Transcript Economics in Business

6.3 Economics for Business
Unit Slides
UK Versity
Understand the micro-economic
business environment
Definition of micro and
macroeconomics
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
Definition of macroeconomics
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
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.
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.
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
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.
The International
Monetary System
2
Chapter Two
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
10
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: 1875-1914
Interwar Period: 1915-1944
Bretton Woods System: 1945-1972
The Flexible Exchange Rate Regime: 1973-Present
11
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
12
Evolution of the International
Monetary System (contd.)
Classic Gold Standard (1876 - 1913)
•
During this period in most major countries:
1. gold alone is assured of unrestricted coinage
2. two-way convertibility between gold and national currencies at a
stable ratio
3. gold 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
•
•
•
13
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.
14
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
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Evolution of the International
Monetary System (contd.)
• Bretton Woods System (1944 – 1973)
British
pound
German
mark
French
franc
Par
Value
U.S. dollar
Pegged at $35/oz.
Gold
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Evolution of the International
Monetary System (contd.)
Bretton Woods System (1944 – 1973)
• Problem with the system is that U.S. constantly incurred
trade deficits as other countries wanted to maintain US$
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
17
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.
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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.
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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
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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.
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Dollar price per £
(exchange rate)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
Demand
(D)
$1.40
Trade deficit
S
D
Q of £
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Dollar price per £
(exchange rate)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
$1.60
$1.40
Demand
(D)
Dollar depreciates
(flexible regime)
Demand (D*)
D=S
Q of £
23
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.
24
Dollar price per £
(exchange rate)
Fixed versus Flexible
Exchange Rate Regimes
Supply
(S)
Contractionary
policies
(fixed regime)
Demand
(D)
$1.40
Demand (D*)
D* = S
Q of £
25
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
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What Is the Euro (€)?
• The euro is the single currency of the
EMU which was adopted by 11
Member States on 1 January 1999.
• 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)
Euro Conversion Rates
1 Euro is Equal to:
40.3399 BEF
Belgian franc
1.95583 DEM
German mark
166.386 ESP
Spanish peseta
6.55957 FRF
French franc
.787564 IEP
Irish punt
1936.27 ITL
Italian lira
40.3399 LUF
Luxembourg
franc
2.20371 NLG
Dutch guilder
13.7603 ATS
Austrian
schilling
200.482 PTE
Portuguese
escudo markka
5.94573 FIM
Finnish
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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.
 Loss of national monetary and
exchange rate policy independence
 Country-specific asymmetric shocks
can lead to extended recessions
– Approximately equal in terms
of population and GDP
• Price transparency and
competition
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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.
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Analyse the impact of market structures on business organisations
1.3
Market Structures
The collection of factors that determine how
buyers and sellers interact in a market,
• Price change
• Levels of production
• Selling
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 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.
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
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.
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.
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
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.
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.
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.
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.
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.
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.
2.2
• Explain the impact of government policies on
the economy
Government Policies
• 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
• There are currently 224 policies on
GOV.UK
Fiscal Policy & Monetary
• 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 Policy
•
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.
Fiscal Policy
• 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.
Monetary Policy
• 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
• 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.
Income Tax
• 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 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)
• benefits you get from your job
• income from a trust
• dividends from company shares
Income Tax
• You don’t pay tax on things like:
• income from tax-exempt accounts, like
Individual Savings Accounts (ISAs) and
National Savings Certificates
• some state benefits
• premium bond or National Lottery wins
• the first £4,250 of rent you get from a lodger
in your home
Value Added Tax (VAT)
• 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.
• 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)
• 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.
Section 2
• Understand the macro economic environment
in the domestic context
2.1
• Explain determinants of national income
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
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)
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
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
Aggregate Demand (AD)
• AD is the sum of the final expenditure on UK
produced goods and services measured at
current market prices
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
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)
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
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
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
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
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
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
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
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
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
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
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.
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."
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.
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.
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.
Multinational Financial
Management
• Factors that make multinational financial
management different
• Exchange rates and trading
• International monetary system
• International financial markets
• Specific features of multinational financial
management
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 worldwide production and sales.
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.
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
Consider the following exchange rates:
Euro
Swedish krona
U.S. $ to buy
1 Unit
0.8000
0.1000
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).
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.
Calculate the indirect quotations
for euros and kronas.
# of Units of Foreign
Currency per U.S. $
Euro
1.25
Swedish krona
10.00
Euro:
Krona:
1 / 0.8000 = 1.25.
1 / 0.1000 = 10.00.
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.
Calculate the two cross rates
between euros and kronas.
• Cross rate
Euros
Dollars
=
x
Dollar
Krona
= 1.25 x 0.1000
= 0.125 euros/krona.
• Cross rate
Dollars
= Kronasx
Dollar
Euros
= 10.00 x 0.8000
= 8.00 kronas/euro.
Note:
• The two cross rates are reciprocals of
one another.
• They can be calculated by dividing either
the direct or indirect quotations.
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?
Target price = ($1.75)(1.50)=$2.625
Spanish price = ($2.625)(1.25 euros/$)
= € 3.28.
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?
2.0 euros (8.0 kronas/euro) = 16 kronas.
20 - 16 = 4.0 kronas profit.
Dollar profit = 4.0 kronas(0.1000 dollars per
krona) = $0.40.
What is exchange rate risk?
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.
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.
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) = $0.267.
• Strengthening dollar hurts profits from
international sales.
Describe the current and former
international monetary systems.
• The current system is a floating rate system.
• Prior to 1971, a fixed exchange rate system
was in effect.
– The U.S. dollar was tied to gold.
– Other currencies were tied to the dollar.
The European Monetary Union
In 2002, the full implementation of the
“euro” was completed (those still
holding former currencies have 10
years to exchange them at a bank).
The newly formed European Central
Bank now controls the monetary
policy of the EMU.
The 12 Member Nations of the
European Monetary Union
Austria
Germany
Netherlands
Belgium
Ireland
Portugal
Finland
Italy
Spain
France
Luxembourg Greece
What is a convertible currency?
• A currency is convertible when the issuing
country promises to redeem the currency
at current market rates.
• Convertible currencies are traded in world
currency markets.
What problems arise when a firm
operates in a country whose
currency is not convertible?
• It becomes very difficult for multi-national
companies to conduct business because
there is no easy way to take profits out of
the country.
• Often, firms will barter for goods to export
to their home countries.
What is the difference between
spot rates and forward rates?
• A spot rate is the rate applied to buy
currency for immediate delivery.
• A forward rate is the rate applied to buy
currency at some agreed-upon future
date.
• Forward rates are normally reported as
indirect quotations.
When is the forward rate at a
premium to the spot rate?
• If the U.S. dollar buys fewer units of a foreign
currency in the forward than in the spot
market, the foreign currency is selling at a
premium.
• For example, suppose the spot rate is 0.7 £/$
and the forward rate is 0.6 £/$.
• The dollar is expected to depreciate, because
it will buy fewer pounds.
Continued….
Spot rate = 0.7 £/$
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.
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.
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 rate = 1 + rh .
1 + rf
Spot rate
Forward and spot rates are direct quotations.
rh = periodic interest rate in the home country.
rf = periodic interest rate in the foreign country.
1 + rh
Forward rate
=
Spot rate
1 + rf
1.03
Forward rate
= 1.02
0.8000
Forward rate = 0.8078.
If interest rate parity holds, the implied
forward rate, 0.8078, would equal the
observed forward rate, 0.8100; so
parity doesn’t hold.
•
Which 180-day security (U.S. or
Spanish) offers the higher
return?
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.
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...)
• Buy contract today to exchange 1,275 euros in
180 days at forward rate of 0.8100
dollars/euro.
• At end of 180 days, convert euro investment to
dollars:
€1,275 (0.8100 $/€) = $1,032.75.
• Calculate the rate of return:
$32.75/$1,000 = 3.275% per 180 days
= 6.55% per year.
(More...)
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?
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.
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.
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.
Ph = Pf(Spot rate),
or
Spot rate = Ph/Pf.
If grapefruit juice costs
$2.00/liter in the U.S. and
purchasing power parity holds,
what is price in Spain?
Spot rate = Ph/Pf.
$0.8000= $2.00/Pf
Pf = $2.00/$0.8000
= 2.5 euros.
Do interest rate and purchasing power
parity hold exactly at any point in time?
What impact does relative
inflation have on interest rates
and exchange rates?
• 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.
Describe the international money and
capital markets.
• 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.
•
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.
International Cash Management
• Distances are greater.
• Access to more markets for loans and for
temporary investments.
• Cash is often denominated in different
currencies.
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.
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.
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.
National Income
National Income Accounting
122
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.
123
Factor Market
Product Market
Factor services
Goods & services
Real Flow
Factor Owners
Consumers
Firm
Money Flow
Factor Income
Cost
Revenue
Expenditure
The flow of economic activities in a 2-sector economy
124
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
125
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
126
Real GNP & Nominal GNP
& Per capita GNP
• Real GNP=(Nominal GNP/GNP Deflator)*100
• Per capita GNP = GNP / Population size
127
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
128
Expenditure Approach
C+I+G+X-M
Factor Income- Factor Income
from abroad paid abroad

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
 Output Approach
Income Approach
 W+I+R+P
129
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
130
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 =
131
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
132
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
133
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
• Government Expenditure (G)
at market prices
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
134
Items excluded from National
Income Accounting
• Second-hand goods
• Intermediate goods
• Non-marketed goods / services
Volunteer work / Housework
• Unreported / Illegal market transactions
135
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
136
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
137
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
138
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
139
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
140
Calculating a Price Index
Item
Expenditure Weight
1991
Prices
1991
Price
Relatives
1991
Prices Price
1992 Relatives
1992
Transport
1000
10
15
100
15
Clothing
2000
20
100
100
100 100
Housing
3000
30
500
100
650 130
Food
4000
40
200
100
220 110
100
141
Calculating a Price Index (cont’d)
• Price Index in 1991
=0.1*100+0.2*100+0.3*100+0.4*100
=100
• Price Index in 1992
=
=
• The general price level in 1992 has increased by
%
• Only persistent increase in the price indices
implies inflation
142
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.
143
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
Year
CPI Nominal Real income
income
1991
90
7650
1992
Base year
1993
100
8820
105
9555
8500
=(7650/90)*100
8820
=
9100
=
144
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
145
Implicit GNP Deflator
To measure inflation, this is a better indicator as
it has a wider coverage of commodities
Year GNP deflator Inflation Rate
between ….
1990
90
1991
100
1992
121
1991 &1992
[(121-100)/100]*100%
= 21%
146
Unemployment
• Working Population OR Labour Force
Working Population=Employed+Unemployed+Self-employed
• Un-employment Rate
=(Unemployed/Labour Force)*100%
• Under-employment Rate
147
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
148
C
C
C
Y
C
Y
I
C=f(Y)
Y
C=a
C=a+cY
I=f(Y)
I=I*
I=I*+iY
I
Y
Y
Y
C=a+c’Y
C=c*Y
149