Home > CFA L2, macro economics > CFA Economics – Productivity & Foreign Exchange & Interest Rate Parity Relations

CFA Economics – Productivity & Foreign Exchange & Interest Rate Parity Relations

Post 2 on Economics

Study Session 4

Chapters: 14, 15, 16 & 17

Productivity Curve

Productivity curve = Real GDP/Labour Hour (y-axis) vs Capital / Labour Hour (x-axis) for a given level of technology

· Follows law of diminishing returns

· Increase in capital increases productivity i.e. movement along the productivity curve

· Technological advances shifts productivity curve upwards and increases productivity/labour hour for the same level of capital/labour hour

1/3rd rule à 1 % increase in capital = 1/3 % increase in real GDP (assuming constant technology)

Foreign Exchange Parity Relations

Impact of Current Account Deficit on FX

All else constant, a country with a current account deficit experiences currency depreciation and vice versa… why?

· Current account deficit implies Imports are greater than Exports

· Importers sell domestic currency and buy foreign currency to pay for imports

Impact of Capital (or Financial) Account Surplus on FX

All else constant, a country with a capital account surplus experiences currency appreciation and vice versa…why?

· Capital account surplus implies high demand for domestic assets

· Buyers require domestic currency to purchase these assets and sell foreign currency

Official Reserve Account (i.e. Official Settlement Account)

As the name implies, it includes all reserves i.e. gold, foreign exchange, SDRs, etc. Central banks accumulate and drain reserves by intervening in the FX market (China gets the most coverage here!)

Parity Relations (do not hold in the real world, only holds in economics la-la-land!)

1. Purchasing Power Parity (PPP) states that a basket of goods and services should cost the same all over after adjusting for exchange rates…the Economist’s Big Mac Index is proof that PPP does not hold!

2. Relative Purchasing Power Parity states that expected foreign exchange rates in the future is a ratio of inflation rates between the two countries… the higher inflation currency depreciates relatively.

3. Interest Rate Parity states that forward foreign exchange rate i.e. expected future spot rate is a ratio of interest rates between the two countries

4. International Fischer Relation states that the difference between nominal interest rates is approximately equal to the difference in expected inflation rates

I will try to post some examples of parity relations in another post…

Update: I obviously haven’t had a chance to post examples but go read this post on Currency Wars by BBC’s Paul Mason.

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  1. Hristo
    May 10, 2011 at 5:22 PM

    I have a question for you. While this question might appear obvious, the answer to it still eludes me.

    You state that an importer sells domestic currency and buys foreign currency in order to purchase imports. This makes sense.

    However, I’m not clear then how a country ‘earns’ foreign exchange. Because if it is the case that the importer in a given country must pay for imports in the foreign currency, surely it’s the case then that the exporter from that same country receives domestic currency for their exports. Given this, how does a country earn forex?

    Example, Chinese importer sells renminbi, buys dollars to pay for American imports. I assume these dollars are bought through the banking system. Thus the American exporter receives dollars and not renminbi. Therefore it must be the same for Chinese exporter in that it receives renminbi and not dollars for its exporters. Given this, where is foreign exchange earned?

    This confuses me.

    • May 10, 2011 at 5:37 PM

      i’m not sure what you mean by “how a country earns foreign exchange”… i country or more precisely the central bank of a country can accumulate foreign exchange.

      The mechanism is as you explain it: Chinese exporter receives dollars, sells these dollars to buy renminbi whereas a Chinese importer will sell renminbi to buy dollars and pay in dollars.

      The central bank can accumulate foreign exchange reserves because the amount of goods exported is rarely the same as the amount of goods imported (net exports) – Since China exports a whole lot more than it imports, it receives a lot of dollars which are exchanged for renminbi. These dollars are accumulated as FX reserve by the Chinese central bank which then invests in dollar denominated assets.

      hope that helps.

  2. Hristo
    May 11, 2011 at 7:48 PM

    Thanks for taking the time to respond but I’m still confused and I’ll tell you why. Your above explanation is how I would have typically answered the question but I’m noticing a difference between the currency that a Chinese exporter, say, and an American exporter for example has to pay in. Let me explain better:

    Above you say that the Chinese exporter receives dollars for its exports. Fair enough. Thus this is like saying that the American importer of Chinese goods pays the Chinese exporter USD. In other words the American importer does not need renminbi to pay for the imports as it uses dollars.

    Yet, you then say that a Chinese importer must sell renminbi (i assume to a chinese bank) in order to receive dollars so as to pay for US exports to China. So why is it that the US importer uses their currency, the dollar, while the Chinese importer has to use a foreign currency, the dollar.

    By this logic, what would happen if the US was running a trade surplus? Well it wouldn’t end up accumulating renminbi reserves. How could it if it’s receiving dollars for its exports and paying dollars for its imports?

    This is where I’m confused. Why doesn’t the American importer have to sell dollars and buy renminbi to pay for Chinese exports while the Chinese importer has to sell renminbi and buy dollars to pay for US exports? Doesn’t make sense.

  3. Hristo
    May 11, 2011 at 7:55 PM

    China: Pays for imports using USD
    Receives dollars for exports.
    Therefore trade surplus = accumulated dollars.

    Yet,

    US: Pays for imports using dollars (why not renminbi?)
    US: Receives dollars for exports.
    Therefore trade surplus = even more dollars (no accumulation of renminbi)

    Why the mismatch? In your example no side uses renminbi at all. Therefore only China could ever accumulate reserves. US could not, even if running surplus.

    How about Germany and China or Germany and Japan.

  4. Bob
    May 26, 2011 at 2:26 PM

    Oi Takloo where the hell you at mofo? Ma man Hristo wants his goddam answer yo.

  5. January 17, 2014 at 6:26 AM

    Thanks for sharing your info. I truly appreciate your efforts and I will be waiting
    for your next post thank you once again.

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