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EconomicsNotes

Reading13
Whenregardingcurrencies,forexample,USD/EUR.USDispricecurrency,EURisbasecurrency.Ifthecurrency
rateis1.5USD/EUR,thismeansitcosts$1.50topurchase 1.Oralternativelyyoucanbuy$1.50with 1.
Whatevercurrencyyoucurrentlyown/hold,makesurethatthebid/offerratesareinyourbasecurrency.
Hereisanexample:

USD/EUR

Offer

1.501

1.503

Intheaboveexample,theofferratemeansyoucanbuyeurosfordollarsat$1.503per ,andthebidratemeans
youcansell$1.501per .Ifyouarecurrentlyholdingeuros,thenyoumayusetheserates.However,ifyouare
holdingdollarsandwanttoexchangeforeuros,youmusttakethereciprocal,andswitchthebidofferrates.In
otherwords,thebidbecomestheofferandtheofferbecomesthebid.
Hereisanexampleoftheswitch,ifyouweregiventheabovebidofferbuthelddollars:

EUR/USD

Bid

Bid

Offer

0.6653

0.6662

Togetthebid,1/1.503=0.6653.Togettheoffer,1/1.501=0.6662
Bidofferspreadadealerprovidesisusuallywiderthantheinterbankspread.
Bidshownbyadealercantbehigherthantheinterbankoffer,andtheoffershownbyadealercantbe
lowerthanthecurrentinterbankbid.Ifeitheroccurs,thereisanarbitrageopportunity.
Fowardrate:Ff/d=(Sf/d)
Forwardpremium/discount:Ff/dSf/d=(Sf/d)(ifid)
Thedomesticcurrencywilltradeataforwardpremiumonlyiftheforeignriskfreerateexceedsthe
domesticriskfreerate.
Whengivenforwardpoints,dividethemby10,000,thenadd/subtractthemtothespotrate.
Iftherateisoriginally1.5USD/GBP,andisnow1.75USD/GBP,thenthepoundhasappreciated.
AFXswaptransactionconsistsofsimultaneousspotandforwardtransactions,wherethebasecurrencyisbeing
bought(sold)andsold(bought)forward.
Itisstandardpracticetousethemidmarketspotexchangeratefortheswaptransaction.
Thelongerthetermofthecontract,thewiderthebidaskspread.
Whichevercurrencyyoubuy,youarelongthatcurrency.
YouMUSTpaystrongattentiononwhichcurrenciesareflowinginandout.
Redoproblemsonpage517.
Uncoveredinterestrateparitystatesthatthechangeinspotrateovertheinvestmenthorizonshould,onaverage,
equalthedifferentialininterestratesbetweenthetwocountries.Thatis,theexpectedappreciation/depreciation
oftheexchangeratejustoffsetstheyielddifferential,implyingthatthecurrentforwardexchangerateisan
unbiasedpredictorofthefuturespotrate.
%=ifid
Uncoveredparityassumesthatinvestorsareriskneutral.
Coveredinterestrateparityisanoarbitragecondition.
Thereisnoarbitrageconditionthatforcesuncoveredinterestrateparitytohold.
Thecountrywiththehigherinterestrateisexpectedtoseethevalueofitscurrencydepreciate.
Ff/d=whichmeansthatintheory,theforwardexchangeratewillbeanunbiasedforecastofthefuturespot
exchangerateifbothcoveredanduncoveredinterestrateparityhold.
Ifyouhad%=5%,uncoveredinterestrateparitywouldimplythatthedomesticcurrencyisgoingto
appreciateby5%againsttheforeigncurrency.Coveredinterestrateparityimpliesthatthatdomestic
currencymusttradeata5%forwardpremium.
Ifcoveredinterestparityholds,youwillearnthedomesticrate.
RealExchangeRate:qf/d=Sf/d()
AccordingtoPPP,highinflationcountriesshouldseetheircurrenciesdepreciateoverthelongterm.
InternationalFisherEffect:ifid=;alsowrittenasr=i e
TheinternationalFishereffectisbasedonrealinterestrateparityandexantePPP(notabsolutePPP)
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qf/d=f/d+[(rdrf)(df)];essentiallythismeansthattheleveloftherealexchangerateisafunctionofthelong
termequilibriumexchangerate,therealinterestratedifferential,andtherelativeriskpremia.
CGERhasusedathreeprongedapproachtoderivelongrunequilibriumexchangerateassessmentsforboth
developedandemergingmarketcurrencies:
MacroeconomicBalanceApproach:estimateshowmuchexchangeratesneedtoadjustinordertoclose
thegapbetweenthemediumtermexpectationforacountry'scurrentaccountimbalanceandthat
countrysnormal(orsustainable)currentaccountimbalance.
ExternalitySustainabilityApproach:differsfromtheMacroeconomicBalancedApproachbyfocusingon
stocksofoutstandingassetsordebtinthecapitalaccountratherthanoncurrentaccountflows.The
externalsustainabilityapproachcalculatehowmuchexchangerateswouldneedtoadjusttoensurethata
countrysnetforeignassets/GDPratioornetforeignliability/GDPratiostabilizesatsomebenchmark
level.Itfocusesonadjustmentsresultinginlongtermequilibriuminthecapitalaccount.
ReducedFormEconometricModel:seekstoestimatetheequilibriumpaththatacurrencyshouldtake
onthebasisofthetrendsinseveralkeymacroeconomicvariables,suchasacountry'snetforeignasset
position,itstermsoftrade,andrelativeproductivity.Asahybridapproach,thismodelcombineselements
ofboththecurrentandcapitalaccountinasingle,statisticalequation.
Lookatpage541againanddothoseproblems!
FXCarryTradeinvolvestakingonlongpositionsinhighyieldcurrenciesandshortpositionsinlowyield
currencies.
Itisaleveragedposition;investorsborrowinthefundingcurrencyandinvestthefundsinahighyielding
currency.
Carrytradeisbasedonthesuppositionthatuncoveredinterestrateparitydoesnthold.
qL/H=L/H+(iHiL)()(HL);L=lowyieldcurrency,H=highyieldingcurrency,i=nominalrate, e=expected
inflationrate,and=riskpremia.
Thisequationstatesthattherealexchangeratewillrise,relativetoitslongtermequilibriumvalue,when
a)thenominalyieldspreadbetweenthehighandlowyieldmarketrises,b)inflationexpectationsinthe
highyieldmarketdeclinerelativetothelowyieldmarket,and/orc)theriskpremiumdemandedby
investorstoholdtheassetsofthehighyieldmarketdeclinesrelativetothelowyieldmarket.
Acountrywithalargecurrentaccountsurplus(moregoodsexportedthanimported)shouldseethedemandforits
currencyrise,orappreciate.Countrieswithaconsistentcurrentaccountdeficitwillseetheircurrencydepreciate.
Eventually,however,thecurrencystrengthshouldcontributetodeteriorationinthetradecompetitiveness
ofthecountrywiththetradesurplus.
Toreduceunwantedappreciationofitsexchangerate,acountrywouldimposecapitalcontrolstocounteractthe
surgingcapitalinflows.
Correlationsbetweenequityreturnsandexchangeratesareunstableintheshorttermandtendtowardzerointhe
longrun.
MundellFlemingModel
Expansionarymonetarypolicyaffectsgrowth,inpart,byreducinginterestratesandtherebyincreasing
investmentandconsumptionspending.
Expansionaryfiscalpolicyincreasesspending,eitherdirectlyorbyloweringtaxes,andthusoutputinthe
shorttomediumterm.Atthesametime,expansionaryfiscalpolicytypicallyexertsupwardpressureon
interestratesaslargerbudgetdeficitsneedstobefinanced.
Weshouldexpectexpansionarymonetarypolicytoleadtocapitaloutflowsanddownwardpressureonthe
exchangerate,whileexpansionaryfiscalpolicyshouldleadtocapitalinflowsandupwardpressureonthe
exchangerate.
Expansionarymonetarypolicy:
Withflexibleexchangerates:downwardpressureondomesticinterestrateswillinducecapitalto
flowtohigheryieldingmarkets,puttingdownwardpressureonthedomesticcurrency.
Depreciationofthecurrencywillincreasenetexports,reinforcingtheaggregatedemandimpactof
theexpansionarymonetarypolicy.
Withfixedexchangerates:topreventtheexchangeratefromdepreciating,themonetaryauthority
willhavetobuyitsowncurrencyinexchangeforothercurrenciesintheFXmarket.Doingsowill
tightendomesticcreditconditionsandoffsettheintendedexpansionarymonetarypolicy.
Expansionaryfiscalpolicy:
Withflexibleexchangerates:anexpansionaryfiscalpolicywilltendtoexertupwardpressureon
domesticinterestrates,whichwillinturninduceaninflowofcapitalfromloweryieldingmarkets,
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puttingupwardpressureonthedomesticcurrency.Ifcapitalflowsarehighlysensitivetointerest
ratedifferentials,thenthedomesticcurrencywilltendtoappreciatesubstantially.
Withfixedexchangerates:topreventthedomesticcurrencyfromappreciating,themonetary
authoritywillhavetosellitsowncurrencyintheFXmarket.
Arestrictive(expansionary)domesticmonetarypolicyunderfloatingexchangerateswillgiverisetoan
appreciation(depreciation)ofthedomesticcurrency,withagreaterchangeinthecurrencywhencapital
flowsarehighlymobile.Onthefiscalfront,anexpansionary(restrictive)fiscalpolicywillgiverisetoan
appreciation(depreciation)ofthedomesticcurrencyunderconditionsofhighcapitalmobility.
Acombinationofanexpansionaryfiscalpolicyandarestrictivemonetarypolicyisextremely
bullishforacurrencywhencapitalmobilityishigh;likewise,thecombinationofarestrictivefiscal
andanexpansionarymonetarypolicyisbearishforacurrency.
Whencapitalmobilityislow,theimpactofmonetaryandfiscalpolicypolicychangesondomesticinterest
rateswillnotinducemajorchangesincapitalflows.Insuchcases,monetaryandfiscalpolicyeffectson
exchangerateswilloperateprimarilythroughtradeflowsratherthancapitalflows.
Auniformlyrestrictivefiscal/monetarypolicymixwillbebullishforacurrencybecausethispolicy
mixwilltendtoleadtoanimprovementinthetradebalance.Auniformlyexpansionary
fiscal/monetarypolicywillbebearishforacurrencybecausethetradebalanceundersuch
conditionswoulddeteriorate.
TaylorRule:i=rn+ ( *)+ (yy*)
and arealways0.5;theTaylorisanominalrate.

Thisformulawillgiveyoutheoptimalcentralbankrate(ieFedFundsRate)toachievepricestabilityand
maximumsustainableemployment.
Iftherate(i)increases,thisismonetarytightening,andthecurrencywillappreciate.Ifidecreases,
thisismonetaryloosening,andthecurrencywilldepreciate.
Theneutralrealrate,rn,isexpectedtobeconsistentwithgrowthattheeconomy'slongrunpotential
growthratewithstableinflationatthetargetrate, *.Theneutralnominalpolicyrateisequaltothe
neutralrealrateplusthetargetrateofinflation, *.
r=(i )=rn+ ( *)+ (yy*)
qf/d=f/d+()+ [()()]+ [(yd)(yf)](df);Thisstatesthattherealexchangerateisafunctionof
1)Thelevelofthereallongrunequilibriumexchangerate,2)thespreadbetweenthedomesticandforeign
neutralrealrates,3)thespreadbetweentheactualorexpecteddomesticandforeigninflationgaps,4)the
spreadbetweentheactualorexpecteddomesticandforeignoutputgaps,5)therelativesizeofthe
respectivepolicyresponsecoefficients( and ),and6)thedifferencebetweenthedomesticandforeign
riskpremia.
Abovetargetinflationwillleadtomonetarytightening,whichshouldleadtocurrencyappreciation.
Thecentralbankdoesnotcontrolfiscalpolicy,onlymonetarypolicy.
Intheshortrun,expansivefiscalpolicywillmakecurrenciesappreciate,aswellasgovernmentdebtlevelsand
interestratesrise.Inthelongrun,expansivefiscalpolicycanleadtoabuildupofgovernmentdebt,whichwill
temptthegovernmenttomonetizethedebtthroughaccommodativemonetarypolicy.Thiscouldmakethe
currencydepreciate.
Regardingcapitalinflows,pullfactorsrepresentafavorablesetofdevelopmentsthatencouragedoverseascapital
toflowtowardaparticularcountry.Pushfactorsrepresentafavorablesetoffactorsthatemanatesnotfromthe
recipientcountrypersebutratherfromtheprimarysourcesofinternationallymobilecapital,notablytheinvestor
basedinindustrialcountries.Thepursuitoflowinterestratepoliciesinindustrialcountrieshasoftenencouraged
investorsinthosemarketstomovefundsoffshoretoearnhigherreturnsthatcanbeearneddomestically.
PortfolioBalanceApproach:addressestheimpactofacountry'snetforeignasset/liabilityposition.Global
investorsareassumedtoholdadiversifiedportfolioofdomesticandforeignassets,includingbonds.Theirdesired
allocationisassumedtovaryinresponsetochangesinexpectedreturnandriskconsiderations.investorswillhold
acountry'sbondaslongastheyarecompensatedappropriately.Compensationmaycomeintheformofhigher
interestratesand/orhigherriskpremium.
Unsterilizedinterventionwouldexpandthemonetarybaseandencourageshortterminterestratesmovelower.
Thismethodisbestusedwhenthereisnoinflationthreat.Inasterilizedinterventionoperation,authorities
wouldselldomesticsecuritiestotheprivatesectortomopupanyexcessliquiditycreatedbyitsFXintervention
activities.Theendresultwouldbethatthemonetarybaseandthelevelofshortterminterestrateswouldnotbe
alteredbytheinterventionoperation.Usesterilizedinterventionwheninflationrateishigh.
Currencycrisiscatchmostmarketparticipantsbysurprise.
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Ahighlevelofforeignexchangereservesheldbyacountrytypicallydecreasesthelikelihoodofacurrency
crisis.Foreignexchangereservestendtodeclineasacurrencycrisisapproaches.
Broadmoneygrowthinnominalandrealtermstendstorisesharplyinthetwoyearsleadinguptoa
currencycrisis,peakingaround18monthsbeforeacrisishits.Intheperiodleadinguptoacurrencycrisis,
therealexchangerateissubstantiallyhigherthanitsmeanlevelduringtranquilperiods.
Studiesindicatethattherecanbelonglagsbetweenexchangeratechanges,changesinthepricesoftradedgoods
andchangesinthetradebalance.Intheshortrun,exchangeratestendtobemoreresponsivetoinvestmentand
financingdecisions.
EMcountriesarebetterabletoinfluencetheirexchangeratesbecausetheirreservelevelsasaratiotoaverage
dailyFXturnoveraregenerallymuchgreaterthanthoseofDMcountries.Thismeansthatemergingmarketcentral
banksareinabetterpositiontoaffectcurrencysupplyanddemandthatdevelopedmarketcountrieswherethe
ratioisnegligible.

Reading14
Themethodoftakingacountry'sGDPmeasuredinitsowncurrencyandthenmultiplyingbythecurrentexchange
ratetoexpressitinanothercurrencyisnotappropriate.
Aggregatepriceofthestockmarketinacountry:P=GDP
TheGDPgrowthmustdominatethisfunctioninthelongrun.
Therealinterestrateisessentiallythetherealreturnthatconsumer/saversdemandinexchangeforpostponing
consumption.FastergrowthinpotentialGDPmeansthatconsumersexpecttheirrealincometorisemorerapidly.
Thus,higherratesofpotentialGDPgrowthtranslateintohigherrealinterestratesandhigherexpectedrealasset
returns.
AcountrywithhighpotentialGDPislikelytohavehighrealinterestratesandhigherexpected/required
realassetreturns.
Productionfunction:Y=AF(K,L);Y=output,K=capital,L=labor,andA=totalfactorproductivity(TFP).Note
thatanincreaseinTFPimpliesaproportionateincreaseinoutputforanycombinationofinputs.TFPreflectsthe
generallevelofproductivityortechnologyintheeconomy.
TFP=laborproductivitygrowthgrowthincapitaldeepening.
CobbDouglas:F(K,L)=K L1 ;with beingthesharesofoutputpaidbycompaniestocapital.
Marginalproductofcapital(MPK)= Y/K
CobbDouglasexhibitsconstantreturnstoscale,whichmeansthatifallinputsareincreasedatthesame
percentage,thenoutputrisesatthatpercentage.
y=Y/L=A(K/L) (L/L)1 =Ak
Lowercaselettersmeasurevariablesonapercapitabasis.
CobbDouglasexhibitsdiminishingmarginalproductivity.Avalueof closeto0meansdiminishing
marginalreturnstocapitalareverysignificantandtheextraoutputmadepossiblebyadditionalcapital
declinesquicklyascapitalincreases.Incontrast,avalueof closeto1meansthatthenextunitofcapital
increasesoutputalmostasmuchasthepreviousunitofcapital.
CapitalDeepeningisanincreaseinthecapitaltolabor(k)ratio.Itrepresentsamovementalongthe
productionfunction.Theratiowillincreaseaslongasthegrowthrateofcapital(netinvestment)exceeds
thegrowthrateoflabor.
Capitaldeepening=growthinlaborproductivitygrowthinTFP
AnincreaseinTFPcreatesanupwardshiftintheentireproductionfunction.Italsoincreasesthemarginal
productofcapitalrelativetoitsmarginalcost.Thismakesadditionalcapitalinvestmentsprofitable&tends
tomitigatethelimitsimposedongrowthbydiminishingmarginalreturns.Insummary,sustainedgrowthin
percapitaoutputrequiresprogressinTFP.
ImprovementsinpotentialGDPgrowthindevelopedcountriesislargelydrivenbytechnologicalprogress,
whereasemergingcountriescanseevastimprovementsinbothtechnology&capitaldeepening.
GrowthAccountingEquation: Y/Y= A/A+ K/K+(1 ) L/L
istheelasticityofoutputrelativetocapital.

GrowthrateinpotentialGDP=Longtermgrowthrateoflaborforce+longtermgrowthrateinlaborproductivity.
Accesstoresourcesisimportant.But,ownership&productionofnaturalresourcesisnotnecessaryforacountry
toachieveahighlevelofincome.
DutchDisease:currencyappreciation,drivenbyhighresourceexports,makesothersegmentsofthe
economy,particularlymanufacturing,globallyuncompetitive.IfacountryisexperiencinglowGDPgrowth,
highresourceexports,butlowmanufacturingexports,thenthatcountryissufferingfromDutchDisease.
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LaborForce:workingagepopulation(16to64)thatiseitheremployedoravailableforworkbutnotworking.
Populationgrowthmayincreasethegrowthrateoftheoveralleconomy,butithasnoimpactontherateof
increaseinpercapitaGDP.
AnincreaseinthelaborforceparticipationratemayraisethegrowthofpercapitaGDP.
HumanCapitalistheaccumulatedknowledge&skillsofworkers.
ClassicalModel:focusesontheimpactofagrowingpopulationinaworldwithlimitedresources.
Predictsthatinthelongrun,theadoptionofnewtechnologyresultsinalargerpopulationbutnotaricher
population.Thestandardoflivingisconstantovertime.Modelhasbeendisproven.
NeoclassicalModel:Y=AF(K,L)=AK L1 ;objectiveofthismodelistodeterminethelongrungrowthrateof
outputpercapita&relateittoa)thesavings/investmentrate,b)therateofTFP,andc)populationgrowth.
Inthismodelasustainedincreaseininvestmentincreasestheeconomysgrowthrateonlyintheshortrun.
Capitalissubjecttodiminishingmarginalreturns,solongrungrowthdependssolelyonpopulation
growth,progressinTFP,andlaborsshareofincome.Italsoassumesthattheproductionfunctionexhibits
diminishingmarginalproductivitywithrespecttoanyindividualinput.
Growthrateofoutputperworker: y/y= A/A+ k/k
K=sY K;s=thefractionofincomebeingsavedandsY=grossinvestment. =depreciation,and K=

thechangeincapital.
k/k=sY/K n;withn= L/L
SustainableGrowthRateofOutputperCapita(=equilibriumgrowthrateofcapitalperworker):;
with =growthrateofTFP
SustainableGrowthRateofOutput:+n;putintowords,itisthegrowthrateofTFPscaledbylabor
factorshare+growthrateinthelaborforce.
EquilibriumOutputtoCapital:=[+ +n]=
Capitaldeepeningisoccurring,butithasNOeffectonthegrowthrateoftheeconomyoronthe
marginalproductofcapitaloncethesteadystateisreached.OnlygrowthrateofTFP,growthrateof
labor,andachangeinthelaborshareofoutputhaveanimpactonpotentialGDPgrowth.
Anincreaseinthesavingsrate(s)impliesahighercapitaltolaborratio(k)andhigheroutputperworker
(y)becauseahighersavingsrategeneratesmoresaving/investmentateverylevelofoutput.IthasNO
impactonthesteadystategrowthratesofoutput.
Anincreaseinthelaborforcegrowthrate(n)reducestheequilibriumcapitaltolaborratiobecausea
correspondingincreaseinthesteadystategrowthrateofcapitalisrequired.Thisincreasestheslopeofof
thefunction,andlowerstheequilibriumpointofcapitaltoworkerandoutputperworker.
Anincreaseinthedepreciationrate( )hasasimilareffectasthelaborforcegrowthrate.
AnincreaseinthegrowthrateofTFP( )reducesthesteadystatecapitaltolaborratioandoutputper
workerforgivenlevelsoflaborinputandTFP.Thisresultmustinterpretedwithcare.
Suchfactorsass,n,and changethelevelofoutputperworker,butdonotpermanentlychangethegrowth
rateofoutputperworker.Apermanentincreaseinthegrowthrateinoutputperworkercanonlyoccurif
thereisachangeinthegrowthrateof .
Becauseofdiminishingmarginalreturnstocapital,theonlywaytosustaingrowthinpotentialGDPper
capitaisthroughtechnologicalchangeorgrowthinTFP.Thischangeresultsinanupwardshiftinthe
productionfunctiontheeconomyproducesmoregoodsandservicesforanygivenmixoflaborand
capitalinputs.
Growthrateofoutputpercapita(akagrowthrateofpercapitaincome):y/y=+ s(y/k )
y/k=thecurrent(oractual)outputtocapital,and =theequilibriumoutputtocapital.
Thenewgrowthratewilljumpup,butwillreturntothesustainablegrowthrate.
Growthrateofcapitaltolabor:k/k=+s(y/k )
Readpages648652again.
AbsoluteConvergence:developingeconomieswillcatchuptodevelopedeconomiesandmatchthemin
percapitaoutput.TheNeoclassicalmodelimpliesconvergenceofpercapitagrowthratesamongall
countries,butitdoesNOTimplythatthelevelofpercapitaincomewillbethesame;thatis,itdoesntimply
absoluteconvergence.
ConditionalConvergence:meansthatconvergenceisconditionalonthecountrieshavingthesamesaving
rate,populationgrowthrate,andproductionfunction.Iftheseconditionshold,theneoclassicalmodel
impliesconvergencetothesamelevelofpercapitaoutputaswellasthesamesteadystategrowthrate.
Clubconvergence:onlyrichandmiddleincomecountriesthataremembersoftheclubareconvergingto
theincomeleveloftherichestcountriesintheworld.
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Themaincriticismofneoclassicalmodelisthatitprovidesnoquantifiablepredictionoftherateorformof
TFPchange.TFPisexogenous.
EndogenousGrowthTheory:thismodelfocusesonexplainingtechnologicalprogressratherthantreatingitas
exogenous.
Unliketheneoclassicalmodel,therearenodiminishingmarginalreturnstocapitalfortheeconomyasa
wholeintheendogenousgrowthmodels.Increasingthesavingsratepermanentlyincreasestherateof
economicgrowth.
KnowledgeorhumancapitalandR&Dspendingarefactorsofproduction,likecapitalandlabor,andhave
tobepaidforthroughsavings.
R&Dandknowledgecapitalgeneratesbenefitstotheeconomyasawholethatexceedtheprivate
benefittotheindividualcompanymakingtheR&Dinvestment.Thiscancreateapermanently
higherlevelofgrowth.
Savingandinvestmentdecisionscangenerateselfsustaininggrowthatapermanentlyhigherrate.
Endogenousproductionfunction:ye=f(ke)=cke;whereoutputperworker(ye)isproportionaltothestock
ofcapitalperworker(ke),cisthe(constant)marginalproductofcapitalintheeconomy,andthesubscript
edenotestheendogenousgrowthmodel.Thefunctionisastraightline.
Accordingtoendogenousgrowth,thereisnoreasonwhytheincomesofdevelopedanddevelopingcountries
shouldconverge.Developedcountriescangrowasfastastheywant.
Accordingtotheneoclassicalmodelandtheendogenousmodel,openeconomieswillbothexperiencesignificant
improvementsingrowth.
Inwardorientedpoliciesattempttodevelopdomesticindustriesbyrestrictingimports.Thesepolicies
encouragetheproductionofdomesticsubstitutes,despitethefactthatitmaybemorecostlytodoso.
ThesepoliciesresultinpoorGDPgrowthandinefficientindustriesproducinglowqualitygoods.
Outwardorientedpoliciesattempttointegratedomesticindustrieswiththoseoftheglobaleconomy
throughtradeandmakeexportsakeydriverofgrowth.ThesepoliciesresultinhighGDPgrowthand
convergencewithdevelopedcountries.
Allowingforeigndirectinvestment(FDI)willstrengthenacurrency.
Maintainingalowcurrencyexchangerateisapolicyaimedatmaintainingdemandforthecountry'sexports.It
wouldhavelittledirectimpactonthepotentialgrowthrateofaggregatesupply.Itmightboostlongtermcapacity
growthindirectly,however,byencouragingadoptionofleadingedgetechnology.Nonetheless,itwouldnotbe
expectedtobeaspowerfulascapitaldeepeningand/orinvestmentintechnologywhenattemptingtoboostlong
termgrowth.
ArelativelylowlevelofGDPpercapitainacountryislesslikelytoindicateattractiveequityinvestment
opportunities.LowpercapitaGDPsuggeststhatacountrymaylacksufficientindustrialandfinancial
infrastructuretosupportsometypesofindustries.Italsoindicatesthatdomesticpurchasingpowerisrelatively
limited,decreasingthepotentialforhighermargin,domesticallyorientedbusinesses.
Inacountrythathasalowstandardofliving(ieGDPpercapita)&alargeinformalworkforce,thecountry'stax
rateisunlikelytobeanimpedimenttowardsgrowth.

Reading15
Statutes:lawsenactedbylegislativebodies(DoddFrank).
AdministrativeRegulationsorAdministrativeLaw:rulesissuedbygovernmentagenciesorotherregulators.
JudicialLaw:interpretationofcourts.
IndependentRegulators:theirauthoritycomesfromtherecognitionbyagovernmentbodyoragencybutthey
arenotgovernmentagenciesperse.
SelfRegulatingOrganizations(SRO):areprivatenongovernmentalorganizationsthatbothrepresentand
regulatetheirmembers.Theyarenottypicallyfundedbyagovernment.Theyareleastlikelytouseprice
mechanisms.Theytypicallyregulatebehaviourandoftenprovidepublicgoodsintheformofstandards.
SubstantiveLawfocusesontherightandresponsibilitiesofentitiesandrelationshipsamongentities.Awell
developedlegalsystemofsubstantiveandprocedurallawsandrespectforpropertyrightsarelikelytoencourage
growth,notlimitit.
ProceduralLawfocusesontheprotectionandenforcementofthesubstantivelaws.
InformationalFrictions:resultinavarietyofissues,whichregulatorsattempttoaddress.Theseissuesinclude
adverseselection(privateinformationinthehandsofsome,butnotall,marketparticipants,whichaffectsthe
consumptionofgoodsandservices),andmoralhazard(incentiveconflictsthatarisefromthedelegationof
6

decisionmakingtoagentsorfromcontractsthatwillaffectthebehaviorofonepartytothedetrimentoftheother
partytothecontract).
Insidertradingrestrictionsrespondtoinformationalfrictions.
RegulatoryCaptureTheory:isthetheorythatregulationoftenarisestoenhancetheinterestsoftheregulated.
Forexample,regulatoryactionsanddeterminationscanrestrictpotentialcompetitionandcoordinatethechoiceof
rivals.
RegulatoryCompetition:regulatorsmaycompetetoprovidearegulatoryenvironmentdesignedtoattract
certainentities.
RegulatoryArbitrage:regulatorsmayidentifyandusesomeaspectofregulationsthatallowsthemtoexploit
differencesineconomicsubstanceandregulatoryinterpretationorinforeignanddomesticregulatoryregimesto
theirbenefit.
PrudentialSupervision:regulationandmonitoringofthesafetyandsoundnessoffinancialinstitutionsinorder
topromotefinancialstability,reducesystemwiderisks,andprotectcustomersoffinancialinstitutions.
Regulatorytoolsandgovernmentinterventionsinmarketsincludetheuseofpricemechanism,suchastaxesand
subsidies;regulatorymandatesandrestrictionsonbehaviors,includingestablishingrightsandresponsibilities;
provisionofpublicgoods;andpublicfinancingofprivateprojects.
CoaseTheorem:statesthatifanexternalitycanbetradedandtherearenotransactioncosts,thentheallocation
ofpropertyrightswillbeefficientandtheresourceallocationwillnotdependontheinitialassignmentofproperty
rights.
RegulatoryBurden:referstothecostofregulationfortheregulatedentity;thiscostissometimesviewedasthe
privatecostsofregulationorgovernmentburden.
NetRegulatoryBurden:istheprivatecostsofregulationlesstheprivatebenefitsofregulation.
SunsetProvision:isatypeofregulationwhichwouldautomaticallyberemoved,unlesstheregulatortookfurther
action.Theuseofasunsetprovisionwillrequireregulatorstoundertakeanewcostbenefitanalysistocontinue
theregulation.
Acountrywithmorestringentregulationsmayseecapitalflowout.
Blackoutperiodsareestablishedbycompaniesinresponsetoconcernsaboutinsidertrading.TheyareNOTatool
usedbygovernmenttointerveneinthefinancialservicessector
Capitalrequirementsareutilizedbygovernmentregulatorstoreducesystemicriskandfinancialcontagion.