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6.3 Economics for Business Unit Slides UK Versity.

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1 6.3 Economics for Business Unit Slides UK Versity

2 Understand the micro-economic business environment

3 Definition of micro and macroeconomics

4 Definition of microeconomics The branch of economics that analyzes the market behaviour of individual consumers and firms in an attempt to understand the decision-making process of firms and households

5 The field of economics that studies the behaviour of the aggregate economy. Macroeconomics examines economy-wide phenomena such as changes in unemployment, national income, rate of growth, gross domestic product, inflation and price levels Definition of macroeconomics

6 Supply and Demand In microeconomics, supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers (at current price) will equal the quantity supplied by producers (at current price), resulting in an economic equilibrium for price and quantity.

7 The four basic laws of supply and demand are: If demand increases and supply remains unchanged, a shortage occurs, leading to a higher equilibrium price. If demand decreases and supply remains unchanged, a surplus occurs, leading to a lower equilibrium price. If demand remains unchanged and supply increases, a surplus occurs, leading to a lower equilibrium price. If demand remains unchanged and supply decreases, a shortage occurs, leading to a higher equilibrium price.

8 Average and Marginal revenue Average revenue", for a specific level of sales, is the total revenue divided by the number of units sold, or in other words, revenue per unit, or, simply, "price". This average is over the entire sales in a given time period, market, etc. "Marginal revenue" is "average revenue" evaluated at every possible level of sales

9 Factors of Production An economic term to describe the inputs that are used in the production of goods or services in the attempt to make an economic profit. The include land, labor, capital and entrepreneurship.

10 10 The International Monetary System Chapter Objective: This chapter serves to introduce the student to the institutional framework within which: (1) International payments are made, (2) The movement of capital is accommodated, (3) Exchange rates are determined. Chapter Outline Evolution of the International Monetary System Current Exchange Rate Arrangements European Monetary System Euro and the European Monetary Union Fixed versus Flexible Exchange Rate Regimes 2 Chapter Two

11 11 Evolution of the International Monetary System Definition: IMS is institutional framework within which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined Bimetallism: Before 1875 Classical Gold Standard: Interwar Period: Bretton Woods System: The Flexible Exchange Rate Regime: 1973-Present

12 12 Evolution of the International Monetary System Bimetallism (prior to 1875) – Gold and Silver used as international means of payment and the exchange rate among currencies was determined by either their gold or silver content. – Gresham’s law - exchange ratio between two metals was officially fixed, therefore only more abundant metal was used, driving the more scarce metal out of circulation

13 13 Evolution of the International Monetary System (contd.) Classic Gold Standard ( ) During this period in most major countries: alone is assured of unrestricted coinage 2.two-way convertibility between gold and national currencies at a stable ratio is freely exported or imported The exchange rate between two country’s currencies would be determined by their relative gold contents Highly stable exchange rates under the classical gold standard provided an environment that was conducive to international trade and investment. Price-specie-flow mechanism corrected misalignment of exchange rates and international imbalances of payment Might lead to deflationary pressures

14 14 Evolution of the International Monetary System (contd.) Interwar period (1915 – 1944) characterized by: – Economic nationalism – Attempts and failure to restore gold standard – Economic and political instability These factors highlighted some of the shortcomings of the gold standard The result for international trade and investment was profoundly detrimental.

15 15 Evolution of the International Monetary System (contd.) Bretton Woods System (1944 – 1973) Creation of the International Monetary Fund (IMF) and the World Bank Under the Bretton Woods system, the U.S. dollar was pegged to gold at $35 per ounce and other currencies were pegged to the U.S. dollar. Each country was responsible for maintaining its exchange rate within ±1% of the adopted par value by buying or selling foreign reserves as necessary. US dollar based gold exchange standard

16 16 Evolution of the International Monetary System (contd.) Bretton Woods System (1944 – 1973) British pound French franc U.S. dollar Gold Pegged at $35/oz. Par Value German mark

17 17 Evolution of the International Monetary System (contd.) Bretton Woods System (1944 – 1973) Problem with the system is that U.S. constantly incurred trade deficits as other countries wanted to maintain US$ reserves (Triffin Paradox) Special Drawing Rights (SDR) – new reserve asset, (US$, FF, DM, BP, JY) Smithsonian Agreement (1971) – US$ devalued to $38/oz. European, Japanese currencies allowed to float–Mar 1973

18 18 Evolution of the International Monetary System (contd.) Flexible Exchange Rate Regime (1973–present) Jamaica Agreement (1976) Flexible exchange rates were declared acceptable to the IMF members. – Central banks were allowed to intervene in the exchange rate markets to iron out unwarranted volatilities. Gold was abandoned as an international reserve asset. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds.

19 19 Contemporary Currency Regimes Free Float – The largest number of countries, about 36, allow market forces to determine their currency’s value. Managed Float – About 50 countries combine government intervention with market forces to set exchange rates. Pegged to (or horizontal band around) another currency – Such as the U.S. dollar or euro No national currency – About 40 countries do not bother printing their own, they just use the U.S. dollar. For example, Ecuador, Panama, and El Salvador have dollarized.

20 20 Fixed vs. Flexible Exchange Rate Regimes Arguments in favor of flexible exchange rates: – Easier external adjustments. – National policy autonomy. Arguments against flexible exchange rates: – Exchange rate uncertainty may hamper international trade. – No safeguards to prevent crises. Currencies depreciate (or appreciate) to reflect the equilibrium value in flexible exchange rates Governments must adjust monetary or fiscal policies to return exchange rates to equilibrium value in fixed exchange rate regimes

21 21 Fixed versus Flexible Exchange Rate Regimes Suppose the exchange rate is $1.40/£ today. In the next slide, we see that demand for British pounds far exceed supply at this exchange rate. The U.S. experiences trade deficits. Under a flexible ER regime, the dollar will simply depreciate to $1.60/£, the price at which supply equals demand and the trade deficit disappears.

22 22 Fixed versus Flexible Exchange Rate Regimes SD Q of £ Dollar price per £ (exchange rate) $1.40 Trade deficit Demand (D) Supply (S)

23 23 Fixed versus Flexible Exchange Rate Regimes Supply (S) Demand (D) Demand (D*) D = S Dollar depreciates (flexible regime) Q of £ Dollar price per £ (exchange rate) $1.60 $1.40

24 24 Fixed versus Flexible Exchange Rate Regimes Instead, suppose the exchange rate is “fixed” at $1.40/£, and thus the imbalance between supply and demand cannot be eliminated by a price change. The US Federal Reserve Bank may initially draw on its foreign exchange reserve holdings to satisfy the excess demand for British pounds. If the excess demand persists the government would have to shift the demand curve from D to D* – In this example this corresponds to contractionary monetary and fiscal policies.

25 25 Fixed versus Flexible Exchange Rate Regimes Supply (S) Demand (D) Demand (D*) D* = S Contractionary policies (fixed regime) Q of £ Dollar price per £ (exchange rate) $1.40

26 26 European Monetary System (EMS) EMS was created in 1979 by EEC countries to maintain exchange rates among their currencies within narrow bands, and jointly float against outside currencies. Objectives: – Establish zone of monetary stability – Coordinate exchange rate policies vis-à-vis non-EMS countries – Develop plan for eventual European monetary union Exchange rate management instruments: – European Currency Unit (ECU) Weighted average of participating currencies Accounting unit of the EMS – Exchange Rate Mechanism (ERM) Procedures by which countries collectively manage exchange rates

27 27 What Is the Euro (€)? The euro is the single currency of the EMU which was adopted by 11 Member States on 1 January These original member states were: Belgium, Germany, Spain, France, Ireland, Italy, Luxemburg, Finland, Austria, Portugal and the Netherlands. Prominent countries initially missing from Euro : – Denmark, Greece, Sweden, UK – Greece: did not meet convergence criteria, was approved for inclusion on June 19, 2000 (effective Jan. 2001) 1 Euro is Equal to: BEFBelgian franc DEMGerman mark ESPSpanish peseta FRFFrench franc IEPIrish punt ITLItalian lira LUFLuxembourg franc NLGDutch guilder ATSAustrian schilling PTEPortuguese escudo FIMFinnish markka Euro Conversion Rates

28 28 Benefits and Costs of the Monetary Union Transaction costs reduced and FX risk eliminated Creates a Eurozone – goods, people and capital can move without restriction Compete with the U.S. – Approximately equal in terms of population and GDP Price transparency and competition  Loss of national monetary and exchange rate policy independence  Country-specific asymmetric shocks can lead to extended recessions

29 29 The Long-Term Impact of the Euro If the euro proves successful, it will advance the political integration of Europe in a major way, eventually making a “United States of Europe” feasible. It is likely that the U.S. dollar will lose its place as the dominant world currency. The euro and the U.S. dollar will be the two major currencies.

30 1.3 Analyse the impact of market structures on business organisations

31 Market Structures The collection of factors that determine how buyers and sellers interact in a market, Price change Levels of production Selling

32 Perfect Competition or Pure Market Perfect competition describes a market structure whose assumptions are strong and therefore unlikely to exist in most real-world markets. Economists have become more interested in pure competition partly because of the growth of e-commerce as a means of buying and selling goods and services. And also because of the popularity of auctions as a device for allocating scarce resources among competing ends. Perfect competition

33 Perfect Competition or Pure Market Many sellers each of whom produce a low percentage of market output and cannot influence the prevailing market price. Many individual buyers, none has any control over the market price Perfect freedom of entry and exit from the industry. Firms face no sunk costs and entry and exit from the market is feasible in the long run. This assumption means that all firms in a perfectly competitive market make normal profits in the long run. Homogeneous products are supplied to the markets that are perfect substitutes. This leads to each firms being “price takers” with a perfectly elastic demand curve for their product.

34 Perfect Competition or Pure Market Perfect knowledge – consumers have all readily available information about prices and products from competing suppliers and can access this at zero cost – in other words, there are few transactions costs involved in searching for the required information about prices. Likewise sellers have perfect knowledge about their competitors. Perfectly mobile factors of production – land, labour and capital can be switched in response to changing market conditions, prices and incentives. No externalities arising from production and/or consumption

35 Monopoly A situation in which a single company or group owns all or nearly all of the market for a given type of product or service. By definition, monopoly is characterized by an absence of competition, which often results in high prices and inferior products. market

36 Oligopoly A situation in which a particular market is controlled by a small group of firms. An oligopoly is much like a monopoly, in which only one company exerts control over most of a market. In an oligopoly, there are at least two firms controlling the market.

37 Labour & Factor Markets Factor Market a factor market refers to markets where services of the factors of production are bought and sold such as the labour markets, the capital market, the market for raw materials, and the market for management or entrepreneurial resources. Labour Market Where people are willing to work

38 Market Failure An economic term that encompasses a situation where, in any given market, the quantity of a product demanded by consumers does not equate to the quantity supplied by suppliers. This is a direct result of a lack of certain economically ideal factors, which prevents equilibrium.

39 Market Failure Market failures have negative effects on the economy because an optimal allocation of resources is not attained. In other words, the social costs of producing the good or service (all of the opportunity costs of the input resources used in its creation) are not minimized, and this results in a waste of some resources.

40 Market Regulation A medium for the exchange of goods or services over which a government body exerts a level of control. This control may require market participants to comply with environmental standards, product-safety specifications, information disclosure requirements and so on.

41 Market Regulation Regulated markets provide obvious protection for consumers. However, some argue that the formal regulation of markets is unnecessary and imposes inefficiencies and unnecessary costs on markets and on taxpayers. These people argue that there are plenty of ways for markets to self-regulate.

42 Competition A method of pricing in which the seller makes a decision based on the prices of its competition. Competition-driven pricing focuses on determining a price that will achieve the most profitable market share and does not always mean the price is the same as the competition, it could be slightly lower. Research is done in an attempt to eliminate the competition and it is important to accurately interpret communication signals in order to prevent a price war.

43 Competition Determining how to profitably achieve the greatest market share without incurring excessive costs requires strategic decision making. As such, the focus of the firm should not solely be on obtaining the largest market share, but in finding the appropriate combination of margin and market share that is most profitable in the long run.

44 Explain the impact of government policies on the economy 2.2

45 A policy is a statement of what the government is trying to achieve and why. Government policy is the sum of all the individual policies – as a whole they help to define where the government stands on broad political issues. On GOV.UK you can see all our policies and find out exactly what we are doing, who’s involved, who we’re working with (partner organisations) and who we’ve asked (consultations). Government Policies

46 There are currently 224 policies on GOV.UK Government Policies

47 Fiscal policy is the means by which a government adjusts its spending levels and tax rates to monitor and influence a nation's economy. It is the sister strategy to monetary policy through which a central bank influences a nation's money supply. These two policies are used in various combinations to direct a country's economic goals. Fiscal policymonetary policy Fiscal Policy & Monetary

48 Fiscal policy is based on the theories of British economist John Maynard Keynes. Also known as Keynesian economics, this theory basically states that governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to be healthy when between 2-3%), increases employment and maintains a healthy value of money.Keynesian economics Fiscal Policy

49 To find a balance between changing tax rates and public spending. For example, stimulating a stagnant economy by increasing spending or lowering taxes runs the risk of causing inflation to rise. This is because an increase in the amount of money in the economy, followed by an increase in consumer demand, can result in a decrease in the value of money - meaning that it would take more money to buy something that has not changed in value. Fiscal Policy

50 Monetary stability means stable prices and confidence in the currency. Stable prices are defined by the Government's inflation target, which the Bank seeks to meet through the decisions taken by the Monetary Policy Committee (MPC). Monetary Policy

51 Monetary policy in the UK usually operates through the price at which money is lent – the interest rate. In March 2009 the MPC announced that in addition to setting Bank Rate, it would start to inject money directly into the economy by purchasing financial assets – often known as quantitative easing. Monetary Policy

52 Income Tax is a tax you pay on your income. You don’t have to pay tax on all types of income. You pay tax on things like: money you earn from employment profits you make if you’re self-employed some state benefitsstate benefits most pensions, including state pensions, company and personal pensions and retirement annuities interest on savings and pensioner bonds rental income (unless you’re a live-in landlord and get £4,250 or less)live-in landlord benefits you get from your job income from a trust dividends from company shares Income Tax

53 You don’t pay tax on things like: income from tax-exempt accounts, like Individual Savings Accounts (ISAs) and National Savings Certificates some state benefitsstate benefits premium bond or National Lottery wins the first £4,250 of rent you get from a lodger in your homelodger in your home Income Tax

54 A value-added tax (VAT) is a form of consumption tax. From the perspective of the buyer, it is a tax on the purchase price. From that of the seller, it is a tax only on the value added to a product, material, or service, from an accounting point of view, by this stage of its manufacture or distribution. The manufacturer remits to the government the difference between these two amounts, and retains the rest for themselves to offset the taxes they had previously paid on the inputs.consumption taxvalue added The purpose of VAT is to generate tax revenues to the government similar to the corporate income tax or the personal income tax. Value Added Tax (VAT)

55 The value added to a product by or with a business is the sale price charged to its customer, minus the cost of materials and other taxable inputs. A VAT is like a sales tax in that ultimately only the end consumer is taxed. It differs from the sales tax in that, with the latter, the tax is collected and remitted to the government only once, at the point of purchase by the end consumer. With the VAT, collections, remittances to the government, and credits for taxes already paid occur each time a business in the supply chain purchases products.sales tax Value Added Tax (VAT)

56 Section 2 Understand the macro economic environment in the domestic context

57 2.1 Explain determinants of national income

58 What is National Income? National Income measures the total value of goods and services produced within the economy over a period of time. National Income can be calculated in three main ways 1.The sum of factor incomes earned in production 2.Aggregate demand of goods and services 3.The sum of value added from each productive sector of the economy

59 Why is National Income important? Measuring the level and rate of growth of National Income (Y) is important to economists when they are considering -Economic growth and where a country is in the business/economic cycle -Changes to the average living standards of the population -Looking at the distribution of National Income (income, wealth etc)

60 Gross Domestic Product (GDP) GDP measures the value of output produced within the domestic boundaries of the UK GDP includes the output of foreign owned firms with production plants located in the UK

61 Gross Domestic Product (GDP) There are three ways of calculating GDP all of which should sum to the same amount National Output = National Expenditure = National Income Under the new definitions introduced in 1998, GDP is now known as Gross Value Added

62 Aggregate Demand (AD) AD is the sum of the final expenditure on UK produced goods and services measured at current market prices

63 Gross Domestic Product (GDP) The full equation for GDP using this approach is GDP = C + I + G + (X – M) C House Spending (consumption) I Capital Investment Spending G General Government Spending X Exports of Goods and Services M Imports of Goods and Services

64 GDP by Factor Income GDP is the sum of the final incomes earned through the production of goods and services The main factor incomes are as follows: - income from employment and self employment - profits of commercial companies - rental income from the ownership of property = Gross Domestic Product (by factor income)

65 Gross Domestic Product (GDP) Only factor incomes generated through the output of goods and services are included in the calculation of GDP by income We exclude from the accounts - Transfer payments (e.g.. State pension, income support and JSA) - Private transfers of money from one individual to another - Income that is not registered with the Inland Revenue

66 GDP by Value Added from Each Sector This measures the value of output produced by each industry using the concept of value added Value added is the difference between the value of goods as they leave a stage of production and the cost of the goods as they enter that stage

67 GDP by Value Added from Each Sector We use this approach to avoid problems of double counting the value of intermediate input We try to calculate the value added at each stage of The Supply chain This is difficult when production is complex

68 GDP and GNP Gross National Product (GNP) measures the final value of output or expenditure by UK owned factors of production whether they are located in the UK or overseas. Output produced by Nissan in the UK counts towards our GDP but some of the profits made by Nissan here are sent back to Japan – adding their GNP

69 NPIA GNP = GDP + Net property income from abroad (NPIA) NPIA is the net balance of interest, profits and dividends (IPD) coming into the UK from UK assets owned overseas matched against the flow of profits and other income from foreign owned assets located within the UK

70 GDP and GNP GDP is the value of output produced by factors of production located within a country Output produced by a country’s citizen’s regardless of where the output is produced, is measured by gross national product (GNP) For the UK, GNP is higher than GDP

71 Limitations of National Income Data Each method of estimating GDP is imprecise leading to inaccuracies in the published figures Non-marketed output e.g.. DIY, the value of housework and voluntary activities are not yet part of official NY figures Transfer payments are excluded i.e. Benefit payments received with no corresponding output e.g. unemployment and child benefits

72 Limitations of National Income Data Double Counting. In the output method of calculating GDP we ignore intermediate output and count only value added – but this is done by using a sample of firms from each industry and calculating value added can be difficult

73 GDP and the Standard of Living Once GDP has been calculated it is -Converted into £s at the official exchange rate -Divided by the country’s population This gives an average figure for GNP per head

74 Standard of Living The standard of living refers to the amount of goods and services consumed by households in one year and is found by applying the equation: -Standard of living = real national income/population A high standard of living means households consume a large number of goods and services

75 Equilibrium Economic equilibrium can be static or dynamic and may exist in a single market or multiple markets. It can be disrupted by exogenous factors, such as a change in consumer preferences, which can lead to a drop in demand and consequently a condition of oversupply in the market. In this case, a temporary state of disequilibrium will prevail until a new equilibrium price or level is established, at which point the market will revert back to economic equilibrium.

76 Circular Flow The circular flow of income is a neoclassical economic model depicting how money flows through the economy. In the most simple version, the economy is modeled as consisting only of households and firms. Money flows to workers in the form of wages, and money flows back to firms in exchange for products. This simplistic model suggests the old economic adage, "Supply creates its own demand."

77 Multiplier In Keynesian economic theory, a factor that quantifies the change in total income as compared to the injection of capital deposits or investments which originally fueled the growth. It is usually used as a measurement of the effects of government spending on income, and it can be calculated as one divided by the marginal propensity to save.

78 Inflation The rate at which the general level of prices for goods and services is rising, and, subsequently, purchasing power is falling. Central banks attempt to stop severe inflation, along with severe deflation, in an attempt to keep the excessive growth of prices to a minimum.

79 Deflation A general decline in prices, often caused by a reduction in the supply of money or credit. Deflation can be caused also by a decrease in government, personal or investment spending. The opposite of inflation, deflation has the side effect of increased unemployment since there is a lower level of demand in the economy, which can lead to an economic depression. Central banks attempt to stop severe deflation, along with severe inflation, in an attempt to keep the excessive drop in prices to a minimum.

80 Factors that make multinational financial management different Exchange rates and trading International monetary system International financial markets Specific features of multinational financial management Multinational Financial Management

81 What is a multinational corporation? A multinational corporation is one that operates in two or more countries. At one time, most multinationals produced and sold in just a few countries. Today, many multinationals have world- wide production and sales.

82 Why do firms expand into other countries? To seek new markets. To seek new supplies of raw materials. To gain new technologies. To gain production efficiencies. To avoid political and regulatory obstacles. To reduce risk by diversification.

83 What are the major factors that distinguish multinational from domestic financial management? Currency differences Economic and legal differences Language differences Cultural differences Government roles Political risk

84 Are these currency prices direct or indirect quotations? Since they are prices of foreign currencies expressed in U.S. dollars, they are direct quotations (dollars per currency). Consider the following exchange rates: U.S. $ to buy 1 Unit Euro Swedish krona

85 What is an indirect quotation? An indirect quotation gives the amount of a foreign currency required to buy one U.S. dollar (currency per dollar). Note than an indirect quotation is the reciprocal of a direct quotation. Euros and British pounds are normally quoted as direct quotations. All other currencies are quoted as indirect.

86 Calculate the indirect quotations for euros and kronas. # of Units of Foreign Currency per U.S. $ Euro 1.25 Swedish krona Euro: 1 / = Krona:1 / =

87 What is a cross rate? A cross rate is the exchange rate between any two currencies not involving U.S. dollars. In practice, cross rates are usually calculated from direct or indirect rates. That is, on the basis of U.S. dollar exchange rates.

88 Cross rate = x = 1.25 x = euros/krona. Cross rate= x = x = 8.00 kronas/euro. Calculate the two cross rates between euros and kronas. Euros Dollars Dollar Krona Kronas Dollars Dollar Euros

89 The two cross rates are reciprocals of one another. They can be calculated by dividing either the direct or indirect quotations. Note:

90 Target price = ($1.75)(1.50)=$2.625 Spanish price = ($2.625)(1.25 euros/$) = € Assume the firm can produce a liter of orange juice in the U.S. and ship it to Spain for $1.75. If the firm wants a 50% markup on the product, what should the juice sell for in Spain?

91 2.0 euros (8.0 kronas/euro) = 16 kronas = 4.0 kronas profit. Dollar profit = 4.0 kronas( dollars per krona) = $0.40. Now the firm begins producing the orange juice in Spain. The product costs 2.0 euros to produce and ship to Sweden, where it can be sold for 20 kronas. What is the dollar profit on the sale?

92 Exchange rate risk is the risk that the value of a cash flow in one currency translated from another currency will decline due to a change in exchange rates. What is exchange rate risk?

93 Currency Appreciation and Depreciation Suppose the exchange rate goes from 10 kronas per dollar to 15 kronas per dollar. A dollar now buys more kronas, so the dollar is appreciating, or strengthening. The krona is depreciating, or weakening.

94 Affect of Dollar Appreciation Suppose the profit in kronas remains unchanged at 4.0 kronas, but the dollar appreciates, so the exchange rate is now 15 kronas/dollar. Dollar profit = 4.0 kronas / (15 kronas per dollar) = $ Strengthening dollar hurts profits from international sales.

95 The current system is a floating rate system. Prior to 1971, a fixed exchange rate system was in effect. – The U.S. dollar was tied to gold. – Other currencies were tied to the dollar. Describe the current and former international monetary systems.

96 The European Monetary Union In 2002, the full implementation of the “euro” was completed (those still holding former currencies have 10 years to exchange them at a bank). The newly formed European Central Bank now controls the monetary policy of the EMU.

97 The 12 Member Nations of the European Monetary Union Austria Belgium Finland France Germany Ireland Italy Luxembourg Netherlands Portugal Spain Greece

98 A currency is convertible when the issuing country promises to redeem the currency at current market rates. Convertible currencies are traded in world currency markets. What is a convertible currency?

99 It becomes very difficult for multi-national companies to conduct business because there is no easy way to take profits out of the country. Often, firms will barter for goods to export to their home countries. What problems arise when a firm operates in a country whose currency is not convertible?

100 A spot rate is the rate applied to buy currency for immediate delivery. A forward rate is the rate applied to buy currency at some agreed-upon future date. Forward rates are normally reported as indirect quotations. What is the difference between spot rates and forward rates?

101 When is the forward rate at a premium to the spot rate? If the U.S. dollar buys fewer units of a foreign currency in the forward than in the spot market, the foreign currency is selling at a premium. For example, suppose the spot rate is 0.7 £/$ and the forward rate is 0.6 £/$. The dollar is expected to depreciate, because it will buy fewer pounds. Continued….

102 Spot rate = 0.7 £/$ Forward rate = 0.6 £/$. The pound is expected to appreciate, since it will buy more dollars in the future. So the forward rate for the pound is at a premium.

103 When is the forward rate at a discount to the spot rate? If the U.S. dollar buys more units of a foreign currency in the forward than in the spot market, the foreign currency is selling at a discount. The primary determinant of the spot/forward rate relationship is the relationship between domestic and foreign interest rates.

104 What is interest rate parity? Interest rate parity implies that investors should expect to earn the same return on similar-risk securities in all countries: Forward and spot rates are direct quotations. r h = periodic interest rate in the home country. r f = periodic interest rate in the foreign country. Forward rate Spot rate = 1 + r h 1 + r f.


106 Forward rate If interest rate parity holds, the implied forward rate, , would equal the observed forward rate, ; so parity doesn’t hold. Forward rate Spot rate = 1 + r h 1 + r f = Forward rate =

107 A U.S. investor could directly invest in the U.S. security and earn an annualized rate of 6%. Alternatively, the U.S. investor could convert dollars to euros, invest in the Spanish security, and then convert profit back into dollars. If the return on this strategy is higher than 6%, then the Spanish security has the higher rate. Which 180-day security (U.S. or Spanish) offers the higher return?

108 What is the return to a U.S. investor in the Spanish security? Buy $1,000 worth of euros in the spot market: $1,000(1.25 euros/$) = 1,250 euros. Spanish investment return (in euros): 1,250(1.02)= 1,275 euros. (More...)

109 Buy contract today to exchange 1,275 euros in 180 days at forward rate of dollars/euro. At end of 180 days, convert euro investment to dollars: €1,275 ( $/€) = $1, Calculate the rate of return: $32.75/$1,000 = 3.275% per 180 days = 6.55% per year. (More...)

110 The Spanish security has the highest return, even though it has a lower interest rate. U.S. rate is 6%, so Spanish securities at 6.55% offer a higher rate of return to U.S. investors. But could such a situation exist for very long?

111 Arbitrage Traders could borrow at the U.S. rate, convert to pesetas at the spot rate, and simultaneously lock in the forward rate and invest in Spanish securities. This would produce arbitrage: a positive cash flow, with no risk and none of the traders own money invested.

112 Impact of Arbitrage Activities Traders would recognize the arbitrage opportunity and make huge investments. Their actions would tend to move interest rates, forward rates, and spot rates to parity.

113 What is purchasing power parity? Purchasing power parity implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries. P h = P f (Spot rate), or Spot rate = P h /P f.

114 If grapefruit juice costs $2.00/liter in the U.S. and purchasing power parity holds, what is price in Spain? Spot rate = P h /P f. $0.8000= $2.00/P f P f = $2.00/$ = 2.5 euros. Do interest rate and purchasing power parity hold exactly at any point in time?

115 Lower inflation leads to lower interest rates, so borrowing in low-interest countries may appear attractive to multinational firms. However, currencies in low-inflation countries tend to appreciate against those in high-inflation rate countries, so the true interest cost increases over the life of the loan. What impact does relative inflation have on interest rates and exchange rates?

116 Eurodollar markets – Dollars held outside the U.S. – Mostly Europe, but also elsewhere International bonds – Foreign bonds: Sold by foreign borrower, but denominated in the currency of the country of issue. – Eurobonds: Sold in country other than the one in whose currency it is denominated. Describe the international money and capital markets.

117 To what extent do capital structures vary across different countries? Early studies suggested that average capital structures varied widely among the large industrial countries. However, a recent study, which controlled for differences in accounting practices, suggests that capital structures are more similar across different countries than previously thought.

118 International Cash Management Distances are greater. Access to more markets for loans and for temporary investments. Cash is often denominated in different currencies.

119 Multinational Capital Budgeting Decisions Foreign operations are taxed locally, and then funds repatriated may be subject to U.S. taxes. Foreign projects are subject to political risk. Funds repatriated must be converted to U.S. dollars, so exchange rate risk must be taken into account.

120 Multinational Credit Management Credit is more important, because commerce to lesser-developed countries often relies on credit. Credit for future payment may be subject to exchange rate risk.

121 Multinational Inventory Management Inventory decisions can be more complex, especially when inventory can be stored in locations in different countries. Some factors to consider are shipping times, carrying costs, taxes, import duties, and exchange rates.

122 122 National Income National Income Accounting

123 123 Introduction National income accounting provides us with ex-post data about national income, it cannot explain the level and determinants of national income. The following identities are true for any level of income. In order to explain and predict the level of national income, models are constructed.

124 124 Firm Consumers Factor Owners Factor MarketProduct Market Factor servicesGoods & services ExpenditureRevenueCostFactor Income Real Flow Money Flow The flow of economic activities in a 2-sector economy

125 125 GNP v.s. GDP Gross National Product (GNP) The total value at market prices of final goods and services produced by the citizens in an economy in a specified period. Gross Domestic Product (GDP) The total value at market prices of final goods and services produced within the domestic boundary of a territory in a specified period

126 126 GNP & GDP Flow concept Resale of existing houses  Sale of used cars / existing shares  Commission / Brokers ’ fee  Imputed rents of owner-occupied dwellings  Capital gain is not income (Irving Fisher) Only the interest earned from the capital gain is considered as income

127 127 Real GNP & Nominal GNP & Per capita GNP Real GNP=(Nominal GNP/GNP Deflator)*100 Per capita GNP = GNP / Population size

128 128 Measurement of National Income Income Approach  NNP at factor cost OR National Income Output Approach  GDP at factor cost Expenditure Approach  GDP at market Prices

129 129 GDP at market price - Indirect sales tax + Indirect subsidies  GDP at factor cost + Net income from abroad  GNP at factor cost - Depreciation  NNP at factor cost Expenditure Approach C+I+G+X-M  Income Approach  W+I+R+P  Output Approach Factor Income- from abroad Factor Income paid abroad 

130 130 NNP at factor cost - Retained profits - Social insurance / Mandatory Provident Fund - Direct business Tax + Transfer payments  Personal income - Direct personal taxes  Disposable personal income - Consumption = Saving

131 131 Income Approach W+I+R+P = NNP at factor cost Profits are stated net of depreciation / capital consumption allowances If the figures exclude net income from abroad, NDP at factor cost can be obtained. NDP at factor cost + Net income from abroad =

132 132 Output Approach The total value of the final goods and services produced by the primary / secondary / tertiary industries In order to avoid double counting, the value-added method is adopted to exclude intermediate goods. GDP at factor cost + Indirect Taxes – Indirect Subsidies = Distinguish between Indirect / Direct / Business / Personal Taxes

133 133 Expenditure Approach People spend their income. Thus, the total expenditure on final goods and services must be equal to the total value of final goods and services produced domestically. Any output that is not sold to consumers is bought by producers in the form of unintended inventory investment. C+I+G+(X-M) = Aggregate / Total expenditure

134 134 Expenditure Approach Private Consumption Expenditure (C) Gross Investment Expenditure (I) Firms : plant (in progress) / unused raw materials Households : residential building Inventory investment : intended unintended (reduce information cost) - gross domestic fixed capital formation* - change in stocks & work in progress *gross national fixed capital formation  GNP at market prices Government Expenditure (G) roads/education/medical & health services/law & order/public works/ … salary to civil servants, NOT transfer payments at the cost to taxpayers, NOT at market prices Net Exports (X-M) the value of imports is included in C, I, G, X Exports include domestic exports & re-exports

135 135 Items excluded from National Income Accounting Second-hand goods Intermediate goods Non-marketed goods / services Volunteer work / Housework Unreported / Illegal market transactions

136 136 Merits & Uses of National Income Statistics Reflecting & comparing the standards of living of different countries Per capita real GNP  standard of living Providing information to the government and firms for economic planning Reflecting the economic growth of a country % change in real GNP over a period of time

137 137 Limitations of National Income Statistics Factors that may understate the standard of living / the welfare Exclusion of the value of leisure Same Q produced with fewer working hours  higher welfare Exclusion of non-marketed / unreported transactions

138 138 Limitations of National Income Statistics Factors that may overstate the standard of living / the welfare Undesirable Side-effects of Production Air pollution / traffic congestion / … Understate the real / social costs to society  externality /divergence between social costs & private costs

139 139 When comparing economic performances using national income statistics, Price Level use real GNP  eliminate the effect of inflation Size of Population  use per capital GNP Income Distribution more even distribution  higher welfare Composition of National income more consumption, less national defence  higher welfare Exchange Rates expressed in the same currency whether the exchange rates reflects the purchasing power of the 2 currencies

140 140 Inflation A general and sustained increase in the prices of all goods and services GNP deflator / GDP deflator Consumer Price Index (CPI) Producer Price Index (PPI) When constructing price indices different weighting will be given to different commodities reflecting their relative importance on the consumers ’ expenditure A base year is chosen during which the economy experiences no economic crisis

141 141 Calculating a Price Index ItemExpenditure 1991 WeightPrices 1991 Price Relatives 1991 Prices 1992 Price Relatives 1992 Transport Clothing Housing Food

142 142 Calculating a Price Index (cont ’ d) Price Index in 1991 =0.1* * * *100 =100 Price Index in 1992 = The general price level in 1992 has increased by % Only persistent increase in the price indices implies inflation

143 143 Consumer Price Indices Only consumer goods are included Persistent increase in the CPI implies an increase in the cost of living unless there is a compensating rise in money income CPI(A), CPI(B), HSCPI are constructed to measure the change in the cost of living of different income groups since they have different consumption patterns. Different weights are assigned to different categories of goods to reflect their relative importance.

144 144 Uses of the CPI In the following table, the real income is increasing, this implies that the standard of living is also increasing for a typical citizen YearCPINominal income Real income =(7650/90)* Base year = =

145 145 Limitations of the CPI Only consumer goods are included  CANNOT reflect the inflation rate accurately Change in consumption pattern  the weights are fixed  misleading Change in quality of goods  CPI  due to better quality  overstate inflation Possibility of Substitution  overstate the impact of inflation if consumers substitute cheaper goods for dearer goods

146 146 Implicit GNP Deflator To measure inflation, this is a better indicator as it has a wider coverage of commodities YearGNP deflatorInflation Rate between … &1992 [( )/100]*100% = 21%

147 147 Unemployment Working Population OR Labour Force Working Population=Employed+Unemployed+Self-employed Un-employment Rate =(Unemployed/Labour Force)*100% Under-employment Rate

148 148 Method of Analysis Endogenous variable the value of the variable is determined inside the model (  x, y) Exogenous variable the value of the variable is determined by forces outside the model (  m, c) any change is regarded as autonomous

149 149 CCC CII YYY YY Y C=f(Y)C=aC=a+cYC=a+c’YC=c*Y I=f(Y)I=I*I=I*+iY

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