Economics

Hung Truong, CFA

Class Policy
➢ In a session, the students will be called for class attendance in the beginning of the class
▪ A student who does not show their presence will be recorded 3.
▪ The students who come to class within 10 minutes since the attendance check has finished will be recorded 1 (if not, no record for
their attendance)
▪ The students who leave the class with the approval of the lecturer within 45 minutes before the class ending time will be recorded 1.
A student knowingly leaves the class without the approval of the lecturer will be recorded 3 for the whole session.
▪ Teacher can do class attendance any time in the class
➢ A student who have the number of the absence sessions accounting for more than 20% of total will be banned in the final exam.
➢ A student will be recorded as “being absent in a session with the approval of the lecturer” if this student shows the specific evidence of
their absence. The lecturer only accepts one of three absence reasons (1) overlapping the class time of subjects with image evidences, (2)
health issues with the doctor certificate (3) attending the faculty's activity with a reference letter.
Students with above reasons will fill out the absence form (link below) before the date that the session occurs
https://docs.google.com/forms/d/1CXUyptTE18vciQBk4wI8wG3JlNOaFHUWVRtpXwgyRMU/edit
The absence form sent by email will not be accepted.
➢ Other rules in class:
▪ The mobile phone must be in a silent mode or turned off.
▪ The student are not allowed to do any personal activities in a class
▪ No food in the class.
▪ Be proactive to participate in the class activity
▪ The lecturer is allowed to remove any student out of the class if the students do not comply with class rules.
CFA1 Grade Allocation
Weight Method

Class Assessment 20% • 2 Individual test (50%): Multiple Choice Questions conducted in
E-Learning (Week 13)
Test 1: Week 4
Test 2: Week 6
Test Date will be announced soon
• Plus/Minus score if any (Max +/-2)

Mid-semester test 30% Multiple Choice Questions

Final Exam 50% Multiple Choice Questions

The students can receive the plus/minus score

• Plus score: receive an additional score in class activities such as solving the questions, discussing the topics in the class, attending
the group discussion…. The plus score will be given depending on the difficulty of questions, situations in the class that are decided
by lecturers.
• Minus score: A student who refuses to/ do not actively participate in the class activities mentioned above will receive the minus
scores.
• A student will be banned from the final exam if there are from 3 times refusing to attending the class engagement activity.
 MICROECONOMIC

Learning Objectives

1. Breakeven, Shutdown and Scale

FIRM AND MARKET STRUCTURES 2. Market Structures

Foundational Knowledge
Total, average, marginal, fixed and variable costs

• Total fixed cost (TFC) is the summation of all expenses that do not change as the level
of production varies and typically is incurred whether the firm produces anything or not.

• Quasi - fixed cost remains constant over some range of output but will rise if output
increases beyond a specified quantity.

• Total variable cost (TVC) is the summation of all variable expenses and rises with
increased production and falls with decreased production.

• Total cost (TC) is the summation of total fixed cost and total variable
cost: TC = TFC + TVC
Foundational Knowledge
Total, average, marginal, fixed and variable costs

Formula Shape
As Q rises ➔ more units of labor needed
Marginal cost ∆𝑇𝐶 ➔MC initially decreases due to specialization but eventually
(MC) ∆𝑄 increases due to diminishing marginal product ➔J-shaped
MC curve.
As Q rises ➔ TFC are spread over more and more units
Average fixed 𝑇𝐹𝐶 ➔AFC falls at a decreasing rate
cost (AFC)
𝑄 ➔downward sloping AFC curve.
Average Like MC, AVC is shaped like a "U-curve" due to
variable cost 𝑇𝑉𝐶 diminishing marginal product.
(AVC) 𝑄
As Q rises, ATC initially declines due to the fall in AFC and
Average total 𝑇𝐶 AVC, but eventually increases due to the effect of falling AFC
cost (ATC) 𝑄 is offset by the increase in AVC ➔U-shaped ATC curve.
Foundational Knowledge
MC
Cost
ATC

AVC

AFC

Output
• MC intersects ATC and AVC from below at their respective minimum points.
• MC is below AVC/ATC ➔ AVC/ATC falls.
• MC is above AVC/ATC ➔ AVC/ATC rises.
Foundational Knowledge
Total, average and marginal revenue :

is equal to sum of
Total revenue
individual units sold ෍ 𝑃𝑖 ∗ 𝑄𝑖
(TR)
time their respective
price
Average is equal to total 𝑇𝑅 σ 𝑃𝑖 ∗ 𝑄𝑖
revenue (AR) revenue divided by =
quantity
𝑄 𝑄

Marginal the increase in total

∆𝑇𝑅
revenue revenue from selling 𝑀𝑅 =
(MR) one more unit ∆𝑄
Foundational Knowledge
Elasticity of demand

P P
P1
P1
P0
P0

Q1 Q 0 Q Q1 Q0 Q
Inelastic demand Elastic demand
I Elasticity I < 1 I Elasticity I > 1
Changes in price have no A small change in price causes a
significant effect on quantity larger change in quantity
demanded. demanded.
Foundational Knowledge
Elasticity of demand
P P
P1 P1
=
P0 P0

Q1 = Q0 Q Q1 Q0 Q
Perfectly inelastic demand Perfectly elastic demand
Elasticity = O Elasticity = - oo
Quantity demanded is
Quantity demanded goes to
unchanged when price is
zero when price is up/down
up/down
Foundational Knowledge
Short run vs Long Run Perfect Competition vs Imperfect Competition
Perfect Competition:
In the short run: the time period over +The firm demand that is horizontal (perfectly elastic) at the market price
which some factors of production are + Price = Marginal Revenue
fixed. P
P1 (D) P = MR = AR
In the long run: All factors of =
production (costs) are variable. P0

Q Q Q
Imperfect Competition: 1 0
+ The firm demand is a downward-sloping demand curve
P

(D) P = AR
MR
Q
Foundational Knowledge
Profit maximization :
Profit maximization rule

MR > MC MR < MC

The additional revenue from The additional revenue from

the extra unit of output is the extra unit of output is less
greater than the additional than the additional cost ➔
cost ➔increase profit or decrease profit or increase
reduce loss. loss.
Produce more Produce less

Produce the quantity of output where MR = MC ➔ profit maximization

Module 1: Breakeven, Shutdown and Scale
1. Shutdown and Breakeven under perfect competition

Cost/Price/MR

MC
ATC
Stay in the market

AVC
P1 Breakeven
Operate in Short-Run
(D) P = MR = AR Shutdown in Long-Run
P2
Shutdown
Output
Module 1: Breakeven, Shutdown and Scale
2. Shutdown and Breakeven under perfect competition

P ≥ ATC ➔ AR ≥ ATC ➔ Profit ≥ 0 ➔ Stay in the market

P ≥ P1 (*) AR = ATC ➔ economic profit = 0 ➔ Breakeven point
AVC ≤ P < ATC In the short run: The losses < fixed costs
➔ AVC ≤ AR << ➔Minimize its losses by continuing in business
P2 ≤ P ➔Stay in the market
< P1 ATC
➔Economic losses In the long run: All costs are variable ➔shutdown to
minimize losses ➔Exit the market

P < AVC ➔ AR < AVC ➔ the losses > fixed costs

P < P2 ➔shutdown to minimize losses ➔Exit the market
Module 1: Breakeven, Shutdown and Scale
3. Shutdown and Breakeven under imperfect competition
Cost/Price/MR ATC

MC AVC
Breakeven
point

(D) P = AR
MR
Output
Module 1: Breakeven, Shutdown and Scale
3. Shutdown and Breakeven under imperfect competition

Short run Long run

TR ≥ TC (AR ≥ ATC) Stay in the market Stay in the market

TVC ≤ TR < TC
Stay in the market Exit the market
(AVC ≤ AR < AC)

TR < TVC (AR < AVC) Shut down production Exit the market
Module 1: Breakeven, Shutdown and Scale
4. Economies and Diseconomies of Scale
Cost SRATC6
SRATC1
SRATC2 SRATC5
SRATC3 SRATC4

LRATC
Economies of scale Diseconomies of scale
Increasing returns to Constant return to Decreasing returns to
scale scale scale
Output
Q*
• Resulting from labor specialization, mass production • Resulting from the increasing bureaucracy of larger firms
& investment in more efficient equipment and which leads to inefficiency, problems with motivating a
technology larger workforce, and greater barriers to innovation and
• Negotiation power with lower input prices entrepreneurial activity
Module 2: CHARACTERISTICS OF MARKET STRUCTURES
1. Characteristics of the types of market

Perfect Competition Oligopoly

Market
Structures

Monopolistic
Monopoly and
Competition
Concentration
Module 2: CHARACTERISTICS OF MARKET STRUCTURES
1. Characteristics of the types of market

Monopolistic Oligopoly Monopoly

Perfect competition
competition

Number of sellers Many firms Many firms Few firms Single firm

Barries to entry Very low Low High Very high

Good substitutes but Very good substitutes or

Nature of substitutes Very good substitutes No good substitutes
differentiated differenti- ated

Nature of competition Price only Price, marketing, features Price, marketing, features Advertising

Pricing power None Some Some to significant Significant

Example Rice, sugar Toothpaste, beverage Cement, steel Electricity

Module 2: CHARACTERISTICS OF MARKET STRUCTURES
2. 1. Monopolistic: Characteristics

• Many independent sellers: small market share, no significant

price power, focus on average market price (not individual
competitors 'price)
• Differentiated Products: competing products are considered
Characteristics close substitutes for one another
• Firms compete less on price and more on marketing,
perceived quality, and differences in features
• Low barriers to entry
Module 2: CHARACTERISTICS OF MARKET STRUCTURES
2. 2 Monopolistic: Short - Run
• Maximize economic profits by producing the quantity Q* for which MR = MC ➔ short -run
output decision for a firm MR = MC.
• Price is charged for that quantity from the demand curve D.

P * > ATC ➔ economic profits P * < ATC ➔ economic losses

Module 2: CHARACTERISTICS OF MARKET STRUCTURES
2. 3 Monopolistic: Long - Run
In the long run, new firms have entered the market ➔Shift down demand Curve D at P*= ATC
The monopolistic competitive firm will operate at the point where entry is no longer profitable:
• P* = ATC ➔ economic profit = 0 and earn normal profit
• Each firm is producing the quantity for which ATC is not a minimum
Module 2: CHARACTERISTICS OF MARKET STRUCTURES
3. 1 Oligopoly: Characteristics

• Few firms
• The firms are interdependent. A price change by one
firm can be expected to be met by a price change by
Characteristics its competitors in response.
• High barriers to entry
Module 2: CHARACTERISTICS OF MARKET STRUCTURES
3. 2 Oligopoly: Kinked demand curve model
The kinked demand curve model assumes that an increase in a firm's product price will
not be followed by its competitors but a decrease in price will
• Above PK
D curve: relatively elastic (a small price increase will result
in a large decrease in demand)
➔ if a company raises its price above PK, its competitors
will remain at PK, and it will lose market share because it
has the highest price

• Below PK
D curve: relatively less elastic
➔ if a firm decreases its price below PK, other firms will
follow the price cut, and all firms will experience a
relatively small increase in sales
Module 2: CHARACTERISTICS OF MARKET STRUCTURES
3. 2 Oligopoly: Kinked demand curve model

Profit are maximized only when MC passes through the MR gap.

Module 2: CHARACTERISTICS OF MARKET STRUCTURES
3.3 Oligopoly: Cournot Model

• There are only two firms with identical and constant MC of production.
• In equilibrium, no firm has an incentive to change output.
• In the long run, prices and output are stable-there is no possible change in
output or price that would make any firm better off.
• Both firms sell the same quantity of outputs, splitting the market equally at
the equilibrium price.
• Pperfect competition < Pequilibrium < Pmonopoly
Module 2: CHARACTERISTICS OF MARKET STRUCTURES
3.4 Oligopoly: Nash equilibrium model (game theory)

• A Nash equilibrium is reached when the choices of all firms are such that
there is no other choice that makes any firm better off (increase profit or
decline loss).
• Each firm tries to maximize its own profits given the responses of its
rivals: each firm anticipates how its rival will respond to a change in its
strategy and tries to maximize its profits under the forecasted scenario.

The firms in the market are interdependent, but their actions

are noncooperative: firms do not collude to maximize profits.
Module 2: CHARACTERISTICS OF MARKET STRUCTURES
3.4 Oligopoly: Nash equilibrium model (game theory)
B honors B cheats
A collusion agreement
to charge a high price of A earns 150 A earns 50
A honors
2 firms, but each firm B earns 150 B earns 200
may cheat by charging A earns 200 A earns 100
A cheats
a low price, the profits B earns 50 B earns 100
of each firm are as
shown:
Firm A 's choice
B honors B cheats • If A hornors:
E(Profit) = 50% x (150 + 50)
A honors A earns 150 A earns 50 = 100
B earns 150 B earns 200 • If A cheats:
A earns 200 A earns 100 E(Profit) = 50% x (200 + 100)
A cheats
B earns 50 B earns 100 = 150
➔ Firm A chooses to cheat
Module 2: CHARACTERISTICS OF MARKET STRUCTURES
3.4 Oligopoly: Nash equilibrium model (game theory)
Firm B 's choice

B honors B cheats • If B hornors:

E{R) = 50% x {150 + 50)
A earns 150 A earns 50 = 100
A honors
B earns 150 B earns 200 • If B cheats:
E{R) = 50% x {200 + 100)
A cheats A earns 200 A earns 100 = 150
B earns 50 B earns 100 ➔ Firm B chooses to cheat

Nash equilibrium

B honors B cheats
Nash equilibrium when both firm
A and B choose to cheat the A earns 150 A earns 50
A honors
agreement to charge a low price B earns 150 B earns 200
and each firm earns 100.
A cheats A earns 200 A earns 100
B earns 50 B earns 100
Module 2: CHARACTERISTICS OF MARKET STRUCTURES
3.5 Oligopoly: Stackelberg dominant model

• There is a single firm (leader) that has a significantly large market share
because of its greater scale and lower cost structure -the dominant firm
(DF).
• Price is charged by the dominant firm and other competitors (CF) take this
price.
• In long-run equilibrium, under these rules, the leader charges a higher price
and receives a greater proportion of the firms’ total profit.
Module 2: CHARACTERISTICS OF MARKET STRUCTURES
3.5 Oligopoly: Stackelberg dominant model

MCCF

ATC*
MCDF
P*
Market Demand
DDF (dominant firm)
MRDF

QCF QDF Q
Module 3: IDENTIFYING MARKET STRUCTURES
4. Concentration Measurement

N-firm concentration ratio is the sum of the percentage market shares of the largest N
firms in a market.
This measure is simple to calculate and understand, it does not directly measure market
power or elasticity of demand.

Herfindahl-Hirschman Index (HHI) is calculated as the sum of the squares of the market
shares of the largest firms in the market.

Both methods do not consider barriers to entry. A firm with high market share may not have
much pricing power if barriers to entry are low and there is potential competition
Module 3: IDENTIFYING MARKET STRUCTURES
4. Concentration Measurement
Practice
Given the market shares of the following firms, calculate the 4-firm concentration
ratio and the 4-firm HHI, both before and after a merger of Acme and Blake.
Firm Market Share

Acme 25%

Blake 15%

Curtis 15%

Dent 10%

Erie 5%

Federal 5%
Module 3: IDENTIFYING MARKET STRUCTURES
4. Concentration Measurement
Answer

The 4-firm concentration ratio

• Before the merger, the 4-firm concentration ratio for the market is 25 + 15 + 15 + 10 = 65%.
• After the merger, the Acme + Blake firm has 40% of the market, and the 4-firm
concentration ratio is 40 + 15 + 10 + 5 = 70%. Although the 4-firm concentration ratio has
only increased slightly, the market power of the largest firm in the industry has increased
significantly, from 25% to 40%.
The 4-firm HHI
• Before the merger, the 4-firm HHI is 0.252 + 0.152 + 0.152 + 0.102 = 0.1175.
• After the merger, the 4-firm HHI is 0.402 + 0.152 + 0.102 + 0.052 = 0.1950, a significant
increase.
 MACROECONOMIC

Learning Objectives

1. Phases of Business Cycle

2. Resource Use, Consumer and
UNDERSTANDING BUSINESS Business, Housing, External trade
sector activity vary over the
CYCLE business cycle
Foundational Knowledge: GDP
GDP – Gross Domestic Product

Gross Domestic Product (GDP): Output Definition

The total market value of the newly final goods and services produced in a country within a certain time period
● Newly final goods and services: means goods and services will not be resold or used in the production of other goods
and services
● Certain time period: goods and services must be produced in the certain time period in a country
● Market value: The only goods and services included in the calculation of GDP are those whose value can be
determined by being sold in the market.
+ The value of labor not sold, such as a homeowner’s repairs or By-products of production processes are also excluded
in GDP
+ Exceptions: Goods and services provided by government are included in GDP even though they are not explicitly
priced in markets. GDP also includes the value of owner-occupied housing
Transfer payments from the government sector to individuals, such as unemployment compensation or welfare benefits
and Capital gains that accrue to individuals when their assets appreciate in value are also excluded in GDP
Foundational Knowledge: GDP
GDP – Gross Domestic Product

Gross Domestic Product (GDP): Income Definition

The aggregate income earned by all households, all companies, and the government within the
economy in a given period of time (income definition).

Payment consists of:

● Compensation of employees: wages and benefits (primarily employer contributions to private
pension plans and health insurance) that individuals receive in exchange for providing labor
● Rent: payment for the use of property.
● Interest: payment for lending funds
● Profits: the return that owners of a company receive for the use of their capital and the
assumption of financial risk when making their investments
Foundational Knowledge: GDP
Nominal and real GDP and calculate and interpret the GDP deflator
Nominal GDP: the total value of all goods and services produced by an economy, valued at current
market prices.

Using current-year Q, but current year P

Real GDP: measures the output of the economy using prices from a base year, removing the effect
of changes in prices so that inflation is not counted as economic growth.

Using current-year Q, but base – year P

Foundational Knowledge: GDP
Nominal and real GDP and calculate and interpret the GDP deflator

GDP Deflator : is a price index that can be used to convert nominal GDP into real GDP, taking out the
effects of changes in the overall price level

Per-capita real GDP is defined as real GDP divided by population and is often used as a measure of
the economic well-being of a country’s residents
Foundational Knowledge: GDP
The fundamental relationship among saving, investment, the fiscal balance, and the trade balance
● Under expenditure approach,
GDP = C + I + G + (X – M).
● Under income approach,
GDP = C + S + T
where:
C = consumption spending
I = Business Investment
G = Government Purchase
X = Export , M = Import
S = household and business savings
T = net taxes (taxes paid minus transfer payments received)

C + I + G + (X – M) = C + S + T ⇒ (G – T) + (X – M)= (S – I) ⇒ (G – T) = (S – I) – (X – M)
G-T: fiscal balance (payment – collection) deficit as G-T > 0
X-M: trade balance (export – import) deficit as X-M<0

A government deficit (G – T > 0) must be financed by some combination of a trade deficit (X – M < 0) or an
excess of private saving over private investment (S – I > 0)
Foundational Knowledge: AGGREGATE DEMAND AND SUPPLY
Aggregate Demand curve
The aggregate demand (AD) curve
+ the total level of expenditures in an economy by consumers, businesses, governments, and foreigners
+ the negative relationship between the price level and the level of real output demanded by consumers,
businesses, and government
The aggregate demand curve slopes downward because:
+ Wealth effect: changes in price level affect consumers’ purchasing power. A decrease in the price level ⇒
increases the purchasing power of existing nominal wealth ⇒ consumers will demand more goods and services
+ Interest rate effect: When the price level increases ⇒ consumers need to hold greater nominal money balances
(to purchase the same amount of real goods and services). However, the nominal money supply constant ⇒
interest rate increases ⇒ decrease both demand for consumption goods and business investment demand
+ Real exchange rate effect: the increase in domestic price level relative to the price level in a foreign country ⇒
decrease in exports (the foreigners feel more expensive for imported products and increase in imports ⇒
reduce net exports (X – M), reducing aggregate demand for real goods and services.
Foundational Knowledge: AGGREGATE DEMAND AND SUPPLY
Shift in Aggregate Demand curve
● Increase in consumers’ wealth: the proportion of income saved decreases and
spending increases, increasing aggregate demand (C increases)
● Business expectations: more optimistic about future sales ⇒ increase their Increase in Aggregate Demand
investment ⇒ increases aggregate demand (I increases).
● Consumer expectations of future income: expect higher future incomes ⇒
save less for the future and increase spending now ⇒ increasing aggregate
demand (C increases)
● High capacity utilization: ⇒ invest in more plant and equipment ⇒ increasing
aggregate demand (I increases).
● Expansionary monetary policy: banks have more funds to lend ⇒ Lower
interest rates ⇒ increase investment and consumers’ spending (C and I
increase).
● Expansionary fiscal policy: decrease in taxes ⇒ increase disposable income and
consumption. An increase in government spending ⇒ increases aggregate
demand directly (C increases, G increases)
● Exchange rate: A decrease in the relative value of a country’s currency will
increase exports and decrease imports (net X increases)
● Global economic growth: GDP growth in foreign economies tends to increase
the quantity of imports (domestic exports) foreigners demand ⇒ increase
exports ⇒ increase aggregate demand (net X increases).
Foundational Knowledge: AGGREGATE DEMAND AND SUPPLY
Aggregate Supply curve
The aggregate supply (AS) curve
+ represents the amount of output that firms will produce at different price levels.
+ describes the relationship between the price level and the quantity of real GDP supplied, when all other factors are
kept constant.

● Very short run AS - VSRAS (perfectly elastic): Firms will adjust output in
Aggregate Supply Curve
response to changes in demand without changing price by adjusting labor
hours and intensity of use of plant and equipment.

● Short run AS - SRAS (upward slopes): When the price level increases, but
firms see no change in input prices (because some input prices are sticky,
meaning that they do not adjust to changes in the price level in the short
run) ⇒ Firms respond by increasing output in anticipation of greater profits
from higher output prices.

● Long run AS - LRAS (perfectly inelastic): In the long run, wages and other
input prices change proportionally to the price level, so the price level has
no long-run effect on aggregate supply. Referred as potential GDP or full-
employment GDP
Foundational Knowledge: AGGREGATE DEMAND AND SUPPLY
Shift in the short -run aggregate supply (SRAS) curve
The short-run aggregate supply (SRAS) curve reflects the relationship between output and the price level when
wages and other input prices are held constant (or are slow to adjust to higher output prices).

● Labor productivity: Holding the wage rate constant, an increase in labor

productivity (output per hour worked) ⇒ decrease unit costs to
Increase in Aggregate Supply
producers output ⇒ increasing SRAS (shifting it to the right).
● Input prices: A decrease in nominal wages or the prices of other
important productive inputs ⇒ decrease production costs ⇒ increase
production, increasing SRAS.
● Expectations of future output prices: expect the price of their output to
increase in the future ⇒ expand production, increasing SRAS
● Taxes and government subsidies: Either a decrease in business taxes or
an increase in government subsidies for a product ⇒ decrease the costs
of production ⇒ increase the production, increasing SRAS
● Exchange rates: Appreciation of a country’s currency in the foreign
exchange market ⇒ decrease the cost of imports ⇒ decrease in
production costs ⇒ increase output, increasing SRAS
Foundational Knowledge: AGGREGATE DEMAND AND SUPPLY
Shift in the short -run aggregate supply (SRAS) curve
The long-run aggregate supply (LRAS) curve is vertical (perfectly inelastic) at the potential (full-employment) level of
real GDP.

Factors that will shift the LRAS curve are:

● Increase in the supply and quality of labor: Because LRAS reflects output at full employment, an increase in the
labor force will increase full-employment output and the LRAS. An increase in the skills of the workforce, through
training and education, will increase the productivity of a labor force of a given size, increasing potential real
output and increasing LRAS.
● Increase in the supply of natural resources: Just as with an increase in the labor force, increases in the available
amounts of other important productive inputs will increase potential real GDP and LRAS.
● Increase in the stock of physical capital: For a labor force of a given size, an increase in an economy’s
accumulated stock of capital equipment will increase potential output and LRAS
● Technology: In general, improvements in technology increase labor productivity (output per unit of labor) and
thereby increase the real output that can be produced from a given amount of productive inputs, increasing
LRAS.
Foundational Knowledge: AGGREGATE DEMAND AND SUPPLY
How fluctuations in aggregate demand and aggregate supply cause short-run changes in the economy
and the business cycle.
Shift aggregate demand to the left from AD0 ⇒ AD1
(decrease in aggregate demand) Adjustment to a Decrease in Aggregate Demand

● Reason: decrease in the growth rate of the money supply, an increase in

taxes, a decrease in government spending, lower equity and house prices,
or a decrease in the expectations of consumers and businesses for future
economic growth.
● Consequence:
➢ GDP* full employment (potential) GDP) < GDP1 and P0 < PSR
➢ Lower new short-run equilibrium output, GDP1

Recessionary Gap : GDP1 < GDP* and rising employment ⇒ drive down wages
⇒ increase production ⇒ increase SRAS (Shift to right)⇒ GDP1 returns to
GDP*
Action: increasing aggregate demand through government action is the
preferred alternative.
+ expansionary fiscal policy (increasing government spending or decreasing
taxes)
+ expansionary monetary policy (increasing the growth rate of the money
supply to reduce interest rates)
Foundational Knowledge: AGGREGATE DEMAND AND SUPPLY
How fluctuations in aggregate demand and aggregate supply cause short-run changes in the economy
and the business cycle.
Shift aggregate demand to the right from AD0 ⇒ AD1
(increase in aggregate demand)
Adjustment to a Increase in Aggregate Demand
Consequence:
● GDP* full employment (potential) GDP) > GDP1 and P0 > PSR
● Higher new short-run equilibrium output, GDP1

Inflationary Gap : GDP1 > GDP* ⇒ Competition among producers for

workers, raw materials, and energy ⇒ decrease production ⇒
decrease SRAS (Shift to leftt) ⇒ GDP1 returns to full-employment GDP
(GDP*) but at a price level that is higher still.

Action: decreasing aggregate demand through government action is

the preferred alternative.
+ tightening fiscal policy: decreasing government spending, increasing
taxes, or slowing the growth rate of the money supply
+ tightening monetary policy: slowing the growth rate of the money
supply,
Foundational Knowledge: AGGREGATE DEMAND AND SUPPLY
How fluctuations in aggregate demand and aggregate supply cause short-run changes in the economy
and the business cycle.

Shift aggregate supply to the left from SRAS0 ⇒ SRAS1 Stagflation

(decrease in SRAS) from an increase in the prices of raw materials or
energy

⇒ P1> P0 and GDP1 < GDP* (the new short-run equilibrium is at lower
GDP and a higher overall price level)
⇒ Stagflation

Stagflation is an especially difficult situation for policy makers because:

+ increase aggregate demand to restore full employment ⇒ increase
the price level even more.
+ Conversely, a decision by policy makers to fight inflation by decreasing
aggregate demand will decrease GDP even further
Foundational Knowledge: AGGREGATE DEMAND AND SUPPLY
The effect of combined changes in aggregate supply and demand on the economy.
Module 1: Business Cycle
1. Phase of Business Cycle
• Four stages: expansion (real GDP is increasing), peak (real GDP stops increasing and begins
decreasing), contraction or recession (real GDP is decreasing), and trough (real GDP stops
decreasing and begins increasing)
•
Real GDP
Average
Peak

Expansion

Contraction
Recession Trough
Module 1: Business Cycle
2. Business Cycle and Resource Use
Inventory Labor & Capital
Expansion Peak Contraction Trough
• Costly if adding or remove the labor and
- Sales increase - Sales start to - Sales decrease - Sales start to
capital to response with changes in economic
- Inventory decrease - Inventory increase
increase - Unsold decrease - Inventory
growth
➔ Inventory ➔ becomes • Begin with temporary adjustment of labor
Inventory/sale accumulate Inventory/sale depleted more and production level (ex, adjusting the hours
at normal level ➔ decreases to quickly they work, adjust their production levels by
Inventory/sale and maintain at ➔ using existing physical capital more or less
above normal normal level Inventory/sale
intensively)
level below normal
level • As an expansion/contraction persists, hire or
lay off workers or invest/sell plant and
equipment
Module 1: Business Cycle
3. Business Cycle and Consumer Sector Activity
• Consumer spending depends on the level of consumers’ current incomes and their
expectations about their future incomes ➔ consumer spending increases during
expansions and decreases during contractions
• Consumer spending in some sectors is more sensitive to business cycle phases than
spending in other sectors:
✓Durable goods (high value, appliances, furniture, automobiles) & Service: highly
cyclical, spend more  expansion, spend less  contraction
✓Services: more discretionary, more cyclical consumer spending
✓Nondurable goods: (food at home or daily – use products): remain relatively
stable over the business cycle
Module 1: Business Cycle
4. Business Cycle and Housing Activity
• Mortgage rates: Low interest rate → home buying and construction 
• Housing costs relative to income: When incomes are cyclically high (low) relative to
home costs (including mortgage financing costs), home buying and construction
tend to increase (decrease). However, if the home prices are rising faster than the
income, leading to decrease in purchase and construction activity.
• Speculative activity: rising home prices can lead to purchases based on
expectations of further gains. Prices  → home buyer and construction  →
bubble → falling price.

• Demographic factors: high-demanding population segment (25- to 40-year-old)

and increasing urbanization rate → housing 
Module 1: Business Cycle
5. Business Cycle and External Trade Sector Activity
The most important factors determining the level of a country’s imports and exports
are domestic GDP growth, GDP growth of trading partners, and currency exchange
rates.
• Domestic GDP Growth  → Import
• Other countries’ GDP Growth  → Export
•  domestic value of currency => exports, import.
Module 1: Business Cycle
6. Business Cycle Summary
Trough: Peak:
• GDP growth rate changes from negative to positive. • GDP growth rate decreases.
• High unemployment rate, increasing use of overtime • Unemployment rate decreases but hiring slows.
and temporary workers. • Consumer spending and business investment grow
• Spending on consumer durable goods and housing at slower rates.
may increase. • Inflation rate increases.
• Moderate or decreasing inflation rate.

Expansion: Contraction/recession:
• GDP growth rate increases. • GDP growth rate is negative.
• Unemployment rate decreases as hiring accelerates. • Hours worked decrease, unemployment rate
• Investment increases in producers’ equipment and increases.
home construction. • Consumer spending, home construction, and
• Inflation rate may increase. business investment decrease.
• Imports increase as domestic income growth • Inflation rate decreases with a lag.
accelerates. • Imports decrease as domestic income growth slows.
Module 1: Business Cycle
7. Economic Indicators

Leading Coincident Lagging

Indicators indicators Indicators

Change Change Change

direction direction at direction
before roughly the after
peaks or same time
expansions
troughs in as peaks or
the troughs or
business contractions
cycle are already
underway.
 MACROECONOMIC

Learning Objectives

1. Fiscal Policy Objective

2. Fiscal Policy Tools and
FISCAL POLICY Implementation
Module 1: Fiscal Policy Objective
1.Monetary vs Fiscal Policy
Fiscal Policy Monetary Policy
Government's use of spending and taxation The central bank’s actions that affect the
to influence economic activity quantity of money and credit in an economy
• G < T: Budget surplus to influence economic activity

• G > T: Budget deficit • Expansionary: the central bank increases

• G = T: Balanced budget the quantity of money and credit in an
economy
G: Government Expenditure, T: Tax Revenue

• Expansionary: increase in the deficit (or a • Contractionary: the central bank is

decrease in a surplus) reducing the quantity of money and
credit in an economy
• Contractionary: decrease in a deficit (or
increase in a surplus)
Module 1: Fiscal Policy Objective
2. Role and Objective of Fiscal Policy
Objectives of fiscal policy
● Influencing the level of economic activity and aggregate demand.
● Redistributing wealth and income among segments of the population.
● Allocating resources among economic agents and sectors in the economy.
Discretionary fiscal policy refers to the spending and taxing decisions of a national
government that are intended to stabilize the economy.
+ Decreased taxes and increased government spending ⇒ Increase a budget deficit, overall
demand, economic growth, and employment.
+ Increased taxes and decreased government spending ⇒ decrease a budget deficit, overall
demand, economic growth, and employment.
Automatic stabilizers : fiscal tools automatically are adjusted by the state of the economy
+ During a recession, tax receipts will fall, and government expenditures on unemployment
insurance payments will increase ⇒ Budget deficit but not indicate an expansionary fiscal
policy
Module 1: Fiscal Policy Objective
3. Arguments about whether the size of a national debt relative to GDP matters

A fiscal deficit ⇒ funded by debt ⇒ concerns if debt ratio is too high

Debt ratio is the ratio of aggregate debt to GDP

If the real interest rate on the government’s debt > the real growth rate of the
economy ⇒ debt ratio increases

If the real interest rate on the government’s debt < the real growth rate of the
economy ⇒ debt ratio decreases
Module 1: Fiscal Policy Objective
3. Arguments about whether the size of a national debt relative to GDP matters
NOT
Module 2: Fiscal Policy Tools and Implementation
4. Tools of Fiscal Policy

Revenue Spending
Module 2: Fiscal Policy Tools and Implementation
5. Advantage and Disadvantage of fiscal policy tools:
Module 2: Fiscal Policy Tools and Implementation
6.1 Fiscal Multiplier
The fiscal multiplier determines the potential increase in aggregate demand resulting from an
increase in government spending. The magnitude of the multiplier effect depends on the tax rate and
on the marginal propensity to consume.
Where,
MPC: marginal propensity to consume
T: tax rate

*What is the total impact on aggregate demand from $100 government spending? (tax rate = 25%, MPC = 80%)

Government What the first layer What the second layer What the first layer
What the first layer
Spending receives: receives: spend:
spend:
$100 Disposable income Disposable income $75xMPC =
$75xMPC = $75x0.8=$60
$100 × (1 − 0.25) = $75 $60 × (1 − 0.25) = $45 $75x0.8=$60

1
fiscal multiplier = = 2.5 The impact on aggregate demand is $100 x 2.5 = $250
1−0.8x(1−0.25)
Module 2: Fiscal Policy Tools and Implementation
6.2 Balanced Budget Multiplier:

Increase the tax to offset the increase in spending ⇒ Budget balance

If tax = 25%, MPC = 80% ⇒ fiscal multiplier = 1/ [1-0.8x(1-0.25)] = 2.5

+ Increase in government spending $100 ⇒ overall increase aggregate demand by $100 x 2.5 = $
250

+ Increase in taxes $100 ⇒ the overall decrease in aggregate demand: 100 x MPC x fiscal
multiplier = 100x 0.8 x 2.5 = 200

⇒ the net effect on aggregate demand: 250 - 200 = +$50

To balance, amount of increase in taxes = 100/MPC = 100/0.8 = $125

Module 2: Fiscal Policy Tools and Implementation
7. Ricardian equivalence:

Ease fiscal policy (increase G, decrease T) ⇒ increase T in the future

⇒ People will save more to offset the expected cost of higher future taxes and reduce
current consumption
⇒ If taxpayers reduce current consumption and increase current saving by just enough to
repay the principal and interest on the debt the government issued to fund the increased
deficit
⇒ No effect on aggregate demand
⇒ Failure of fiscal policy. This is called Ricardian equivalence
Module 2: Fiscal Policy Tools and Implementation
8. Determine whether a fiscal policy is expansionary or contractionary
Expansionary: decrease in surplus or increase in deficit
Contractionary: increase in surplus or decrease in deficit

9. Difficulties of implementing fiscal policy

● Wrong economic forecast ⇒ incorrect policy decisions
● Lag for implementation: recognition lag (the time to recognize signals), action lag (the time to
vote), impact lag (the time to be effective)
● Misreading economic statistics
● Crowding-out effect: Greater government borrowing tends to increase interest rates, which
decreases private investments which reduce the impact of expansionary fiscal policy
● Supply shortages: slow economic growth by the lack of supply constraints, not low demand ⇒
fiscal policy is not effective
● Limits to deficit: not too high deficit/ GDP
● Multiple targets: high unemployment coupled with high inflation
 MACROECONOMIC

Learning Objectives

1. Central Bank Objectives and

Tools
MONETARY POLICY 2. Monetary policy effects and
limitations
Foundational Knowledge: MONEY AND INFLATION
Functions and Definitions of money

Function Broad Money

Medium of
Unit of account Store of value
exchange

prices of all Notes, coins,

payment for money can be Narrow Money checkable bank
goods and goods and saved to deposits
services services are purchase goods
expressed in later.
units of money

Liquid assets which

can be used to make
purchases
Foundational Knowledge: MONEY AND INFLATION
Levels of Money Supply
Foundational Knowledge: MONEY AND INFLATION
Money Creation Process

Reserve

Deposit
Depositor Banks Loans Borrowers

Excess Reserve

Deposit
Seller
Continuous process
Foundational Knowledge: MONEY AND INFLATION
Relationship of Money and the Price Level

Quantity equation of exchange

Velocity is the average number of times per year each unit of money is used to buy goods or services

Assuming that velocity and real output remain constant, any increase in the money supply will lead to a
proportionate increase in the price level.

The belief that real variables (real GDP and velocity) are not affected by monetary variables (money
supply and prices) is referred to as money neutrality.
Foundational Knowledge: MONEY AND INFLATION
Demand for and supply of money

Demand for money

Supply and Demand for Money

The amount of wealth that households and firms in an
economy choose to hold in the form of money

Three reasons for holding money:

- Transaction demand: meet the need for undertaking
transactions
- Precautionary demand: held for unforeseen future
needs.
- Speculative demand: Money that is available to take
advantage of investment opportunities that arise in the
future
Foundational Knowledge: MONEY AND INFLATION
Demand for and supply of money

Supply of Money
Increase in the Money Supply
● determined by the central bank (the Fed in the
United States) and is independent of the interest
rate.
● Supply curve is vertical (perfectly inelastic)

Short-term interest rates are determined by the

equilibrium between money supply and money
demand.

A central bank can affect short-term interest rates by

increasing or decreasing the money supply (shift in MS
line)
Foundational Knowledge: MONEY AND INFLATION
Inflation, hyperinflation, disinflation, and deflation

Inflation is a persistent increase in the price level over time. An increase in the price of a
single good, or in relative prices of some goods, is not inflation. The inflation rate is the
percentage increase in the price level, typically compared to the prior year.

Hyperinflation: high and accelerating inflation

Disinflation refers to an inflation rate that is decreasing over time but remains greater
than zero.

Deflation: A persistently decreasing price level (i.e., a negative inflation rate)

Foundational Knowledge: MONEY AND INFLATION
Explain the construction of indexes used to measure inflation

Consumer price index (CPI) represents the purchasing patterns of a typical urban household

The GDP deflator is another widely used inflation measure

Producer price index (PPI) or wholesale price index (WPI) measures the price level of the
goods in process.
Headline inflation refers to price indexes for all goods.

Core inflation refers to price indexes that exclude food and energy. Food and energy prices are
typically more volatile than those of most other goods.
Foundational Knowledge: MONEY AND INFLATION
Cost-push inflation

Cost -Push Inflation Inflation can result from an initial decrease in

aggregate supply (SRAS0 ⇒ SRAS1) caused by
an increase in the real price of an important
factor of production, such as wages or energy

Wage pressure can be a source of cost-push

inflation (sometimes called wage-push inflation
when it occurs).

+ Upward pressure on wages is more likely to

emerge when cyclical unemployment is low,
+ High expected inflation ⇒ workers will increase
their wage demands accordingly
Foundational Knowledge: MONEY AND INFLATION
Demand-pull inflation

Demand-pull inflation can result from an increase in

Demand -Pull Inflation
the money supply, increased government spending, or
any other change that increases aggregate demand
(AD0⇒ AD1)

When the economy operates at above potential GDP,

unemployment falls below its natural rate, resulting in
the upward pressure on wages è decrease in short-run
AS ⇒ SRAS0 ⇒ SRAS1 and price level even higher

⇒ Pull AD1 back to AD0 by reducing the money

supply.
Module 1: Central bank Objectives and Tools
1. Describe the roles and objectives of central banks
Role of central banks
1. Sole supplier of currency
2. Banker to the government and other banks: provide banking services to the
government and other banks in the economy
3. Regulator and supervisor of payments system: imposing standards of risk-taking
allowed and reserve requirements of banks under its jurisdiction
4. Lender of last resort: supply money to banks that are experiencing shortages.
5. Holder of gold and foreign exchange reserves
6. Conductors of monetary policy: Central banks control or influence the quantity of
money supplied in an economy and growth of money supply over time.
Module 1: Central bank Objectives and Tools
1. Describe the roles and objectives of central banks
Objective of central banks:
Primary objectives: to control inflation so as to promote price stability.
In addition to price stability, some central banks have other stated goals, such as:
• Stability in exchange rates with foreign currencies.
• Full employment.
• Sustainable positive economic growth.
• Moderate long-term interest rates.
Most developed countries have an explicit target inflation rate ( around 2-3%)
Some countries choose to peg their currency to that of another country (mostly US
dollar) ⇒ They stick to the monetary policy of the pegged countries (inflation rate)
Module 1: Central bank Objectives and Tools
2. Tools to implement monetary policy tools

Policy Rate Reserve Requirement Open market operations

Policy rate: The rate banks can Reserve requirements: the Open market operations: Buying
borrow funds from reserve from percentage of deposits banks are and selling of securities by the
central banks required to retain as reserves central bank

One way to lend money to banks is Higher reserve requirements => Central banks buy securities:
through a repurchase agreement. The lower available funds for lending, higher available fund for
central bank purchases securities lower money supply ⇒ lower commercial banks ⇒ higher
from banks that, in turn, agree to interest rates lending and money supply ⇒ lower
repurchase the securities at a higher interest rates
price in the future
Buying and selling of securities by
A lower rate ⇒ lower banks’ cost of the central bank: opposite effect
funds ⇒ lower interest rates overall.
Module 1: Central bank Objectives and Tools
3. Monetary transmission mechanism

C: Consumer Spending, I: Investment, AD: Aggregate Demand

Module 2: Monetary Policy Effects and Limitations
4. Qualities of effective central bank

Independence Credibility Transparency

A central bank should be To be effective, central banks Central banks periodically disclose the
should follow through on their state of the economic environment by
free from political interference. issuing inflation report, report their
stated intentions
Operational independence: the views on the economic indicators and
central bank is allowed to A credible central bank’s targets other factors they consider in their
independently determine the policy can become self-fulfilling interest rate setting policy
rate. prophecies
⇒ easier to anticipate and implement
Target independence: the central monetary policy
bank also defines how inflation is
computed, sets the target inflation
level and determines the horizon over
which the target is to be achieved
Module 2: Monetary Policy Effects and Limitations
5. Target of central banks

Interest rate targeting Inflation target Exchange rate targeting

Increasing the money supply : Set inflation target, mostly 2%, Target a foreign exchange rate between
specific interest rates > the with a permitted deviation of ±1% their currency and another (often the U.S.
target band so the target band is 1% to 3%. dollar)

Decreasing the money supply: Central banks are not necessarily The targeting country can purchase or sell
specific interest rates < the targeting current inflation, which is its currency in the foreign exchange markets
target band the result of prior policy and to influence the FX rate. Ex, If the value of
events, but inflation in the range the domestic currency falls relative to the
of two years in the future. U.S. dollar, use foreign reserves to purchase
their domestic currency (which will reduce
money supply growth and increase interest
rates) ⇒ Appreciate domestic currency
Module 2: Monetary Policy Effects and Limitations
6. Limitation of monetary policy
● Long-term rates may not rise and fall with short-term rates because of the effect of monetary
policy changes on expected inflation. If money supply growth is seen as inflationary (decrease in
short-term rate), higher expected future asset prices will make long-term bonds relatively less
attractive and will increase long-term interest rates. Bond market participants that act in this way
have been called bond market vigilantes.
● Increasing growth of the money supply will not decrease short-term rates because individuals
hold the money in cash balances instead of investing in interest-bearing securities (Liquidity trap)
● The central bank has limited ability to stimulate the economy in case of deflation as the nominal
policy rate can not be reduced to zero.
● Developing countries face problems in successfully implementing monetary policy such as illiquid
market for government bond market, difficulties for determining the neutral rate of interest for
policy purposes, lack of credibility of central banks.
Module 2: Monetary Policy Effects and Limitations
7. Explain the interaction between monetary and fiscal policy
 MACROECONOMIC

Learning Objectives

1. Geopolitics 'Definition
2. Geopolitical Risks
INTRODUCTION TO GEOPOLITICS 3. Tools of Geopolitics
Module 1: Geopolitics
1. Geopolitics from a cooperation versus competition perspective.
Geopolitics
+ interactions among nations, including the actions of state actors (national governments)
and nonstate actors (corporations, nongovernment organizations, and individuals).
+ how geography affects interactions among nations and their citizens.
One way to examine geopolitics is through analysis of the extent to which individual
countries cooperate with one another.

A country might be more cooperative on some issues and less cooperative on others, and its
degree of cooperation can change over time or with the outcomes of the country’s domestic
politics

A country will typically cooperate with other countries when doing so advances its national
interests with its top priorities being those that ensure its survival.
Module 1: Geopolitics
1. Geopolitics from a cooperation versus competition perspective.

To facilitate the flow of resources, state and nonstate actors may cooperate on
standardization of regulations and processes such as International Financial Reporting
Standards for firms presenting their accounting data to the public.

Cultural factors, such as historical emigration patterns or a shared language, can be another
influence on a country’s level of cooperation. Among these cultural factors are a country’s
formal and informal institutions, such as laws, public and private organizations, or distinct
customs and habits.

Cultural exchange is one means through which a country may exercise soft power, which is
the ability to influence other countries without using or threatening force
Module 1: Geopolitics
2. Geopolitics and its relationship with globalization.
Globalization refers to the long-term trend toward worldwide integration of economic activity and
cultures.
Nationalism refers to a nation pursuing its own economic interests independently of, or in competition
with, the economic interests of other countries.
Globalization
• Open to globalization but have the size • Engage extensively in international trade
and scale to influence other countries and other forms of cooperation with
without necessarily cooperating. many other countries

Hegemony Multilateralism

Non-cooperation
Autarky Bilateralism Cooperation

• Goal of national self-reliance • engage in bilateralism (two countries)

• Government control of industry more than multicountry arrangements.
and media
Nationalism
Module 1: Geopolitics
3. Functions and objectives of the international organizations

● promoting international monetary cooperation and exchange rate stability,

International Monetary Fund
● assists in setting up international payments systems, and makes resources
(IMF) available to member countries with balance of payments problems.

● provides low-interest loans, interest-free credits, and grants to developing

World Bank countries for many specific purposes.
● provides resources and knowledge and helps form private/public partnerships
with the overall goal of fighting poverty.

● the goal of ensuring that trade flows freely and works smoothly.
World Trade Organization
● the main focus is on instituting, interpreting, and enforcing a number of
(WTO) multilateral trade agreements that detail global trade policies for a large
majority of the world’s trading nations.
Module 1: Geopolitics
4. Geopolitical Risk
• Event risk refers to events about which we know the timing but not the outcome, such as national
elections.
• Exogenous risk refers to unanticipated events, such as outbreaks of war or rebellion.
• Thematic risk refers to known factors that have effects over long periods, such as human migration
patterns or cyber risks.
Evaluate effect on investments of a
geopolitical risk

Impact Velocity
Likelihood Magnitude of its effects on How quickly investment values
Probability of geopolitical risk investment outcomes would reflect these effects

Black swan risk is a term for the risk of low-likelihood exogenous events that have
substantial short-term effects.
Module 1: Geopolitics
5. Tools of Geopolitics

Tools of Geopolitics

National security Economic Financial

Include armed conflict, • Cooperative economic tools: • Include foreign investment

espionage, or bilateral or free trade areas, common and the exchange of
multilateral agreements markets, and economic and currencies.
designed to reinforce or monetary unions. • Cooperatively if they allow
prevent armed conflict. • Noncooperative economic foreign investment and the
tools: domestic content free exchange of currencies
requirements, voluntary • Noncooperatively when
export restraints, and they restrict these activities
nationalization or put sanction on the
financial interests
 MACROECONOMIC

Learning Objectives

1. Pros and Cons of International

Trade
INTERNATIONAL TRADE 2. Trade Restriction
3. Capital Restriction
Foundational Knowledge:
Comparative advantage and absolute advantage

A country is said to have an absolute advantage in the production of a good if it can

produce the good at a lower resource cost than another country

A country is said to have a comparative advantage in the production of a good if it

has a lower opportunity cost in the production of that good, expressed as the
amount of another good that could have been produced instead.

Countries with lower relative cost of (a comparative advantage in) the production
of a specific good will specialize in producing that good and export it while
importing goods for which other countries have a lower relative cost or production
Foundational Knowledge:
Comparative advanage and absolute advantage
Output per unit of labor

Determine absolute advantage and

comparative advantage of each country

Benefit of Trade
Absolute advantage: Portugal has absolute advantage in both wine and cloth
Assume Portugal shifts 8 workers from cloth to wine
Comparative advantage:
and ENgland shifts 10 workers from wine to cloth
Portugal:
The change in Portugal’s production is 8 × 110 =
● opportunity cost of a yard of cloth is 110 / 100 = 1.1 bottles of wine
+880 wine and –8 × 100 = –800 cloth.
● opportunity cost of a bottle of wine is 100 / 110 = 0.91 yards of cloth
The change in England’s production is –10 × 80 = –
England
800 wine and 10 × 90 = +900 cloth.
● opportunity cost of a yard of cloth is 80 /90 = 0.89 bottles of wine
● opportunity cost of a bottle of wine is 90 / 80= 1.125 yards of cloth
⇒ total output has increased through trade, there’s
⇒ Portugal has a comparative advantage in the production of wine with lower
greater specialization by Portugal in wine
opportunity cost of a bottle of wine. Similarly, England has a comparative
production, and there’s greater specialization by
advantage in the production of cloth
England in cloth production
Module 1: International Trade
1. The benefits and costs of international trade

Benefits of international trade Costs of international trade

1. Benefiting consumers by reducing the 1. The loss of domestic jobs in an
pricing power of domestic importing industry and increased
monopolies and offering the greater economic inequality at least in the
variety of products, as well as the short-run
reduced costs from specialization.
In the long run—after, workers receive
additional training and find work in other
2. Benefiting domestic producers of industries—the short-run costs of free
exported goods. trade are mitigated to some significant
degree, or even reversed.
Module 1: International Trade
2. Reasons for trade and capital restriction

Support from economists Little support from economists

Infant industry: protection new Protecting domestic jobs: some jobs are
industries from the foreign competition lost but some jobs will be created and the
customers will enjoy the lower price
National security: protect producers of without import restrictions.
goods crucial to the country’s national
defense so that those goods are Protecting domestic industries: Industry
available domestically in the event of firms often use political influence to get
conflict protection from foreign competition,
usually to the detriment of consumers,
who pay higher prices.
Module 1: International Trade
3. Types of trade restrictions

● Tariffs: Taxes on imported good collected by the government.

● Quotas: Limits on the amount of imports allowed over some period.
● Export subsidies: Government payments to firms that export goods
● Minimum domestic content: Requirement that some percentage of product
content must be from the domestic country.
● Voluntary export restraint: A country voluntarily restricts the amount of a
good that can be exported, often in the hope of avoiding tariffs or quotas
imposed by their trading partners.
Module 1: International Trade
4. Economic Implication of Trade Restrictions

● Tariffs: Taxes on imported good collected by the government.

⇒ increases the domestic price, decreases the quantity imported, and
increases the quantity supplied domestically, increases the government
budget

● Quotas: Limits on the amount of imports allowed over some period.

⇒ increases the domestic price, decreases the quantity imported, increases
the quantity supplied domestically, increases the government budget if the
import licenses are sold
Module 1: International Trade
4. Economic Implication of Trade Restrictions
Tariffs and Quota.

Without tariffs:
At Pworld,
The domestic quantity supplied: QS1,
The domestic quantity demanded” QD1,
⇒ Import quantity: QD1-QS1

With tariffs:
At Pprotection
the domestic quantity supplied is QS2,
The domestic quantity demanded is QD2,
⇒ Import quantity: QD2-QS2

The entire shaded area in represents the loss of consumer

surplus in the domestic economy.
Module 1: International Trade
4. Economic Implication of Trade Restrictions
Voluntary export restraint (VER):
+ a voluntary agreement by a government to limit the quantity of a good that can be exported.
+ a welfare loss to the importing country equal to that of an equivalent quota with no
government charge for the import licenses; that is, no capture of the quota rents.

Export subsidies:
+ payments by a government to its country’s exporters
+ Benefit producers (exporters) of the good but increase prices and reduce consumer surplus
in the exporting country
+ In a small country, the price will increase by the amount of the subsidy to equal the world
price plus the subsidy
+ In a large country, the world price decreases and some benefits from the subsidy accrue to
foreign consumers, while foreign producers are negatively affected.
Module 1: International Trade
5. Capital Restriction

● Impose capital restrictions on the flow of financial capital across borders.

● Restrictions include:
+ outright prohibition of investment in the domestic country by foreigners,
+ prohibition of or taxes on the income earned on foreign investments
+ prohibition of foreign investment in certain domestic industries, and restrictions on
repatriation of earnings of foreign entities operating in a country.

⇒ Consequences: decrease economic welfare but however, over the short term, they have
helped developing countries avoid the impact of great inflow/outflow of foreign investors
Module 1: International Trade
5. Capital Restriction
Common objectives of capital restriction.

Reduce the volatility of domestic asset prices

Maintain fixed exchange rate

Keep domestic interest rate low

Protect strategic industries/national security

Module 1: International Trade
6. Motivations and advantages of trading blocs, common markets, and
economic unions.
Economic welfare is improved by
reducing or eliminating trade
restrictions.

However, a trade agreement

increases trade restrictions on
imports from non-member countries,
economic welfare gains are reduced
and, in an extreme case, could be
outweighed by the costs such
restrictions impose.
 MACROECONOMIC

Learning Objectives

1. The Foreign Exchange market

2. Managing Exchange rate
CAPITAL FLOWS AND THE FX 3. Exchange rate Calculation

MARKET
Module 1: Foreign Exchange Market
1. Functions of and participants in the foreign exchange market
Foreign currency markets serve companies and individuals that purchase or sell foreign goods and
services, foreign physical assets as well as foreign financial securities.
+ For hedging purposes: using a forward currency contract to reduce or eliminate its foreign
exchange risk associated with the cross-border transaction
+ For speculative purposes: Investors, companies, and financial institutions, such as banks and
investment funds, all regularly enter into speculative foreign currency transactions.
Participants in the foreign exchange market:
+ Sell side: dealers and originators of forward foreign exchange (FX) contracts are large
multinational banks
+ Buy side: Corporations, Investment accounts, governments and government entities, retail
market (households and relatively small institutions)
Module 1: Foreign Exchange Market
2. Quotation of an exchange rate

An exchange rate is the price or cost of units of one currency in units of another currency

1.25 USD / EUR or 1EUR = 1.25 USD

Price Currency Base Currency

● Direct quote for a USD-based investor (from the point of view of an investor in the price currency)
● Indirect quote for an EUR-based investor (from the point of view of an investor in the base
currency)

EUR as Price currency: 1/1.25 EUR/USD => 0.8EUR/USD or 1USD = 0.8EUR

Module 1: Foreign Exchange Market
2. Quotation of an exchange rate
Calculate and interpret the percentage change in a currency relative to another currency.

If a USD/EUR exchange rate has changed from 1.42 to 1.39 USD/EUR. How much
change in the value of EUR and USD?

1 EUR = 1.42 USD 1 USD = 1/1.42 = 0.7042 EUR

1 EUR = 1.39 USD 1 USD = 1/1.39 = 0.7194 EUR

⇒ The percentage change in EUR in terms of ⇒ The percentage change in USD in terms of
USD: 1.39/1.42 -1 = -0.0211 ~ -2.11% EUR : 0.7194/0.7042-1 = +2.16%
The euro has depreciated by 2.11% relative to The dollar has appreciated 2.16% with
the dollar. respect to the euro

The appreciation of USD is not equal to the decrease level of EUR

Module 1: Foreign Exchange Market
3. Calculate and interpret currency cross-rate
The cross rate is the exchange rate between two currencies implied by their exchange rates
with a common third currency
If we have MXN/USD = 10.70 and USD/AUD = 0.60. What is the cross rate between
Australian dollars and pesos (MXN/AUD)?

6.42 MXN/AUD
or 1AUD = 6.42 MXN

Practice
Module 1: Foreign Exchange Market
4. Nominal exchange rate and real exchange rate
𝐶𝑃𝐼𝑏𝑎𝑠𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
Real exchange rate (Price/Base) = nominal exchange rate (price/base) x
𝐶𝑃𝐼𝑝𝑟𝑖𝑐𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦

Note: Exchange rate is quoted as price currency/base currency

To be easier to remember: Real exchange rate (Price/Base) = nominal exchange

𝐶𝑃𝐼
rate (price/base)
𝑏𝑎𝑠𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
𝐶𝑃𝐼𝑝𝑟𝑖𝑐𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦

Understanding the formula:

An increase(decrease) in the price level in the price currency country relative to the price
level in the base currency country
➔ decrease(increase) the real exchange rate, increasing(decreasing) the purchasing power
of the price currency in terms of base country goods.
Module 1: Foreign Exchange Market
4. Nominal exchange rate and real exchange rate
Practice

At a base period, the CPIs of the United States and United Kingdom are both 100,
and the exchange rate is $1.70/£. Three years later, the exchange rate is $1.60/£,
and the CPI has risen to 110 in the United States and 112 in the United Kingdom.
What is the real exchange rate at the end of the three-year period?
Module 1: Foreign Exchange Market
4. Nominal exchange rate and real exchange rate
Practice
At a base period, the CPIs of the United States and United Kingdom are both 100,
and the exchange rate is $1.70/£. Three years later, the exchange rate is $1.60/£,
and the CPI has risen to 110 in the United States and 112 in the United Kingdom.
What is the real exchange rate at the end of the three-year period?
Answer:
𝐶𝑃𝐼𝑈𝐾
Real exchange rate ($/£) = nominal exchange rate ($/£) x
𝐶𝑃𝐼𝑈𝑆
112
= 1.6 x = 1.629 ($/£)
110
Module 1: Foreign Exchange Market
5. Spot exchange rate and forward exchange rate

A spot exchange rate is the currency exchange rate for immediate delivery, which for
most currencies means the exchange of currencies takes place two days after the trade.

A forward exchange rate is a currency exchange rate for an exchange to be done in the
future. Forward rates are quoted for various future dates (e.g., 30 days, 60 days, 90 days,
or one year). A forward is actually an agreement to exchange a specific amount of one
currency for a specific amount of another on a future date specified in the forward
agreement.
Module 1: Foreign Exchange Market
5. Spot exchange rate and forward exchange rate
Forward Quotation
A forward exchange rate is expressed in terms of the difference between the spot exchange rate and the
forward exchange rate.

Forward exchange rate = spot exchange rate + basis points/ percentage

1 basis point = 1/10000 . Ex: 4.5 points = 4.5/10000=0.00045

Practice 1 Practice 2
The AUD/EUR spot exchange rate is 0.7313 with The AUD/EUR spot rate is quoted at 0.7313, and
the 1-year forward rate quoted at +3.5 points. the 120-day forward exchange
What is the 1-year forward AUD/EUR exchange rate is given as –0.062%. What is the 120-day
rate? forward AUD/EUR exchange rate?

Answer: The forward exchange rate is 0.7313 + Answer: The forward exchange rate is 0.7313 (1 −
0.00035 = 0.73165 0.00062) = 0.7308
Module 1: Foreign Exchange Market
6. The arbitrage relationship between spot rates, forward rates, and interest rates.
The percentage difference between forward and spot exchange rates is approximately equal to the
difference between the two countries’ interest rates. If not, there is an arbitrage trade with a riskless
profit to be made.

Interest rate parity (No arbitrage relation):

𝑓𝑜𝑟𝑤𝑎𝑟𝑑 (1 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑝𝑟𝑖𝑐𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦) Note: spot and forward rates expressed as price
= currency/base currency
𝑠𝑝𝑜𝑡 (1 + 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑏𝑎𝑠𝑒 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦)

The currency with higher interest rates should depreciate over time by approximately the amount
of the interest rate differential.
Module 1: Foreign Exchange Market
6. The arbitrage relationship between spot rates, forward rates, and interest rates.
Practice
Consider two currencies, the ABE and the DUB. The spot ABE/DUB exchange rate is 4.5671,
the 1-year riskless ABE rate is 5%, and the 1-year riskless DUB rate is 3%. What is the 1-year
no-arbitrage forward exchange rate?

Answer: ABE: Price currency, DUB Base currency

𝑓𝑜𝑟𝑤𝑎𝑟𝑑𝐴/𝐷 (1 + 𝑟𝐴 ) (1+𝑟𝐴 ) 1.05

= 𝑓𝑜𝑟𝑤𝑎𝑟𝑑𝐴/𝐷 = 𝑠𝑝𝑜𝑡𝐴/𝐷 𝑥 = 4.5671 𝑥 = 4.6558
𝑠𝑝𝑜𝑡𝐴/𝐷 (1 + 𝑟𝐷 ) (1+𝑟𝐷 ) 1.03

Note that the forward rate is greater than the spot rate by 4.6558 / 4.5671 - 1 = 1.94%. This
is approximately equal to the interest rate differential of 5% - 3% = 2%.
Module 1: Foreign Exchange Market
6. The arbitrage relationship between spot rates, forward rates, and interest rates.

What happens if the forward exchange rate differs from this no-arbitrage rate?

⇒ Investors will get benefits from arbitrage

Consider a forward rate of 4.6000 so that the appreciation in the DUB is less than that implied by
interest rate parity (4.6558) ⇒ ABE is more attractive than DUB ⇒ Borrowing DUB to invest in ABE

An investor can:
● Borrow 1,000 DUB for one year at 3% to purchase ABE and get 4,567.1 ABE (exchange at spot
rate of 4.5671 ABE/DUB)
● Invest the 4,567.1 ABE at the ABE rate of 5% to have 1.05(4,567.1) = 4,795.45 ABE at the end of
one year.
● Enter into a currency forward contract to exchange 4,795.45 ABE in one year at the forward rate
of 4.6000 ABE/DUB in order to receive 4,795.45 / 4.6000 = 1,042.49 DUB.
⇒ Gain 1042.49 - 1030 = 12.49 DUB
Module 1: Foreign Exchange Market
6. The arbitrage relationship between spot rates, forward rates, and interest rates.
Practice
The spot ABE/DUB exchange rate is 4.5671, the 90-day riskless ABE rate is 5%, and the 90-day
riskless DUB rate is 3%. What is the 90-day forward exchange rate that will prevent arbitrage
profits?

Answer: ABE: Price currency, DUB Base currency

90
𝑓𝑜𝑟𝑤𝑎𝑟𝑑𝐴/𝐷 (1 + 𝑟𝐴 𝑥 )
= 360
𝑠𝑝𝑜𝑡𝐴/𝐷 90
(1 + 𝑟𝐷 𝑥 )
360

90 90
(1+𝑟𝐴 𝑥 ) (1+0.05𝑥 )
360 360
𝑓𝑜𝑟𝑤𝑎𝑟𝑑𝐴/𝐷 = 𝑠𝑝𝑜𝑡𝐴/𝐷 𝑥 90 = 4.5671 𝑥 90 = 4.5898
(1+𝑟𝐷 𝑥 ) (1+0.03𝑥 )
360 360
Module 1: Foreign Exchange Market
7. Forward premium and Forward discount

If forward > spot rate: forward premium

If forward <spot rate: forward discount

The forward discount or premium for the base currency is the percentage difference between the
forward price and the spot price.

Practice
USD/EUR spot = $1.312
USD/EUR 90-day forward = $1.320

The (90-day) forward premium or discount on the euro = forward/spot – 1 = 1.320 /1.312
– 1 = 0.609%.
Module 2: Managing Exchange Rates
8. Exchange rate regime
Currency board arrangement

Peg exchange domestic currency for a specified foreign currency at a fixed exchange
rate such as Hong Kong dollars

Conventional fixed peg arrangement

Formal dollarization
pegs its currency within margins of ±1% versus another currency or a basket of major
currencies
use the currency of Countries Countries Target zone
another country without with their
their own own pegs its currency but with wider range of ±2% versus another currency or a basket of
currency currency major currencies
Crawling peg
Monetary Union the exchange rate is adjusted periodically, typically to adjust for higher inflation
versus the currency used in the peg.

use the common Managed floating exchange rate

currency such as EU the monetary authority attempts to influence the exchange rate in response to
specific indicators such as the balance of payments, inftion rates, or employment
without any specific target FX
Independently floating
the exchange rate is market-determined without deep intervention of
government
Module 2: Managing Exchange Rates
9. Balance of payments

Current Account Capital Account Financial Account

Mainly measures the flows of goods and Capital transfers: debt forgiveness and Government-owned assets abroad
services goods and financial assets that migrants include gold, foreign currencies, foreign
● Merchandise and services: bring when they come to a country or securities, reserve position in IMF,
● Income receipts: foreign income take with them when they leave. credits and other long-term assets,
from dividends on stock holdings and Sales and purchases of non-financial direct foreign investment, and claims
interest on debt securities. assets: that are not produced assets against foreign banks.
● Unilateral transfers: one-way include rights to natural resources and
transfers of assets, such as money intangible assets, such as patents, Foreign-owned assets in the country
received from those working abroad copyrights, trademarks, franchises, and are divided into foreign official assets
and direct foreign aid leases. and other foreign assets in the domestic
country
Module 2: Managing Exchange Rates
10. How decisions by consumers, firms and governments affect the balance of
payments
(exports – imports) = (private savings – investment in physical capital) + tax revenue –
government spending
Or
(X – M) = (S – I) + (T – G)

Deficit in trade account (X-M <0) ~ a country’s domestic saving (include private savings
and government savings) < domestic investment
⇒ domestic investment must be financed by foreign borrowing.
⇒ surplus in the combined capital account

Any current account deficit (X-M<0) must be made up by a net surplus in the capital and financial
accounts.
Module 2: Managing Exchange Rates
11. Changes in exchange rate

Domestic currency 

Current Account Capital & Financial flows

• Export  • Capital inflows to domestic country
• Import  • Capital outflows to foreign country

Capital & Financial Account

Trade Deficit
Offset Surplus
THE END