1.

Absolute Advantage
The differentiation between the varying abilities of companies and nations to produce
goods efficiently is the basis for the concept of absolute advantage. Absolute advantage looks
at the efficiency of producing a single product. This analysis helps countries avoid the
production of products that would yield little or no demand, leading to losses. A country’s
absolute advantage, or disadvantage, in a particular industry, can play an important role in the
types of goods it chooses to produce

As an example, if Japan and Italy can both produce automobiles, but Italy can produce
sports cars of a higher quality and at a faster rate with greater profit, then Italy is said to have
an absolute advantage in that particular industry. In this example, Japan may be better served
to devote the limited resources and manpower to another industry or other types of vehicles,
such as electric cars, in which it may enjoy an absolute advantage, rather than trying to
compete with Italy's efficiency.

Comparative Advantage
Comparative advantage takes a more holistic view, with the perspective that a country
or business has the resources to produce a variety of goods. The opportunity cost of a given
option is equal to the forfeited benefits that could have been achieved by choosing an
available alternative in comparison. In general, when the profit from two products is
identified, analysts would calculate the opportunity cost of choosing one option over the
other.

For example, assume that China has enough resources to produce either smartphones
or computers. China can produce 10 computers or 10 smartphones. Computers generate a
higher profit. Therefore, the opportunity cost is the difference in value lost from producing a
smartphone rather than a computer. If China earns $100 for a computer and $50 for a
smartphone then the opportunity cost is $50. If China has to choose between producing
computers over smartphones it will select computers.

2. TRADE

Trade involves the transfer of goods or services from one person or entity to another,

often in exchange for money. Economists refer to a system or network that allows trade as
a market.

The "fair trade" movement, also known as the "trade justice" movement, promotes the
use of labour, environmental and social standards for the production of commodities,
particularly those exported from the Third and Second Worlds to the First World. Such ideas
have also sparked a debate on whether trade itself should be codified as a human right

International trade, which is governed by the World Trade Organization, can be

restricted by both tariff and non-tariff barriers. International trade is usually regulated by
governmental quotas and restrictions, and often taxed by tariffs. Tariffs are usually on
imports, but sometimes countries may impose export tariffs or subsidies. Non-tariff
barriers include Sanitary and Phytosanitary rules, labeling requirements and food safety
regulations. All of these are called trade barriers.

Trade sanctions against a specific country are sometimes imposed, in order to punish

that country for some action. An embargo, a severe form of externally imposed isolation, is a
blockade of all trade by one country on another. For example, the United States has had
an embargo against Cuba for over 40 years.

FACTORS THAT INFLUENCE TRADE

Changes in Tastes

The terms of trade of a country may also be affected by the changes in tastes. If tastes
or preferences of the people in country A shift from the product Y of country B to its own
product X, the terms of trade will become favourable to country A. 

Changes in Factor Endowments

If there is an increase in the supply of labour in country A, specialising in the

production of labour-intensive commodity cloth, while factor endowments in country B
remain unchanged, the fall in labour cost will lower the price of cloth. Consequently, more
quantity of cloth will be offered by country A for the same quantity of steel resulting in the
terms of trade becoming unfavourable to A. If labour becomes scarcer in this country, the
terms of trade are likely to become favourable for it

Changes in Technology

The terms of trade of a country get affected also by the changes in techniques of
production. As there is technological improvement in the home country, say A, there is rise in
productivity and/or a fall in the cost of producing exportable commodity, say cloth. If the
technological progress is labour-saving in this labour-intensive export sector (cloth industry)
there will be worsening of the terms of trade as the offer curve of country A will shift to the
right. 

ROLE OF THE GOV

They must set international trade policy, cannot be done by the private sector. The
purpose of it in broad strokes is first to maintain safety, next is to regulate the trade to ensure
it benefits the nation, and play a role in the market to facilitate positive trade balances while
promoting the sale of products. It must protect intellectual property and patents.

3. GLOBALISATION

Globalization or globalisation is the process of interaction and integration among

people, companies, and governments worldwide. As a complex and multifaceted
phenomenon, globalization is considered by some as a form of capitalist expansion which
entails the integration of local and national economies into a global, unregulated market
economy
Economically, globalization involves goods, services, the economic resources of capital,
technology, and data. Also, the expansions of global markets liberalize the economic
 activities of the exchange of goods and funds. Removal of cross-border trade barriers has
made formation of global markets more feasible.

4. FACTORS OF PRODUCTION

Land, labor, and capital as factors of production were originally identified by the early
political economists such as Adam Smith, David Ricardo, and Karl Marx. Today, capital and
labor remain the two primary inputs for the productive processes and the generation of profits
by a business.

In economics, capital consists of assets that can enhance one's power to perform

economically useful work. For example, in a fundamental sense a stone or an arrow is capital
for a hunter-gatherer who can use it as a hunting instrument, while roads are capital for
inhabitants of a city.As a factor of production, capital refers to the purchase of goods
made with money in production. For example, a tractor purchased for farming is
capital. Along the same lines, desks and chairs used in an office are also capital.

Labor refers to the effort expended by an individual to bring a product or service to the
market. Again, it can take on various forms. For example, the construction worker at a
hotel site is part of labor as is the waiter who serves guests or the receptionist who
enrolls them into the hotel.

In economics, total-factor productivity (TFP), also called multi-factor productivity, is

usually measured as the ratio of aggregate output (e.g., GDP) to aggregate inputs Under some
simplifications about the production technology, growth in TFP becomes the portion of
growth in output not explained by growth in traditionally measured inputs of labour and
capital used in production.TFP is calculated by dividing output by the weighted average of
labour and capital input, with the standard weighting of 0.7 for labour and 0.3 for
capital. Total factor productivity is a measure of economic efficiency and accounts for part of
the differences in cross-country per-capita income.The rate of TFP growth is calculated by
subtracting growth rates of labor and capital inputs from the growth rate of output.

The production operations of any business combine two factor inputs:

 Labour – i.e. management, employees (full-time, part-time, temporary etc)

 Capital – i.e. plant & machinery, IT systems, buildings, vehicles, offices

The relatively importance of labour and capital to a specific business can be described
broadly in terms of their "intensity" (or to put it another way, significance).

 Labour-intensive production relies mainly on labour

 Capital-intensive production relies mainly on capital

Sounds simple! Some examples will help reinforce the point:

Labour intensive
  Food processing (e.g. ready meals)
 Hotels & restaurants
 Fruit farming / picking
 Hairdressing & other personal services
 Coal mining

Capital intensive

 Oil extraction & refining

 Car manufacturing
 Web hosting
 Intensive arable farming
 Transport (airports, railways etc)

MOVEMENT OF CAPITAL

The aim of liberalisation is to enable integrated, open, and efficient financial markets. This is
seen in the Europe Single Market as a condition essential to guarantte economic inetgration
between member states. The market is intended to be conducive to increased competition,
increased specialisation, larger economies of scale, allowing goods and factors of
production to move to the area where they are most valued, thus improving the efficiency of
the allocation of resources. It is also intended to drive economic integration whereby the once
separate economies of the member states become integrated within a single EU-wide
economy. Half the trade in goods within the EU is covered by legislation harmonised by the
EU. The creation of the internal market as a seamless, single market is an ongoing process,
with the integration of the service industry still containing gaps. It also has an increasing
international element, with the market represented as one in international trade negotiations.

5. What Is the Balassa-Samuelson Effect?

The Balassa-Samuelson effect states that productivity differences between the production of
tradable goods in different countries 1) explain large observed differences in wages and in the
price of services and between purchasing power parity and currency exchange rates, and 2) it
means that the currencies of countries with higher productivity will appear to be undervalued
in terms of exchange rates; this gap will increase with higher incomes. 

The Balassa-Samuelson effect suggests that an increase in wages in the tradable goods sector
of an emerging economy will also lead to higher wages in the non-tradable (service) sector of
the economy. The accompanying increase in prices makes inflation rates higher in faster-
growing economies than it is in slow-growing, developed economies.
4+5 Value Chain-globalization

The term value chain refers to the process in which businesses receive raw materials, add
value to them through production, manufacturing, and other processes to create a finished
product, and then sell the finished product to consumers.

The idea of a value chain was pioneered by American academic Michael Porter in his 1985
book "Competitive Advantage: Creating and Sustaining Superior Performance." He used the
idea to show how companies add value to their raw materials to produce products that are
eventually sold to the public.

The concept of the value chain comes from a business management perspective. Value chain
managers look for opportunities to add value to the business. They may look for ways to cut
back on shortages, prepare product plans, and work with others in the chain to add value to
the customer.

There are five steps in the value chain process. They give a company the ability to create
value exceeding the cost of providing its goods or service to customers. Maximizing the
activities in any one of the five steps allows a company to have a competitive advantage over
competitors in its industry. The five steps or activities are:

 Inbound Logistics: Receiving, warehousing, and inventory control.

 Operations: Value-creating activities that transform inputs into products, such as
assembly and manufacturing.
 Outbound Logistics: Activities required to get a finished product to a customer. These
include warehousing, inventory management, order fulfillment, and shipping.
 Marketing and Sales: Activities associated with getting a buyer to purchase a product.
 Service: Activities that maintain and enhance a product's value, such as customer
support and warranty service.

In order to help streamline the five primary steps, Porter says the value chain also requires a
series of support activities. These include procurement, technology development, human
resource management, and infrastructure.

A profitable value chain requires connections between what consumers demand and what a
company produces. Simply put, the connection or sequence in the value chain originates from
the customer's request, moves through the value chain process, and finally ends at the
finished product. Value chains place a great amount of focus on things such as product
testing, innovation, research and development, and marketing.

BETY:

When value chain was established, it was an increase in global trade. (low tariffs of foreign
trade). Every country adds value to their chain production. If your country is situated in the
chain, you can import and export.
Specialization leads these countries to add value to their chain and after that to export the
product.

Productivity- increased due to the addition of technology => lower unemployment

High risks:

- If something happens, everybody is affected (if China can’t produce the cables
anymore, Germans can’t produce electric products)
- Risks of global crisis (like 2008)- nobody could intervene to stop it
- Domestic issues on prices

Advantages:

- Intermediates trade of goods (engine exported from Poland to Italy with materials
from India is an intermediate good)
- High production but spread in many countries of the chain for efficiency
- At the beginning it was beneficial for everyone.

6. WTO

The World Trade Organization (WTO) is an intergovernmental organization that is concerned

with the regulation of international trade between nations. The WTO officially commenced
on 1 January 1995 under the Marrakesh Agreement, signed by 123 nations on 15 April 1994,
replacing the General Agreement on Tariffs and Trade (GATT), which commenced in 1948.
It is the largest international economic organization in the world.

The WTO deals with regulation of trade in goods, services and intellectual property between
participating countries by providing a framework for negotiating trade agreements and a
dispute resolution process aimed at enforcing participants' adherence to WTO agreements,
which are signed by representatives of member governments and ratified by their
parliaments. The WTO prohibits discrimination between trading partners, but provides
exceptions for environmental protection, national security, and other important goals. Trade-
related disputes are resolved by independent judges at the WTO through a dispute resolution
process.

The WTO establishes a framework for trade policies; it does not define or specify outcomes.
That is, it is concerned with setting the rules of the trade policy games. Five principles are of
particular importance in understanding both the pre-1994 GATT and the WTO:

 Non-discrimination.

It has two major components: the most favoured nation (MFN) rule, and the national
treatment policy. Both are embedded in the main WTO rules on goods, services, and
intellectual property, but their precise scope and nature differ across these areas. The MFN
rule requires that a WTO member must apply the same conditions on all trade with other
WTO members, i.e. a WTO member has to grant the most favourable conditions under which
it allows trade in a certain product type to all other WTO members. "Grant someone a
special favour and you have to do the same for all other WTO members." National treatment
means that imported goods should be treated no less favourably than domestically produced
goods (at least after the foreign goods have entered the market) and was introduced to tackle
non-tariff barriers to trade (e.g. technical standards, security standards et al. discriminating
against imported goods).

 Freer trade: gradually, through negotiation.

Lowering trade barriers is one of the most obvious means of encouraging trade. The
barriers concerned include customs duties (or tariffs) and measures such as import bans or
quotas that restrict quantities selectively. From time to time other issues such as red tape and
exchange rate policies have also been discussed.

Since GATT’s creation in 1947-48 there have been eight rounds of trade negotiations. A
ninth round, under the Doha Development Agenda, is now underway. At first these focused
on lowering tariffs (customs duties) on imported goods. As a result of the negotiations, by the
mid-1990s industrial countries’ tariff rates on industrial goods had fallen steadily to less than
4%.But by the 1980s, the negotiations had expanded to cover non-tariff barriers on goods,
and to the new areas such as services and intellectual property.Opening markets can be
beneficial, but it also requires adjustment. The WTO agreements allow countries to introduce
changes gradually, through “progressive liberalization”. Developing countries are usually
given longer to fulfil their obligations.

 Promoting fair competition

The WTO is sometimes described as a “free trade” institution, but that is not entirely
accurate. The system does allow tariffs and, in limited circumstances, other forms of
protection. More accurately, it is a system of rules dedicated to open, fair and undistorted
competition.

The rules on non-discrimination — MFN and national treatment — are designed to secure
fair conditions of trade. So too are those on dumping (exporting at below cost to gain market
share) and subsidies. The issues are complex, and the rules try to establish what is fair or
unfair, and how governments can respond, in particular by charging additional import duties
calculated to compensate for damage caused by unfair trade.

Many of the other WTO agreements aim to support fair competition: in agriculture,
intellectual property, services, for example. The agreement on government procurement (a
“plurilateral” agreement because it is signed by only a few WTO members) extends
competition rules to purchases by thousands of government entities in many countries. And
so on.

 Predictability: through binding and transparency

 Sometimes, promising not to raise a trade barrier can be as important as lowering one,
because the promise gives businesses a clearer view of their future opportunities. With
stability and predictability, investment is encouraged, jobs are created and consumers can
fully enjoy the benefits of competition — choice and lower prices. The multilateral trading
system is an attempt by governments to make the business environment stable and
predictable.

In the WTO, when countries agree to open their markets for goods or services, they
“bind” their commitments. For goods, these bindings amount to ceilings on customs tariff
rates. Sometimes countries tax imports at rates that are lower than the bound rates. Frequently
this is the case in developing countries. In developed countries the rates actually charged and
the bound rates tend to be the same.

A country can change its bindings, but only after negotiating with its trading partners,
which could mean compensating them for loss of trade. One of the achievements of the
Uruguay Round of multilateral trade talks was to increase the amount of trade under binding
commitments. In agriculture, 100% of products now have bound tariffs. The result of all this:
a substantially higher degree of market security for traders and investors.

 Encouraging development and economic reform

The WTO system contributes to development. On the other hand, developing countries
need flexibility in the time they take to implement the system’s agreements. And the
agreements themselves inherit the earlier provisions of GATT that allow for special
assistance and trade concessions for developing countries.

Over three quarters of WTO members are developing countries and countries in transition
to market economies. During the seven and a half years of the Uruguay Round, over 60 of
these countries implemented trade liberalization programmes autonomously. At the same
time, developing countries and transition economies were much more active and influential in
the Uruguay Round negotiations than in any previous round, and they are even more so in the
current Doha Development Agenda.

At the end of the Uruguay Round, developing countries were prepared to take on most of
the obligations that are required of developed countries. But the agreements did give them
transition periods to adjust to the more unfamiliar and, perhaps, difficult WTO provisions —
particularly so for the poorest, “least-developed” countries.

7. Philips curve

The Phillips curve is an economic concept developed by A. W. Phillips stating that

inflation and unemployment have a stable and inverse relationship. The theory claims that
with economic growth comes inflation, which in turn should lead to more jobs and less
unemployment. However, the original concept has been somewhat disproven empirically due
to the occurrence of stagflation in the 1970s, when there were high levels of both inflation
and unemployment.
 Understanding the Phillips Curve

The concept behind the Phillips curve states the change in unemployment within an
economy has a predictable effect on price inflation. The inverse relationship between
unemployment and inflation is depicted as a downward sloping, concave curve, with inflation
on the Y-axis and unemployment on the X-axis. Increasing inflation decreases
unemployment, and vice versa. Alternatively, a focus on decreasing unemployment also
increases inflation, and vice versa.

The belief in the 1960s was that any fiscal stimulus would increase aggregate demand and
initiate the following effects. Labor demand increases, the pool of unemployed workers
subsequently decreases and companies increase wages to compete and attract a smaller talent
pool. The corporate cost of wages increases and companies pass along those costs to
consumers in the form of price increases.

This belief system caused many governments to adopt a "stop-go" strategy where a target
rate of inflation was established, and fiscal and monetary policies were used to expand or
contract the economy to achieve the target rate. However, the stable trade-off between
inflation and unemployment broke down in the 1970s with the rise of stagflation, calling into
question the validity of the Phillips curve.

The Phillips Curve and Stagflation

Stagflation occurs when an economy experiences stagnant economic growth, high

unemployment and high price inflation. This scenario, of course, directly contradicts the
theory behind the Philips curve. The United States never experienced stagflation until the
1970s, when rising unemployment did not coincide with declining inflation. Between 1973
and 1975, the U.S. economy posted six consecutive quarters of declining GDP and at the
same time tripled its inflation.

Expectations and the Long Run Phillips Curve

The phenomenon of stagflation and the break down in the Phillips curve led economists
to look more deeply at the role of expectations in the relationship between unemployment and
inflation. Because workers and consumers can adapt their expectations about future inflation
rates based on current rates of inflation and unemployment, the inverse relationship between
inflation and unemployment could only hold over the short run.

When the central bank increases inflation in order to push unemployment lower, it may
cause an initial shift along the short run Phillips curve, but as worker and consumer
expectations about inflation adapt to the new environment, in the long run the the Phillips
curve itself can shift outward. This is especially thought to be the case around the natural rate
of unemployment or NAIRU (Non Accelerating Inflation Rate of Unemployment), which
essentially represents the normal rate of frictional and institutional unemployment in the
economy. So in the long run, if expectations can adapt to changes in inflation rates then the
long run Phillips curve resembles and vertical line at the NAIRU; monetary policy simply
raises or lowers the inflation rate after market expectations have worked themselves out.
 In the period of stagflation, workers and consumers may even begin to rationally expect
inflation rates to increase as soon as they become aware that the monetary authority plans to
embark on expansionary monetary policy. This can cause an outward shift in the short run
Phillips curve even before the expansionary monetary policy has been carried out, so that
even in the short run the policy has little effect on lowering unemployment, and in effect the
short run Phillips curve also becomes a vertical line at the NAIRU.

Key Takeaways

The Phillips curve states that inflation and unemployment have an inverse relationship.
Higher inflation is associated with lower unemployment and vice versa.

The Phillips curve was a concept used to guide macroeconomic policy in the 20th
century, but was called into question by the stagflation of the 1970's.

Understanding the Phillips curve in light of consumer and worker expectations, shows
that the relationship between inflation and unemployment may not hold in the long run, or
even potentially in the short run.

Balance of Payments in the context of trade =Balance of payments statistics (BOP)

cover an economy’s transactions with the rest of the world. Among those trade in goods and
services plays a prominent role. The current account of the balance of payments shows an
economy’s trade in goods and services by residents with non-residents as separate
components. It records gross transactions, i.e. exports (credit) and imports (debit), and the
resulting balance (credit minus debit).:

I.CA(Current Acc)- has four components:

1. Trade:Trade in goods and services is the largest component of the current account. A trade
deficit alone is enough to create a current account deficit.A deficit in goods in services is
large enough to offset any surplus in net income, direct transfers, and asset income.

2.Net Income:This is income received by the country’s residents minus income paid to
foreigners.The country’s residents receive income from two sources.The first is earned on
foreign assets owned by a nation's residents and businesses.That includes interest and
dividends earned on investments held overseas.The second source is income earned by a
country's residents who work overseas.

3.Direct Transfers:This includes remittances from workers to their home country.

4.Asset Income:This is composed of increases or decreases in assets like bank deposits,
central bank and government reserves, securities, and real estate.For example, if a country’s
assets do well,asset income will be high.;

II.CA(CapitalAcc):In international macroeconomics,is the part of the balance of payments

which records all transactions made between entities in one country with entities in the rest of
the world. These transactions consist of imports and exports of goods, services, capital, and
as transfer payments such as foreign aid and remittances.The capital account, on a national
level, represents the balance of payments for a country.The capital account keeps track of the
net change in a nation's assets and liabilities during a year.The capital account's balance will
inform economists whether the country is a net importer or net exporter of capital.

III.FA(FinancialAcc):
Flows from Gov&Citizens working abroad
->FDI(companies buying equity,local ground;local term investments in producing or business
activity.
->PortfolioInvestments:short term.
->ReserveAssets(hold by Central Bank-IntMonetaryFund and other investments).

A special-purpose entity is a legal entity (usually a limited company of some type or,
sometimes, a limited partnership) created to fulfill narrow,specific or temporary
objectives.SPEs are typically used by companies to isolate the firm from financial risk.A
formal definition is "The Special Purpose Entity is a fenced organization having limited
predefined purposes and a legal personality". Normally a company will transfer assets to the
SPE for management or use the SPE to finance a large project thereby achieving a narrow set
of goals without putting the entire firm at risk.SPEs are also commonly used in complex
financings to separate different layers of equity infusion.Commonly created and registered in
tax havens,SPEs allow tax avoidance strategies unavailable in the home district.Round-
tripping is one such strategy.In addition,they are commonly used to own a single asset and
associated permits and contract rights (such as an apartment building or a power plant),to
allow for easier transfer of that asset.They are an integral part of public private partnerships
common throughout Europe which rely on a project finance type structure.A special-purpose
entity may be owned by one or more other entities and certain jurisdictions may require
ownership by certain parties in specific percentages.Often it is important that the SPE is not
owned by the entity on whose behalf the SPE is being set up (the sponsor).For example,in the
context of a loan securitization, if the SPE securitization vehicle were owned or controlled by
the bank whose loans were to be secured,the SPE would be consolidated with the rest of the
bank's group for regulatory, accounting, and bankruptcy purposes, which would defeat the
point of the securitization.Therefore,many SPEs are set up as 'orphan' companies with their
shares settled on charitable trust and with professional directors provided by an
administration company to ensure that there is no connection with the sponsor.

Loans for security.

A secured loan is a loan in which the borrower pledges some asset (e.g. a car or property) as
collateral for the loan,which then becomes a secured debt owed to the creditor who gives the
loan.The debt is thus secured against the collateral and if the borrower defaults,the creditor
takes possession of the asset used as collateral and may sell it to regain some or all of the
amount originally loaned to the borrower.An example is the foreclosure of a home.From the
creditor's perspective, that is a category of debt in which a lender has been granted a portion
of the bundle of rights to specified property.If the sale of the collateral does not raise enough
money to pay off the debt, the creditor can often obtain a deficiency judgment against the
borrower for the remaining amount.The opposite of secured debt/loan is unsecured debt,
which is not connected to any specific piece of property.Instead,the creditor may satisfy the
debt only against the borrower,rather than the borrower's collateral and the
borrower.Generally speaking, secured debt may attract lower interest rates than unsecured
debt because of the added security for the lender;however, credit risk and expected returns for
the lender are also factors affecting rates.

The term secured loan is used in the United Kingdom, but the United States more commonly
uses secured debt.There are two purposes for a loan secured by debt.In the first purpose, by
extending the loan through securing the debt,the creditor is relieved of most of the financial
risks involved because it allows the creditor to take ownership of the property in the event
that the debt is not properly repaid.In exchange, this permits the second purpose where the
debtors may receive loans on more favorable terms than that available for unsecured debt,or
to be extended credit under circumstances when credit under terms of unsecured debt would
not be extended at all.The creditor may offer a loan with attractive interest rates and
repayment periods for the secured debt.
Types:A mortgage loan is a secured loan in which the collateral is property, such as a
home;Anonrecourse loan is a secured loan where the collateral is the only security or claim
the creditor has against the borrower,and the creditor has no further recourse against the
borrower for any deficiency remaining after foreclosure against the property;Aforeclosure is
a legal process in which mortgaged property is sold to pay the debt of the defaulting
borrower;Arepossession is a process in which property, such as a car, is taken back by the
creditor when the borrower does not make payments due on the property.Depending on the
jurisdiction,it may or may not require a court order.

CreditDefaultSwap=A credit default swap (CDS) is a financial derivative or contract that

allows an investor to "swap" or offset his or her credit risk with that of another investor.For
example, if a lender is worried that a borrower is going to default on a loan,the lender could
use a CDS to offset or swap that risk.To swap the risk of default, the lender buys a CDS from
another investor who agrees to reimburse the lender in the case the borrower defaults. Most
CDS will require an ongoing premium payment to maintain the contract, which is like an
insurance policy.A credit default swap is designed to transfer the credit exposure of fixed
income products between two or more parties.In a CDS, the buyer of the swap makes
payments to the swap's seller until the maturity date of a contract.In return,the seller agrees
that-in the event that the debt issuer (borrower) defaults or experiences another credit event-
the seller will pay the buyer the security's value as well as all interest payments that would
have been paid between that time and the security's maturity date.A credit default swap is the
most common form of credit derivative and may involve municipal bonds, emerging market
bonds, mortgage-backed securities or corporate bonds.A credit default swap is also often
referred to as a credit derivative contract.

The global financial crisis (GFC) refers to the period of extreme stress in global financial
markets and banking systems between mid 2007 and early 2009.During the GFC,a downturn
in the US housing market was a catalyst for a financial crisis that spread from the United
States to the rest of the world through linkages in the global financial system.Many banks
around the world incurred large losses and relied on government support to avoid
bankruptcy.Millions of people lost their jobs as the major advanced economies experienced
their deepest recessions since the Great Depression in the 1930s.Recovery from the crisis was
also much slower than past recessions that were not associated with a financial crisis.Failure
of financial firms, panic in financial markets->Financial stresses peaked following the failure
of the US financial firm Lehman Brothers in September 2008. Together with the failure or
near failure of a range of other financial firms around that time,this triggered a panic in
financial markets globally.Investors began pulling their money out of banks and investment
funds around the world as they did not know who might be next to fail and how exposed each
institution was to subprime and other distressed loans.Consequently, financial markets
became dysfunctional as everyone tried to sell at the same time and many institutions wanting
new financing could not obtain it.Businesses also became much less willing to invest and
households less willing to spend as confidence collapsed.As a result,the United States and
some other economies fell into their deepest recessions since the Great Depression.

 Exchange rate regimes

An exchange rate regime is the system that a country’s monetary authority, -generally the
central bank-, adopts to establish the exchange rate of its own currency against other
currencies. Each country is free to adopt the exchange-rate regime that it considers optimal,
and will do so using mostly monetary and sometimes even fiscal policies. There are two main
types: Free float and Fixed/pegged exchange rates. Also, there are alternative systems:
managed/dirty float, target zones, “Crawling-peg” and no national currency (dollarization).

A fixed exchange rate is a regime applied by a government or central bank ties the country's
currency official exchange rate to another country's currency or the price of gold. The
purpose of a fixed exchange rate system is to keep a currency's value within a narrow
band.Fixed rates provide greater certainty for exporters and importers. Fixed rates also help
the government maintain low inflation, which, in the long run, keep the interest rates down
and stimulates trade and investment. Developing economies often use a fixed-rate system to
limit speculation and provide a stable system. A stable system allows importers, exporters,
and investors to plan without worrying about currency moves.

However, a fixed-rate system limits a central bank's ability to adjust interest rates as needed
for economic growth. A fixed-rate system also prevents market adjustments when a currency
becomes over or undervalued. Effective management of a fixed-rate system also requires a
large pool of reserves to support the currency when it is under pressure.

A floating exchange rate is a regime where the currency price of a nation is set by the forex
market based on supply and demand relative to other currencies. This is in contrast to a fixed
exchange rate.

Floating exchange rate systems mean long-term currency price changes reflect relative
economic strength and interest rate differentials between countries. Short-term moves in a
floating exchange rate currency reflect speculation, rumors, disasters, and everyday supply
and demand for the currency. If supply outstrips demand that currency will fall, and if
demand outstrips supply that currency will rise. A currency that is too high or too low could
affect the nation's economy negatively, affecting trade and the ability to pay debts.Flexible
exchange rate and trade presents an atmosphere of uncertainty and confusion in trade and
investment. Susceptibility to uncertainty is greater as soon as exchange rate fluctuates
freely.By nature, flexible exchange rate is inflationary. As soon as the exchange rate falls,
automatically, consequent upon the Balance of payment deficit, import goods become
expensive.

Currency Board: Strict exchange rate regime supported by a monetary system based on
legislative commitment to exchange domestic currency for a specified foreign currency at a
fixed rate. In this regime, the domestic currency is backed 100% by a foreign currency.

Currency Union Dollarization: In this regime, one other country’s currency is used as the
only legal tender or the country belongs to a currency union in which the same legal tender is
shared by all members of the union. Under “dollarization” the country in question completely
gives up monetary independence and monetary policy is run by the advanced nation’s central
bank.

Crawling Peg:This is a method of achieving a desired adjustment in a currency exchange rate

(up or down) by small percentages over a given period, rather than by major revaluation or
devaluation. In this regime, the exchange rate is adjusted periodically according to a set of
indicators with a range of fluctuation of less than 2%. The rate of crawl can be set at a pre-
announced fixed rate at or below the projected inflation differentials (forward looking).
Maintaining a credible crawling peg imposes constraints on monetary policy.

 Limitations

Exchange controls are government-imposed limitations on the purchase and/or sale of

currencies. These controls allow countries to better stabilize their economies by limiting in-
flows and out-flows of currency, which can create exchange rate volatility.Countries with
weak and/or developing economies generally use foreign exchange controls to limit
speculation against their currencies. They often simultaneously introduce capital controls,
which limit the amount of foreign investment in the country.Exchange controls can be
enforced in a few common ways. A government may ban the use of a particular foreign
currency and prohibit locals from possessing it. Alternatively, they can impose fixed
exchange rates to discourage speculation, restrict any or all foreign exchange to a
government-approved exchanger, or limit the amount of currency that can be imported to or
exported from the country.

 Fixed exchange rate regime can prevent shocks?

Under flexible exchange rates the effects of terms-of-trade shocks on growth are
approximately one half that under pegged regimes. Specialists found that economies with
flexible exchange rates grow more rapidly than those with fixed regimes.Focusing on
external shocks, economiststhinks that terms of trade shocks are exacerbated -- in terms of
the impact on economic growth -- in countries with more rigid exchange rate systems.In
pegged systems, a depreciation of the real exchange rate requires a decline in nominal prices;
if these are too rigid, negative terms of trade shocks will produce unemployment and a slower
rate of economic growth.
  Hard and soft pegs difference

A soft peg describes the type of exchange rate regime applied to a currency to keep its value
stable against a reserve currency or a basket of currencies. Currencies with a soft peg are half
way between those with a fixed or hard pegged exchange rate and those with a floating
exchange rate. The main difference between soft and hard pegged currencies is that the soft
peg systems provide a limited degree of monetary policy flexibility to allow governments and
central banks to deal with economic shocks.

Flexible exch rate regime

A flexible exchange-rate system is a monetary system that allows the exchange rate to be

determined by supply and demand.
Every currency area must decide what type of exchange rate arrangement to maintain.
Between permanently fixed and completely flexible however, are heterogeneous approaches.
They have different implications for the extent to which national authorities participate in
foreign exchange markets. According to their degree of flexibility, post-Bretton Woods-
exchange rate regimes are arranged into three categories: currency unions, dollarized
regimes, currency boards and conventional currency pegs are described as “fixed-rate
regimes”; horizontal bands, crawling pegs and crawling bands are grouped into “intermediate
regimes”; and managed and independent floats are described as flexible regimes. All
monetary regimes except for the permanently fixed regime experience the time
inconsistency problem and exchange rate volatility, albeit to different degrees.

Managed float - CB can interviene in the market if necessary - not totally independent due to
some reserves - the market is less liquid and can take loss - lower risk but lower liquidity -
relative independent monetary policy.

Conditions for joining the euro area: convergence criteria

The convergence criteria ensure that a member state is ready to adopt the euro and that its
joining the euro area is not going to cause economic risks for the member state itself or for
the entire euro area. The criteria are set out in Article 140 (1) of the Treaty on the
Functioning of the European Union.

Economic criteria:

The economic conditions for joining the euro area help to ensure that a country is ready for
integration into the monetary regime of the euro area.

There are 4 economic convergence criteria:

1. Price stability

The inflation rate cannot be higher than 1.5 percentage points above the rate of the 3 best-
performing member states.  
2. Sound and sustainable public finances  

Government deficit cannot be higher than 3% of GDP. Government debt cannot be higher
than 60% of GDP.

3. Exchange-rate stability   

The candidate has to participate in the exchange rate mechanism (ERM II) for at least 2 years
without strong deviations from the ERM II central rate and without devaluing its currency's
bilateral central rate against the euro in the same period.

4. Long-term interest rates   

The long-term interest rate should not be higher than 2 percentage points above the rate of the
3 best-performing member states in terms of price stability.

Requirements to adapt national laws

Candidates to join the euro area must also ensure that their national laws and rules provide for
the independence of their national central banks, and that their statutes are in compliance with
the provisions of the treaties and compatible with the statutes of the European Central Bank
(EBC) and the European System of Central Banks (ESCB).

Free float of the exchange rate

A free floating exchange rate, sometimes referred to as clean or pure float, is a flexible
exchange rate system solely determined by market forces of demand and supply of foreign
and domestic currency, and where government intervention is totally inexistent. Clean floats
are a result of laissez-faire or free market economics.

Public Debt

The public debt is how much a country owes to lenders outside of itself. These can include
individuals, businesses, and even other governments. The term "public debt" is often used
interchangeably with the term sovereign debt.

Public debt usually only refers to national debt. But some countries also include the debt
owed by states, provinces, and municipalities. Therefore, be careful when comparing public
debt between countries to make sure the definitions are the same.

Regardless of what it's called, public debt is the accumulation of annual budget deficits. It's
the result of years of government leaders spending more than they take in via tax revenues. A
nation’s deficit affects its debt and vice-versa.

Long term interest rate

Long-term interest rates refer to government bonds maturing in ten years. Rates are mainly
determined by the price charged by the lender, the risk from the borrower and the fall in the
capital value. Long-term interest rates are generally averages of daily rates, measured as a
percentage. These interest rates are implied by the prices at which the government bonds are
traded on financial markets, not the interest rates at which the loans were issued. In all cases,
they refer to bonds whose capital repayment is guaranteed by governments. Long-term
interest rates are one of the determinants of business investment. Low long-term interest rates
encourage investment in new equipment and high interest rates discourage it. Investment is,
in turn, a major source of economic growth.

Interest rate paryty covered

Covered interest rate parity refers to a theoretical condition in which the relationship between
interest rates and the spot and forward currency values of two countries are in equilibrium.
The covered interest rate parity situation means there is no opportunity for arbitrage using
forward contracts, which often exists between countries with different interest rates.

Ucovered interest rate parity

Uncovered interest rate parity (UIP) theory states that the difference in interest rates between
two countries will equal the relative change in currency foreign exchange rates over the same
period. It is one form of interest rate parity (IRP) used alongside covered interest rate parity.If
the uncovered interest rate parity relationship does not hold, then there is an opportunity to
make a risk-free profit using currency arbitrage or Forex arbitrage.

Effective exchange rate and exchange rate - the difference

The real effective exchange rate (REER) is the weighted average of a country's currency in
relation to an index or basket of other major currencies. The weights are determined by
comparing the relative trade balance of a country's currency against each country within the
index.

This exchange rate is used to determine an individual country's currency value relative to the
other major currencies in the index.