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.