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Global Markets Exam Prep
Global Markets Exam Prep
Content
Glossary of abbreviations........................................................................................................................ III
1. Fiscal Policy........................................................................................................................................ 4
1.1 General......................................................................................................................................... 4
2. Monetary policy.................................................................................................................................. 7
4. Exchange rate..................................................................................................................................... 9
4.2 Exchange rates in the long run: the real exchange rate...............................................................9
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Global Markets – Summary
6. Economic growth.............................................................................................................................. 13
6.2 Inequality.................................................................................................................................... 13
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Glossary of abbreviations
r Interest rate
g Growth rate
Y GDP / Output
D Debt
G Government spending
T Taxes
E Exchange rate
eL Human capital
K Physical capital
A Knowledge
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Global Markets – Summary
The most commonly applied measure for economic output is the gross domestic product.
The business or economic cycle is the upward and downward movement of the GDP around its
long-term growth rate.
1. Fiscal Policy
1.1 General
Fiscal policy is the means that the government can take to influence the economic development.
Generally, there are two types of fiscal instruments that governments can leverage:
Each period governments have some government spending (G) and they earn revenue through
taxes (T). These two streams do not need to balance as governments can borrow.
Primary deficit=G−T
Total fiscal deficit includes the interest payment for previously accumulated debt. These
payments can be very substantial depending on the debt level of the country. The fiscal deficit
can vary year to year due to three potential reasons:
1. Automatic stabilizers
a. Tax revenue increases as the economy expands
b. Government spending for e.g., unemployment benefits rise in economic
downturns
Deficit increases during recession and decreases during booms
2. Discretionary Policy
3. Government spending shock
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Global Markets – Summary
Governments can finance the deficits either through borrowing (issuance of bonds) or through
taxation.
High levels of sovereign debt are not necessarily a red flag. Generally, one needs to consider
the relationship between the GDP and the level of sovereign debt to access a countries ability to
repay debt. Countries with strong economies can allow higher levels of debt as they have:
GDP
=measure of ability ¿ repay debt
debt
Debt is sustainable if “r” (interest rate), “g” (growth rate) and the primary surplus (are such that
the debt over GDP stays constant.
If r > g (interest rate on debt higher than economic growth rate), economies need to run primary
surplus to control their debt level. If r < g, governments can run a certain deficit without
increases debt over GDP ratio. Shifts in these two rates can have significant impact on
government debt dynamics.
If it yields future revenue, it doesn’t matter if countries run a deficit (productive investment).
Countries with large debt however need to run a surplus in the future to avoid defaulting.
Countries financing their government consumption with debt need to either reduce future
expenditure or raise future taxes to achieve a surplus.
We can distinguish between two types of government spending and taxation to influence the
economy:
Helicopter money:
Fiscal policies in times of crisis are split into containment and recovery phase.
1. Containment phase: reduce disruptions to the labor market and to business to ensure
growth once containment phase is over
2. Recovery phase: higher quality fiscal measures will be those that have the greatest
impact on growth
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Global Markets – Summary
2. Monetary policy
Objective of monetary policy is to adjust the supply of money in the economy to achieve a
combination of inflation and output stabilization. These policies are carried out by the central
banks which are independent from governments. Responsibilities of central banks are:
conducting monetary policy, regulating banking institutions, providing financial services to the
government, and maintaining the stability of the financial system.
Quantitative easing: purchase large quantities of financial instruments from the market and
thereby injecting liquidity into the economy. During the global financial crisis, the FED for
example targeted industries that were in special need for liquidity by purchasing short-term
corporate debt and mortgage-backed securities.
How does it work? CB creates money to buy bonds from financial institutions which reduces the
interest rates leading to business and individuals to borrow more so they spend more and create
jobs to boost the economy.
Interest on Reserves (IOR): Applied to required reserves and excess reserves. Creating an
incentive for banks to hold a reserve at the CB to guarantying the liquidity of banking sector.
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Global Markets – Summary
3. Fiscal or monetary policies
Short run: monetary expansion leads to an increase in output, a decrease in interest rate and
an increase in the price level.
Medium run: Increase in money supply proportional to the increase in prices no effect on
output (monetary neutrality)
Takes time to legislate tax and spending changes and consumers may not respond in the
intended way to fiscal stimulus (save rather than spend a tax cut). Therefore, monetary policy is
considered the first response.
Policy constraints: policy makers may not have the freedom to implement stabilization policies
as fixed exchange rates or other rules for policy limit their ability to respond.
Incomplete information and the inside lag: models assume that policy makers observe the
state of the economy in real time however in reality data is observed with a lag. The lag between
the shock and the policy action is called “inside lag”. Furthermore, institutional factors impact the
implementation of fiscal policy significantly.
Policy response and the outside lag: even with perfect information it may time until a policy
will show effects. Monetary policy usually takes 6-12 months.
Long horizon plans: if business or individuals plan over long horizons, they may be less
responsive to changes in interest rates.
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Global Markets – Summary
4. Exchange rate
Exchange rate is the price of the home currency expressed in terms of the foreign currents. The
exchange rate can vary over times in both directions. Appreciation is if the home currency can
buy more foreign currency, depreciations is the opposite.
Although with the prevailing exchange rate investments in a different country may yield a higher
return, we don’t know the exchange rate at the end of the investment period. Therefore, returns
in different currencies are not directly comparable. Investor can eliminate this uncertainty by
arranging the exchange rate at the beginning of the period through the forward exchange
market.
Covered interest parity condition: uses forward exchange rate to cover the investors risk
Uncovered interest parity condition: investor makes a forecast of the excepted exchange
rate and does not cover the risk of his investment by forwarding the exchange rate
oo.
4.2 Exchange rates in the long run: the real exchange rate
The law of one price (LOOP) states that prices must be equal in all locations for any good
when expressed in a common currency.
The purchasing power parity (PPP): theory states the overall price levels in each market must
be the same.
EU basket ∈USD
Relative price level ratio (real ER): q US vs EU ¿
US basket
1
If PPP holds: q US vs EU ¿ =US basket
EU basket ∈USD
1
Deviation #1: q US vs EU ¿ >US basket
EU basket ∈USD
1
Deviation #2: q US vs EU ¿ <US basket
EU basket ∈USD
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Global Markets – Summary
5. International capital flows
International financial assets include portfolio investments (equity, debt), foreign direct
investments (FDI, direct investment into private companies), loans and FOREX reserves.
Capital inflows
Flows describe the value of t assets traded for a given year. Inflows ( ) are the
GDP
net purchases of domestic assets by foreign investors. Outflows are net purchases of foreign
assets by domestic investors.
Stocks are the value of assets held in a given year (cumulative flows; domestic assets held by
foreigner + foreign assets held domestic agents/GDP)
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Global Markets – Summary
5.3 International transmission of shocks
In theory, global financial markets should be used to decreases risk and smooth consumption
however they are also often blamed for making countries more prone to financial crisis and
amplifying shocks. Openness favors the transmission of shocks from one country to another,
especially for countries rely on foreign financing (Emerging markets).
Capital controls restrict the movement of capital. Goal is to reduce volatile movement of entering
and exiting capital. Administrative capital controls restrict transactions, payments, or transfer of
funds by prohibitions, Market based controls disincentives transactions through high associated
costs. There are multiple impacts of capital controls on inflows:
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Global Markets – Summary
6. Economic growth
Y =eL+ K + A
One of the key implications of the Solow growth model is that countries with similar parameters
but different initial capital stock will grow at different pace.
With rising capital stock, the depreciation also rises. Therefore, increased investment is required
to avoid recession. Intersection of investment and depreciation = steady state growth.
eL and K can be measured directly, A will be inferred based on above mentioned equation.
Knowledge (A) is a function of technology (T) and efficiency (E)
6.2 Inequality
Generally, we distinguish between two times of inequality: income inequality and wealth
inequality. There are two conflicting objectives governments need to trade-off:
1. Preference view: one dollar in the hand of the poorest is worth more than in the hand of
the richest preference for redistribution
2. Efficiency view: inequalities are the outcome of efforts. Efforts need to be rewarded
low taxes and low redistribution.
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Global Markets – Summary
7. Exam Questions Class of 2022
Question 3: Currency appreciating or depreciating - what can central banks do about it.
Arguments in favor or against.
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Global Markets – Summary