝐉𝐏𝐘E
𝐔𝐒𝐃 = 1.3980 𝐔𝐒𝐃 = 121.10

Find 𝐉𝐏𝐘E
𝐂𝐀𝐃 e.g. 3/ Decompose
𝟏 𝐂𝐇𝐅+
- first 𝐔𝐒𝐃+
𝐂𝐀𝐃 = 𝟏. 𝟑𝟗𝟖𝟎 = 𝟎. 𝟕𝟏𝟓𝟑 𝐄𝐔𝐑
𝐂𝐇𝐅E 𝐔𝐒𝐃E
𝐉𝐏𝐘+ 𝐔𝐒𝐃+ 𝐉𝐏𝐘+ 𝐔𝐒𝐃 × 𝐄𝐔𝐑
𝐔𝐒𝐃 × 𝐂𝐀𝐃 = 𝐂𝐀𝐃

121.10 × 0.7153 = 86.62

Forward Calculations
Page 13
pips
- forward rates typically quoted as spot + points
(pos./neg.)
spot + points = forward premium (base)
spot - points = forward discount (base)
𝐔𝐒𝐃(
e.g./ 𝐄𝐔𝐑 = 1.2875 discount
1 yr. forward rate = 1.28485
1-yr. forward points = -26.5
e.g./
spot 1.2875
1 week - .3 1.2875
1 mos. - 1.1 - 13.3
3 mos. - 5.5 1.28617
6 mos. - 13.3
12 mos. - 26.5
also called swap points

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$1000 CAD
invest @ 𝐢𝐝 for 𝐭 𝟏 convert to USD at 𝐒𝐟'
𝐭=0 𝐭𝟏 𝐝

-1000 1000(1 + 𝐢𝐝 ) invest at 𝐢𝐟 for 𝐭 𝐢

𝐭𝟎 𝐭𝟏
So, for there to be no -1000 𝐒𝐟% 1000 𝐒𝐟% (1 + 𝐢𝐟 )
arb. opp.
𝐝 𝐝

1000(1 + 𝐢𝐝 ) = 𝟏𝟎𝟎𝟎 𝐒𝐟* (𝟏 + 𝐢𝐟 ) amount in USD

𝐝
𝐅𝐟* convert back to ×
(1 + 𝐢𝐝 ) = 𝐒𝐟'𝐝 (𝟏 + 𝐢𝐟 )
𝐝
CAD 𝐒𝐝*
𝐟
𝐅𝐟' if (𝟏 + 𝐢𝐝 ) > 𝐒𝐟' (𝟏 + 𝐢𝐟 ) 𝟏𝟎𝟎𝟎 𝐒𝐟* (𝟏 + 𝐢𝐟 ) 𝐒𝐟*
𝐝 𝐝 𝐝 𝐝
𝐅𝐟' 𝐅𝐟*
𝐝
𝐅𝐟' = 𝐒𝐟' (𝟏 + 𝐢𝐟 ) 𝐝
𝐝 𝐝
(𝟏 + 𝐢𝐝 ) buy CAD, sell USD

𝐅𝐟' = 𝐒𝐟' (𝟏 + 𝐢𝐟 ) e.g. 𝐒𝐟' = 1.6535 𝐢𝐝 = 3.5% 𝐢𝐟 = 5%

𝐝 𝐝 𝐝
(𝟏 + 𝐢𝐝 )
𝟏. 𝟔𝟓𝟑𝟓(𝟏. 𝟎𝟓) 240 pips
𝐅𝐟' = = 𝟏. 𝟔𝟕𝟕𝟓
𝐝 𝟏. 𝟎𝟑𝟓 (points)
i.e. 2.4¢
If 𝐅𝐟' = 1.6900 - what would we do?
𝐝

Simple Rule: Buy low, Sell high

(1 + 𝐢𝐝 ) = 𝐒𝐟'𝐝 (𝟏 + 𝐢𝐟 )
𝐅𝐟'
𝐝

Borrow 1.6535 of (f) , convert to 1 unit of (d) , Sell 𝐅𝐟$ @ 1.69

𝐝

1.035 > 𝟏. 𝟔𝟓𝟑𝟓(𝟏. 𝟎𝟓)

= 𝟏. 𝟎𝟐𝟕𝟑
𝟏. 𝟔𝟗

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𝐅𝐟' = 𝐒𝐟' (𝟏 + 𝐢𝐟 ) 𝐅𝐟'

⇒ (𝟏 + 𝐢𝐟 )
𝐝 𝐝 𝐝
= if num. > den.
(𝟏 + 𝐢𝐝 ) 𝐒𝐟' (𝟏 + 𝐢𝐝 )
𝐝

𝐅𝐟* > 𝐒𝐟*

𝐝 𝐝

But 𝐅𝐝
$ 𝐟 (𝟏 + 𝐢𝐝 )
= den. > num. General Rule:
𝐒𝐝$ (𝟏 + 𝐢𝐟 )
𝐟
- if the base currency
𝐅𝐝' < 𝐒𝐝' is the higher yielding currency
𝐟 𝐟
⇒ forwards will be at a discount
- if the base currency is the lower
yielding currency
⇒ forwards will be at a premium

62