Topics in Demand And Supply Analysis https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd LOS a Elasticities of demand Price elasticity Sensitivity of quantity demanded to change in price Income elasticity Sensitivity of quantity demanded to change in income Cross price elasticity Sensitivity of quantity demanded to change in price of related goods (compliment or substitute) Price elasticity Pe = Cross price elasticity Income elasticity % ∆ in Qd % ∆ in P Ie = % ∆ in Qd % ∆ in I Pe = % ∆ in Qd % ∆ in Py Pe > = Demand is elastic Ie = +ve: Good is a normal good Pe = +ve: Good is substitute Pe < = Demand is inelastic Ie = −ve: Good is an inferior good Pe = −ve: Good is complement Price e High Pe re Pe is close to Low Pe Quantity LOS b & c nT Demand curve Substitution and income effects Substitution effect Income effect Normal good (P È 10%) Ç Qd 10% Ç Qd 10% Inferior but not Giffen good (P È 10%) Ç Qd 10% È Qd 5% Inferior and Giffen good (P È 10%) Ç Qd 10% È Qd 15% Fi Particulars Every Giffen good is an inferior good but every inferior good is not a Giffen good For Giffen goods, income effect is more dominant than substitution effect Veblen Good - Higher price makes goods more desirable Eg Louis Vuitton bag May have a positively sloped demand curve https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd LOS d Diminishing marginal returns Marginal returns refer to the additional output produced by using one more unit of labor or capital while keeping the other constant Total output Marginal product decreasing Marginal product negative Marginal product increasing Inputs beyond this quantity are said to produce diminishing marginal returns Quantity of labor LOS e Breakeven and shutdown points of production Perfect competition Monopolistic competition e Monopoly re Imperfect competition Breakeven quantity TR = TC In short run shutdown if, P < AVC In short run shutdown if, TR < TVC, P < AVC In long run shutdown if, P < ATC In long run shutdown if, TR < TC, P < ATC nT Breakeven quantity P = ATC, TR = TC Fi ª ª ª ª ª P = Price ATC = Average total cost TR = Total revenue TC = Total cost AVC = Average variable cost Cost Marginal cost curve ATC curve AVC curve AFC curve Quantity Oligopoly https://www.fintreeindia.com/ LOS f © 2017 FinTree Education Pvt Ltd Economies and diseconomies of scale Quantity VC per unit TVC TFC TC MC 10 10 100 110 - 18 100 118 8 24 100 124 28 100 128 40 100 140 12 54 100 154 14 10 70 100 170 16 Economies of scale Diseconomies of scale Price Short run ATC curves e Long run ATC curve Diseconomies of scale re Economies of scale nT Constant returns to scale Fi Long run ATC curve shows minimum ATC for each level of output assuming that scale of the firm can be adjusted Quantity The Firm And Market Structures https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd LOS a Characteristics of different markets Characteristics Perfect competition Monopolistic competition Oligopoly Monopoly No of sellers Many Many Few One Product differentiation Homogeneous Differentiated Homogeneous Unique Barriers to entry Very low Low High Very high Pricing power of firm None Some Some or considerable Considerable Non price competition None Advertising + Product differentiation Advertising + Product differentiation Advertising LOS b Perfect competition Monopoly re Monopolistic competition e Relationships between P, MR, MC, economic profit and Pe under different market structures Oligopoly In equilibrium, In equilibrium, P = MR = MC =ATC Pe - Perfectly elastic P > MR = MC Pe > nT In equilibrium, Economic profit = LOS c Economic profit = In equilibrium, P > MR = MC Pe > Economic profit +ve in long run P > MR = MC Pe > Economic profit +ve in long run Profits may be zero Firm’s supply function (Perfect competition) Cost Fi Marginal cost curve Cost Short run market supply curve ATC curve AVC curve D = MR Quantity In the short run, MC curve is above AVC curve In the long run, supply curve MC is above ATC curve There is no well defined supply curve for other markets Quantity https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd Price Marginal cost curve Demand curve P1 MR = P × )1 − P1 ) e Marginal revenue curve Quantity Q1 Under monopolistic competition, oligopoly and monopoly, equilibrium quantity is determined by the intersection of MC and MR LOS d Optimal price and output for firms Firms maximize profits by producing the quantity where MC = MR In perfect competition P = MR In monopolistic competition and monopoly, price is the intersection of demand curve and profit maximizing quantity of output Factors affecting long-run equilibrium under each market structure e LOS e An increase in demand will increase economic profits in the short run under all market structures re +ve economic profits result in entry of firms into the industry (except oligopoly and monopoly) −ve economic profits result in exit of firms nT When firms enter an industry, market supply increases, which causes decrease in market price and an increase in equilibrium quantity Pricing strategies in oligopoly Kinked demand curve Price More elastic Fi Kink Less elastic Quantity Increase in a firm’s product price will not be followed by its competitors, but a decrease in price will Kink is the price above which the demand is elastic and below which the demand is inelastic https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd Cournot model Considers a duopoly i.e two firms with identical and constant marginal cost of production Price Perfect competition Monopoly Monopoly Perfect competition Quantity - Nash equilibrium Nash equilibrium is reached when the choices of all firms are such that there is no other choice that makes any firm better off Eg prisoner’s dilemma Choices: High price Low price A - High price: 300 B - Low price: 500 B - Low price: 1300 A - Low price: 1400 A - High price: 1000 B - High price: 700 re B - High price: 100 e Firms - A & B A - Low price: 500 Dominant firm model One firm has significantly large market share because of its greater scale and lower cost structure (Dominant firm) Market price is determined by the dominant firm and other firms take this price as given nT Firm’s decisions are interdependent If there is a price war, then dominant firm’s market share Ç If there is no price war, then over time dominant firm’s market share È Fi Natural monopoly - Single firm supplying the entire market demand for the product LOS f Pricing strategies Firms under any market maximize profits by producing the quantity where MC = MR In perfect competition P = MR = AR =MC = ATC In monopolistic competition, oligopoly and monopoly, price is the intersection of demand curve and profit maximizing quantity of output Pricing strategies under oligopoly - Kinked demand curve, Cournot model, Nash equilibrium, dominant firm model https://www.fintreeindia.com/ LOS g © 2017 FinTree Education Pvt Ltd N-firm concentration ratio HerfindahlHirschman Index Eg N = Add up the market share of largest companies in the industry Eg N = Add up the square of market shares of largest companies in the industry It captures the merger effect Limitations : Œ Does not comment on pricing power Does not capture the merger effect Limitations : Œ Does not comment on pricing power Both the ratios are used to measure the degree of monopoly or market power of a firm None of the ratios consider barriers to entry LOS h Identifying the market structure in which firm operates Œ Examine no of firms in the industry, check if products are homogeneous or differentiated, see barriers to entry/exit and check if there is any non price competition Fi nT re e Compare these with the characteristics that define each market structure Aggregate Output, Prices And Economic Growth https://www.fintreeindia.com/ LOS a © 2017 FinTree Education Pvt Ltd GDP using expenditure and income approach ª Gross domestic product (GDP) is the total market value of final goods and services produced within a country during a certain time period ª It is most widely used measure of the size of a nation’s economy ª It includes only purchases of newly produced goods and services ª Sale or resale of goods produced in previous periods is excluded ª Goods and services provided by government are included in GDP (valued at cost) ª Value of owner-occupied housing is also included in GDP (value is estimated) Expenditure approach - Total amount spent on goods and services produced during the period Calculated as; Consumption (C) + Investment (I) + Government expenditure (G) + [Exports − Imports] (X − M) Total income earned by households and companies during the period e Income approach - re Calculated as; Consumption (C) + Savings (S) + Taxes (T) LOS b Expenditure approach nT Sum of value added GDP is calculated by adding the value created at each stage of production Fi LOS c Value of final output GDP is calculated using only the final value of good and services Nominal GDP Real GDP Output - Current year Output - Current year Prices - Current year Prices - Base year GDP deflator - Nominal GDP × 100 Real GDP https://www.fintreeindia.com/ LOS d © 2017 FinTree Education Pvt Ltd National income - Compensation to employees + Corporate and govt profits before tax + Non corporate business income + Rent + Interest + (Indirect taxes − Subsidies) Personal income - National income + Transfer payments by govt − Corporate and indirect taxes − Undistributed corporate profits Personal disposable income - Personal income − Personal taxes GDP under income approach can also be calculated as : National income + Capital consumption + allowance Adjustment for difference between GDP under income and expenditure approach LOS e re e Depreciation of physical capital Statistical discrepancy Fundamental relationship among C, S, T, I, G and (X − M) Total income must equal total expenditures GDP under income approach = GDP under expenditure approach C + S + T = C + I + G + (X − M) nT S = I + (G − T) + (X − M) Fiscal deficit Trade surplus Fi (G − T) = (S − I) + (M − X) Fiscal deficit must be financed by some combination of trade deficit or excess of savings over investment https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd LOS f IS and LM curves IS - Investment and Savings LM - Liquidity and Money supply Real interest rate (r) Real interest rate (r) Real income Real income Œ +ve relation r and (S − I) Assumption Real money supply is constant −ve relation y and (S − I) e Therefore, −ve relation b/w r and y Ÿ y Ç = Precautionary & transaction demand Ç Ÿ Demand for money Ç = Cost of money Ç re (S − I) = (G − T) + (X − M) y Ç Fiscal deficit & Trade surplus È = (S −I) È Ÿ rÇ=yÇ Aggregate demand curve LM1 Fi IS Real money supply ‘Constant’ P Ç = MS/P È Price LM2 nT Real interest rate (r) Output (y) If MS/P È then, LM curve shifts to the left (increases real interest rate) IS curve - −ve relation (r & y) LM curve - +ve relation (r & y) Output (y) Aggregate demand curve −ve relation (p & y) ª Marginal propensity to save (MPS) - Proportion of additional income that is saved ª Marginal propensity to consume (MPC) - Proportion of additional income spent on consumption ª MPS + MPC = 100% https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd Supply of money Nominal interest rate Nominal interest rate Money supply Excess of supply Excess of demand r1 r2 r3 Money demand Quantity Quantity Money supply Supply of money is determined by central bank and is independent of interest rate Therefore MS is always perfectly inelastic LOS e Fischer effect @ 10% p.a Inflation True saving re Consumption cost 107 110 e 100 Real rate of return Nominal risk-free rate = Real risk-free rate + Expected inflation nT Nominal risk-free rate = Real risk-free rate + Expected inflation + Risk premium Investors require risk premium for expected inflation LOS f Roles and objectives of central banks Objectives è Sole supplier of currency è Banker to the government and other banks è Regulator and supervisor of payments system è Lender of last resort è Holder of gold and foreign exchange reserves è Conductor of monetary policy è Primary objective - Control inflation è Stability in exchange rates with foreign currencies è Full employment è Sustainable positive economic growth è Moderate long-term interest rates Fi Roles https://www.fintreeindia.com/ LOS g © 2017 FinTree Education Pvt Ltd Costs of expected and unexpected inflation When inflation is higher than expected, borrowers gain at the expense of lenders Unexpected inflation can increase the magnitude and frequency of business cycle LOS h Tools used to implement monetary policy ª Policy rate/discount rate/refinancing rate/2-week repo rate ª Reserve requirements ª Open market operations Expansionary policy Contractionary policy » Policy rate » Reserve ratio Buying securities « Policy rate « Reserve ratio Selling securities LOS i Monetary transmission mechanism Monetary policy Asset prices Market interest rates (fall as discount rate for future CFs increase) Growth expectations (decrease) nT re (increase) e (increase in official interest rate) Domestic demand (reduces) Exchange (appreciate) (foreign investors might want to invest) Net external demand (decreases) (Exports decrease, Imports increase) Inflation rate Fi (decreases) LOS j Independence Qualities of effective central bank Central bank is free from political interference Operational independence - Central bank is allowed to independently determine the policy rate Target independence - Central bank sets the target inflation level Credibility Transparency Central bank follows through on its stated policy intentions Central bank discloses the state of economic environment by issuing inflation reports https://www.fintreeindia.com/ LOS k © 2017 FinTree Education Pvt Ltd Effects of changes in monetary policy LOS m Expansionary » Economic growth « Economic growth « Market interest rates » Market interest rates » Inflation « Inflation « Domestic currency » Domestic currency « Imports » Imports » Exports « Exports Interest rate targeting Exchange rate targeting Most widely used method for making monetary policy decisions Greater volatility of money supply to maintain stable foreign exchange rate Increasing money supply when specific interest rates rise above the target band and decreasing money supply when rates fall below the target band Developing countries target a foreign exchange rate between their currency and another (often the U.S dollar), rather than targeting inflation e LOS l Contractionary Determining whether a monetary policy is expansionary or contractionary re ª Neutral interest rate - It is the rate of interest that neither spurs nor slows the economy ª Neutral interest rate = Real trend rate of growth + long run expected inflation ª Expansionary policy - Policy rate < Neutral interest rate ª Contractionary policy - Policy rate > Neutral interest rate ! ! Monetary policy changes may affect inflation expectations to such an extent that long-term interest rates move opposite to short-term interest rates Individuals may be willing to hold greater cash balances without a change in short-term rates (liquidity trap) Banks may be unwilling to lend greater amounts, even when they have increased excess reserves Short-term rates cannot be reduced below zero Developing economies face unique challenges in utilizing monetary policy due to undeveloped financial markets, rapid financial innovation, and lack of credibility of monetary authority Fi ! ! ! Limitations of monetary policy nT LOS n LOS o Roles and objectives of fiscal policy Roles Objectives è Determining taxation policies and government spending to meet macroeconomic goals Influencing the level of economic activity è Redistributing wealth or income è Allocating resources among industries è https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd LOS k Fiscal policy tools Spending tools Revenue tools Transfer payments, current spending (goods and services used by government), and capital spending (investment projects) Direct taxes (levied on income or wealth) Fiscal multiplier - Indirect taxes (levied on goods and services) 1 − MPC (1 − t) If tax rate « then, fiscal multiplier » If MPC « then, fiscal multiplier « LOS q Arguments about size of fiscal deficit Arguments against Arguments for Debt may be financed by domestic citizens Fiscal deficits may prompt needed tax reform re Fiscal deficits may not be financed by the market when debt levels are high e Higher future taxes lead to disincentives to work Deficits for capital spending can boost productive capacity of the economy nT Crowding-out effect as government borrowing increases interest rates and decreases private sector investment Defecits aid in increasing GDP and unemployment Ricardian equivalence may prevail When the economy is operating below full employment, deficits not crowd out private investment Recardian equivalence - Taxpayers increase savings in order to offset the expected cost of higher future taxes Implementation of fiscal policy and difficulties of implementation ª Delays in realizing the effects of fiscal policy changes limit their usefulness Fi LOS r ª Causes of delay; Ÿ Recognition lag Ÿ Action lag Ÿ Impact lag ª Additional macroeconomic issues; Ÿ Misreading economic statistics Ÿ Crowding-out effect Ÿ Supply shortages Ÿ Limits to deficits Ÿ Multiple targets https://www.fintreeindia.com/ LOS s © 2017 FinTree Education Pvt Ltd Determining whether a fiscal policy is expansionary or contractionary » in surplus - Expansionary « in surplus - Contractionary » in deficit - Contractionary « in deficit - Expansionary LOS t Interaction of monetary and fiscal policy Fiscal policy Interest rate Output Private sector spending Public sector spending Contractionary Contractionary « » » » Expansionary Expansionary » « « « Contractionary Expansionary « « » « Expansionary Contractionary » Varies « » Fi nT re e Monetary policy https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd International Trade And Capital Flows LOS a LOS b Gross domestic product (GDP) Gross national product (GNP) Total market value of goods and services produced within a country during a certain time period Total market value of goods and services produced by labor and capital of a country (can be within the country or outside the country) Benefits and costs of international trade Costs Benefits One country can specialize in the production of one good and benefit from economies of scale Costs of trade are primarily borne by those in domestic industries that compete with imported goods There is more product variety, more competition, and more efficient allocation of resources e Unemployment increases, income inequality Benefits of trade > Costs of trade for economy as a whole Comparative advantage and absolute advantage re LOS c Absolute advantage - Comparative advantage - Lower cost in terms of resources Opportunity cost in terms of other goods Country B Food Drink nT Country A Opportunity cost of good x - Quantity of ‘X’ should be in the denominator Fi Opportunity cost of food for Country A = Opportunity cost of food for Country B = = 1.5 = 0.875 Since opportunity cost of Country B is lower, it has comparative advantage in producing food Country B has absolute advantage in producing both food and drink because it is able to produce more than Country A Country B should produce (and export) food and Country A should produce (export) drink https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd Ricardian model LOS d Heckscher–Ohlin model Two factors of production - labor and capital Only one factor of production labor Comparative advantage Differences in relative amounts of each factor Comparative advantage Differences in labor productivity Country that has more capital will specialize in capital intensive good and trade for less capital intensive good Heckscher-Ohlin model ª This model says price of scarce factor of production in each country will increase ª The good that country exports will rise in price ª The good that country imports will fall in price LOS e Types of trade and capital restrictions Arguments that have support for capital restriction e Infant industry Protection from foreign competition is given to new industries re National security It is in the best interest of a country to protect producers of goods crucial to it’s national defense so that those goods are available domestically in the event of conflict Arguments that have little support for capital restriction Protecting domestic jobs Some jobs are lost, some jobs are created and prices for domestic consumers will be less without import restrictions nT Protecting domestic industries Firms often use political influence to get protection from foreign competition to the detriment of consumers, who pay higher prices Types of trade restrictions Tariffs Quotas Taxes on imported good Ç in domestic price È in quantity imported If domestic government collects the full value of import license, result is same as for a tariff If domestic government does not charge for the import licenses, there would be gain to importers, this is referred to as quota rent Fi Domestic producers gain Restriction on quantity of goods to be imported Foreign exporters lose VER Voluntary export restraint Agreement by a govt to voluntarily unit the quantity of good to be exported No capture of quota rents Protects domestic consumers in importing country Export subsidy Payment by government to its exporters Generally export subsidies will benefit the producer (exporter) Generally it will result in increase of price and reduction of consumer surplus in the exporting country In a small country, price will increase by the amount of subsidy to equal world price + subsidy For a large country, world price decreases and some benefits from subsidy accrue to foreign customers while foreign producers are negatively affected https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd Capital Restrictions ª Prohibition of investment in the domestic country by foreigners ª Prohibition of or taxes on the income earned on foreign investments by domestic citizens ª Prohibition of foreign investment in certain domestic industries ª Restrictions on repatriation of earnings of foreign entities operating in a country LOS f Trading blocs No barriers Free Trade Areas Eg NAFTA No barriers among member countries Customs Union Countries adopt common set of trade restrictions with non-members No barriers among member countries $ e $$ Countries adopt common set of trade restrictions with non-members $ $$ Fi nT Economic Union re Common Markets Monetary Union E No barriers to the movement of labor and capital goods among member countries No barriers among member countries Countries adopt common set of trade restrictions with non-members No barriers to the movement of labor and capital goods among member countries Member countries establish common institutions and economic policy for the union Eg European union (EU) No barriers among member countries Countries adopt common set of trade restrictions with non-members No barriers to the movement of labor and capital goods among member countries Member countries establish common institutions and economic policy for the union Member countries adopt a single currency Eg Euro-zone https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd LOS g Common objectives of capital restrictions è è è è Reduce the volatility of asset prices (domestic ) Maintain fixed exchange rates Keeping domestic interest rates low Protect strategic industries (eg defense industries) LOS h Balance of payments (BOP) Current Account Capital Account Income receipts Unilateral transfers Import/ export of goods and services Dividend and interest income on foreign securities Money received from those working abroad Governmentowned assets abroad Foreign-owned assets in the country Include gold, foreign currencies, foreign securities, reserve position in IMF etc Include domestic securities, domestic currencies, domestic liabilities to foreigners reported by domestic banks e Goods and services Financial Account Sales and purchases of nonfinancial assets Include transfer of title to fixed assets, debt forgiveness Include rights to natural resources and intangible assets, such as patents, copyrights etc nT re Capital transfers ª Current Account is similar to Income statement ª Capital Account is similar to Balance sheet Fi ª Current Account deficit - Imports > Exports ª Any surplus in the current account must be offset by a deficit in the capital and financial accounts (vice versa) LOS i Effect of decisions by consumers, firms, and governments on BOP X – M (trade deficit) = Private savings + Government savings – Investment If a country’s net savings (both government and private) are less than the amount of investment in domestic capital, this investment must be financed by foreign borrowing Foreign borrowing results in capital account surplus (trade deficit) https://www.fintreeindia.com/ International organizations that facilitate trade International Monetary Fund (IMF) Promoting international monetary cooperation Facilitating the expansion and balanced growth of international trade Promoting exchange stability Assisting in the establishment of a multilateral system of payments Vital source of financial and technical assistance to developing countries Provides resources, knowledge and helps form partnerships in public and private sectors Also provides loans at low interest rate, interest-free credits, and grants to developing countries Made up of two development institutions International Bank for Reconstruction and Development (IBRD) - Reduce poverty in middle income countries re Making resources available (with adequate safeguards) to members experiencing BOP difficulties nT International Development Association (IDA) - Focus on world’s poorest countries Fi World Trade Organization (WTO) World Bank Only international organization that deals with global rules of trade between nations Goal - Ensuring that trade flows as smoothly, predictably and freely as possible Multilateral trading system - Agreements that have legal ground-rules for international commerce and guarantee member countries important trade rights e LOS j © 2017 FinTree Education Pvt Ltd https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd Currency Exchange Rates LOS a,b & c Price of one unit of currency in terms of another Exchange rate Exchange rate for immediate delivery Spot exchange rate Exchange rate for a transaction to be done in future Forward exchange rate Real exchange rate Measures changes in relative purchasing power over time Leveraged account Investment firms that use derivatives/leverages Real exchange rate (d/f) = Nominal exchange rate (d/f) x CPI(f) CPI(d) $3 € Base currency $2 € Eg $4 € ZAR 52 ZAR 57 $ $ Closing value Opening value −1 % Depreciation - $ - Appreciated - 57 52 −1 = 9.62% ZAR - Depreciated - 52 57 −1 = 8.77% € - Appreciated $ - Depreciated Opening value Closing value −1 re % Appreciation - $3 € e € - Depreciated $ - Appreciated Price currency nT Functions of and participants in the foreign exchange market Sell side - Originators of forward foreign exchange contracts Usually large multinational banks Buy side - Include corporations, governments and government entities, investment fund managers, hedge fund managers, investors and central bank Fi Transaction cycle for forex in spot market is T + LOS d Eg Cross currency rates $0.002 ZAR 1.03 SW ZAR 1.03 6500 Dong $ × 0.002 × 6500 = 12.62 Dong SW Find Dong SW https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd Points in Percentage (PIP) LOS e PIP = 10,000 ₹66.1215 + PIPS $ Eg ₹66.1215 + 10,000 $ = 66.1218 Interest rate parity LOS f, g & h International Fischer relationship (precise) + Nominal interest rate = (1 + Real interest rate) × (1 + Expected inflation) USA Eg #1 India ₹50 10% $ $1mln ₹50mln $1 ml e n+ 2% int 2% ₹55mln 55 1.02 53.92 53.92 ₹55mln re $1.02mln 10% Forward rate = S × nT Forward rate = 50 × (1 + Int rate)n (1 + Int rate)n (1 + 10%)1 (1 + 2%)1 = 53.92 Eg #2 Interest rate parity Fi Int rate (India) = 20% Int rate (USA) = 10% F = S × ₹50 $ (1 + Int rate)n = ₹54.54 (1 + Int rate)n Expected (1.1538) = ₹54.54 spot rate = 50 × (1.0576) Real int rate = 4% Inflation rate India = USA = (1 + 20%) = 15.38% (1 + 4%) (1 + 10%) = 5.76% (1 + 4%) https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd Arbitrage profit Eg Interest rates - India - 10% USA - 2% Spot = No arbitrage price = ₹60 × = ₹60 Yr forward = $ ₹58 $ 1.1 1.02 ₹64.7 There is arbitrage because ‘No arbitrage price’ ≠ Forward price Forward discount/premium Eg Spot = ₹55 Yr forward = $ Forward price Forward premium on USD = Spot price = 57 55 ₹57 $ − − = 5.45% LOS i e Exchange rate regimes Formal dollarization Monetary union Conventional fixed peg Several countries use common currency Fi nT Country uses the currency of another country and does not have its own monetary policy Countries that issue their own currencies re Countries that not issue their own currencies Country pegs its currency within margins of ±1% versus another currency Currency board arrangement Crawling peg Managed floating exchange rates Exchange rate is adjusted periodically, to adjust for higher inflation versus the currency used in the peg Monetary authority influences the exchange rate in response to specific indicators, such as BOP Peg with horizontal bands Explicit Permitted commitment to fluctuations in exchange currency value domestic currency relative to another for a foreign currency is wider currency at a fixed eg ±2% exchange rate Management within crawling bands Independently floating Width of bands that identify permissible exchange rates is increased over time Exchange rate is market determined Intervention is used only to slow the rate of change and reduce short term fluctuations https://www.fintreeindia.com/ LOS j © 2017 FinTree Education Pvt Ltd Effects of exchange rates on international trade and capital flows Marshall-Lerner condition WX EX + WM(EM − 1) > Pe of Export Export proportion Pe of Import Import proportion Elasticities (E) of export and import demand must meet Marshall-Lerner condition for depreciation of domestic currency to reduce existing trade deficit If INR depreciates from 65 to 80 Export (Gems and Jewelry) Pe of demand Ç e Pe of demand Ç Import (Cars) INR price Ç re USD price È Qd Ç nT Exports Ç Qd È Imports È J-Curve effect Balance of trade Fi Before currency depreciation After currency depreciation Time Currency depreciation may worsen trade deficit initially Importers adjust over time by reducing quantities Marshall-Lerner conditions take effect and the currency depreciation begins to improve the trade balance https://www.fintreeindia.com/ © 2017 FinTree Education Pvt Ltd Absorption approach It is a macroeconomic technique that focuses on capital account Fi nT re e Balance of trade = National income − Total expenditure ... 2 017 FinTree Education Pvt Ltd Economies and diseconomies of scale Quantity VC per unit TVC TFC TC MC 10 10 10 0 11 0 - 18 10 0 11 8 8 24 10 0 12 4 28 10 0 12 8 40 10 0 14 0 12 54 10 0 15 4 14 10 70 10 0 17 0... Inflation, hyperinflation, disinflation and deflation 10 % 13 .36% 11 0 20% Inflation - 10 0 Disinflation - 10 0 11 0 11 7 12 4 Deflation - 10 0 90 80 70 10 % 12 5 6.36% 15 0 5.98% ª Hyperinflation - Inflation that accelerates... ₹50 10 % $ $1mln ₹50mln $1 ml e n+ 2% int 2% ₹55mln 55 1. 02 53.92 53.92 ₹55mln re $1. 02mln 10 % Forward rate = S × nT Forward rate = 50 × (1 + Int rate)n (1 + Int rate)n (1 + 10 % )1 (1 + 2% )1 =