CFA – 4 & 5.

Economics

Demand and Supply

- Demand
o Exception to law of demand – Giffen goods: upward-sloping demand curve
o Demand function: quantity demanded is a function of
 Own price (Px) [negative]
 Consumers’ income (I) [positive for normal goods; negative for inferior goods]
 Price of another good (Py) [negative for complements; positive for substitutes]
o Own-price elasticity of demand

(coefficient of own price in demand function*price/quantity demanded)

 E.g. demand function: Q = 57 – 6.39P; where P = 1.48
 Q = 57 – 6.39*1.48 = 47.54
 Ed = -6.39*1.48/47.54 = -0.20
o Income elasticity of demand

(coefficient of income in demand function*income/quantity demanded)

 Normal goods: positive income elasticity
 Inferior goods: negative income elasticity
o Cross-price elasticity of demand

(coefficient of price of another good in demand function*price of another

good/quantity demanded)
 Substitutes: positive cross-price elasticity of demand
 Complements: negative cross-price elasticity of demand
- Supply
o Law of diminishing marginal returns
 Increasing marginal returns from adding inputs because of specialisation and
division of labour
 Diminishing marginal returns because of operating at full capacity
o Economic profit = total revenue – economic costs/opportunity costs
 Economic costs = accounting costs + implicit opportunity costs
 Normal profit = 0 economic profit = break-even
 In the long run, firms in a competitive market will earn normal profit. Any
positive economic profits will attract more entrants, i.e. long run supply curve
will increase and market price will decrease to the level at which firms earn
normal profits
 In the long run, monopolistic firm can earn positive economic profits
 o Accounting profit = total revenue – accounting costs
o Interaction between costs

MC curve intersects both ATC and AVC at their minimum points
 When MC < AVC, AVC will be decreasing
 When MC > AVC, AVC will be increasing
o Long-run efficient scale
 Economies of scale – decreasing long-run average cost
 Diseconomies of scale – increasing long-run average cost

Market Structures

- Perfect competition

(Left: market demand curve; right: individual firm’s demand curve)

o Horizontal demand curve, i.e. P = MR = AR: firms are price-takers

o A profit-maximising firm should increase Q until MR=MC and when MC is increasing
o Breakeven and shutdown points
  Breakeven point: P = AR = ATC
 Shutdown point: P = AR = AVC

- Monopolistic competition
o Hybrid of strong competition and some monopoly-like conditions
o Most distinctive factor is product differentiation

o A profit-maximising firm should increase Q until MR=MC and when MC is increasing

o MR = P*(1-1/Ep)
 E.g. marginal cost = 40, price elasticity of demand = 1.5, what will the price
likely to be?
 Answer: MR = MC = 40 = P(1-1/1.5) → P = 120
- Oligopoly
o 1st pricing strategy: pricing interdependence
 Competitors will match a price reduction and ignore a price increase
 Given a prevailing price, higher price elasticity of demand if price is increased
because other rivals will have lower prices
 Given a prevailing price, lower price elasticity of demand if price is reduced
because other rivals will match the price reduction

 Kinked at the prevailing price, which cannot be determined in this model

o 2nd pricing strategy: Cournot assumption
  Cournot solution falls between competitive equilibrium and monopoly solution
 When the number of firms increases, the Cournot solution moves towards the
competitive equilibrium
rd
o 3 pricing strategy: Nash equilibrium
 Game theory: two or more participants in a non-cooperative game who
consider and expect their opponents’ rational choices

 Theta better off with open

 Given open, Sigma better off with prop
 Nash equilibrium: prop for Sigma and open for Theta
 Brings up the possibility of collusion
 Mostly unlawful
 Factors affecting successful collusion
o Small number of firms
o One dominant, instead of similar market shares
o Homogeneous products
o Similar cost structures
o Frequent small orders: diminish chance of cheating
o Severe threat of retaliation by other firms

 Assume a dominant leader becomes the price maker

 Optimal price is determined by its own MR = MC
 If one of the other companies attempts to gain market share by undercutting
the price set by the market leader, the market share of the leader will increase,
as some smaller companies will leave the market rather than sell below cost
  Over time, market share of the dominant firm will decrease, as profits attract
entry by other companies
- Monopoly
o Price discrimination
 First-degree price discrimination – charge each customer the highest price the
customer is willing to pay
 Second-degree price discrimination – a menu of quantity or quality-based
pricing options, designed to induce customers to self-select based on their
willingness to pay
 Third-degree price discrimination: customers are segregated by demographic or
other traits
o Monopoly is not always inefficient, as economies of scale and regulation may give a
better outcome for buyers than perfect competition
- Identification of market structure
o Concentration ratio
 Sum of market shares of largest N firms
 Fails to reflect effect of mergers in the industry: if largest and second-largest
incumbents merge, the pricing power of the combined entity is likely to be
larger than that of the two pre-existing companies, but concentration ratio will
not change much
 Fails to reflect low barriers of entry
o HHI
 Sum of squared market shares of the largest N firms
 Can reflect effect of mergers in the industry
 Fails to reflect low barriers of entry

Aggregate Output, Prices and Economic Growth

- Gross domestic product (GDP)
o Expenditure approach
 GDP = C + I + G + (X – M)
 I = Business fixed investment + changes in inventory (inventory investment)
 G = Government spending on goods + government fixed investment
o Value-added approach
o Income approach
 GDP = National income + capital consumption allowance
 National income
= wages
+ corporate profits before tax
+ unincorporated business net income
+ interest income
+ rent
+ indirect taxes less subsidies
 Capital consumption allowance – depreciation of capital stock in production
o Personal income
= National income
– indirect taxes
– corporate income taxes
 – undistributed corporate profits
+ transfer payments
o Personal disposable income = personal income – personal taxes
- Aggregate demand
o Planned expenditure = actual income
 Y = C + I + G + (X – M)
 Y=C+S+T
 S = I + (G – T) + (X – M)
 Domestic private saving is absorbed in three ways: investment, financing
government deficits and building up financial claims against overseas
economies
 G – T = (S – I) – (X – M)
 Fiscal deficit implies that private sector saves more than invests, or a trade
deficit, or both
 X – M = (S – I) – (G – T) (Reading 20)
 Trade surplus implies fiscal surplus, excess of private saving over
investment, or both
 IS curve
 S – I = (G – T) + (X – M)
 Negative relationship – when real interest rate decreases, income increases
o Available real money supply is willingly held by households and businesses
 LM curve
 Quantity theory of money: MV = PY
 Real money = M/P = M (r, Y)
 Equilibrium of money market: real money demand = real money supply
 Positive relationship: when real interest rate increases, income increases
o Construction of AD curve

 When price level increases, given fixed nominal money supply, real money
supply decreases, LM curve shifts to the left, real interest rate increases and
income (output) decreases
- Aggregate supply curve
 o Very short run aggregate supply – horizontal
o Short run aggregate supply – upward-sloping
 Input prices do not fully adjust to the price level in the short run
 Closer to LRAS (steeper) if higher extent to adjust to price level
o Long run aggregate supply – vertical
 Y (L, K)
 L = labour supply
 K = capital stock
 Fixed labour supply and capital stock in the long run
 Full employment level (natural level of output)
 Macro economy is operating at an efficient and unconstrained level
 Resources are deemed fully employed
 Companies have enough spare capacity to avoid bottlenecks
 Unemployment is at its natural rate – modest pool of unemployed workers
(job seekers = job vacancies) looking for and transiting into new jobs
- Economic growth
o Production function
 Y = AF (L, K)
 A = technology/total factor productivity: output for given inputs
 L = labour supply
 K = capital stock
 Diminishing marginal productivity of labour and capital
 Long-term sustainable growth cannot rely solely on capital deepening
investment that increases capital stock relative to labour
 Growth rates of developing countries should exceed those of developed
countries, leading to convergence of incomes over time
 Only way to sustain growth is through A (technology and factor productivity)
o Neoclassical or Solow growth model
 Potential growth of GDP
= growth in technology/total factor productivity
+ share of income by labour * growth of labour
+ share of income by capital * growth of capital
 Growth in technology is calculated as a residual (potential growth of GDP –
growth in labour – growth in capital)
o Practical measurement of sustainable growth
  Sustainable growth = growth of labour + growth of labour productivity

Business Cycle
- A cycle has an expected sequence of phases, alternating between expansion and
contraction
- Phases occur at about the same time throughout the economy in almost all sectors
- Cycles are recurrent (happening again and again over time) but not periodic (not all
having the same intensity or duration)
- Cycles typically last between 1 and 12 years
- Phases
o Trough
o Expansion (early expansion: recovery; late expansion: boom)
o Peak
o Contraction/recession (depression if exceptionally severe)
o Measures of economic activity: inflation, industrial production, unemployment, GDP
growth (interest rate or monetary base are not direct measures but reactions to
economic activities through monetary policy)
- Economic indicators
o Leading economic indicators – turning points precede those of the overall economy
 Stock price index
 Interest rate spread between 10 year-treasury yields and overnight borrowing –
wider spread means economic upswing
 Firms’ order for raw materials
 Manufacturing hours
o Coincident economic indicators – turning points close to those of the overall
economy
 Real personal income
 Industrial output
o Lagging economic indicators – turning points later than those of the overall
economy
 Unemployment
 Inventory-sales ratio
- Unemployment
o Businesses wait until recession looks genuine to lay off, and wait until recovery
looks genuine to rehire
o Labour force changes in response to the economic environment – e.g. during
recovery, new job seekers return to labour force but seldom find work immediately,
leading to initial increasing unemployment
- Inventory-sales ratio
o Inventory levels fluctuate dramatically with business cycles
o Towards the peak, sales slow while businesses may lag in cutting back on new
production, such that inventory-sales ratio is high
o When economy starts to recover, sales of inventories can outpace production, such
that inventory-sales ratio is low
- Capital spending
o In recession, firms most likely adjust the stock of physical capital by not maintaining
equipment
- Neoclassical and Austrian schools
o All markets will reach equilibrium because of invisible hand, i.e. free market
o For any shock that shifts aggregate demand or aggregate supply, economy will
quickly readjust and reach equilibrium
o Fluctuations are caused by misguided government intervention
- Keynesians
o Focus on fluctuations of aggregate demand: if aggregate demand decreases,
Keynesians advocate government intervention (fiscal policy) to restore full
employment and avoid deflationary gap
- Monetarists
o Argue that timing of government policy responses is uncertain and therefore not
necessary
o Only to maintain steady growth of money supply and let the economy find its new
equilibrium
- New Classical and Real Business Cycle (RBC)
o Consider also fluctuations of aggregate supply: if aggregate supply decreases
because cost of production increases; or if aggregate supply increases because of
technological progress, the economy will adjust quickly to find its new equilibrium
o Government intervention is generally not necessary because it may exacerbate
fluctuation or delay convergence to equilibrium
- Neo Keynesians/ New Keynesians
o Assume sticky prices and wages: markets do not reach equilibrium immediately and
seamlessly, and even small imperfections may cause markets to be in disequilibrium
for a long time
o Government intervention is therefore needed
- Unemployment
o Labour force – either have a job or are actively looking for a job
o Long-term unemployed – out of work for a long time but still looking for a job
o Frictionally unemployed – out of work and are about to start another job (“between
jobs”) or during job matching
 Natural unemployment
o Underemployed – having the qualification to work at a significantly higher-paying
job
o Discouraged worker – having stopped looking for a job (statistically outside labour
force)
- Inflation
o Inflation – sustained increases in aggregate price level
o Hyperinflation – extremely fast increase in aggregate price level
 Money supply increases
 Velocity of money increases: consumers accelerate their spending to beat price
increases, and thus money circulates more quickly
o Disinflation – decreasing inflation rate
o Stagflation – high inflation rate combined with high unemployment and slowdown
of economy
 The economy is likely to be left to self-correct, because no short-term economic
policy is effective
o Deflation – sustained decrease in aggregate price level
 Can exacerbate recession, because firms have lower revenue but higher debt
burden in real terms, so that they will reduce investment and employment
o Laspeyres index – price index created by fixed composition of consumption basket
to measure cost of living
 Substitution bias (upward bias) – when the price of a good increases, people
may substitute it with another good with a lower price
 Quality bias (upward bias) – price increases together with quality improvement
 New product bias (upward bias) – new products are frequently introduced but
not included in the fixed basket
o Paasche index – calculation similar to GDP deflator
o Fisher index – geometric mean of Laspeyres index and Paasche index

 Laspeyres index in Feb = (50*4+70*4.5)/(50*3+70*4.4)*100 = 112.45

 Paasche index in Feb = (70*4+60*4.5)/(70*3+60*4.4)*100 = 116.03
 Fisher index in Feb = (112.45*116.03)^(1/2) = 114.23
o Headline inflation
 Inflation calculated based on price index that includes all goods and services in
the economy (GDP deflator)
o Core inflation
 Inflation calculated based on price index of goods and services except volatile
items like food and energy
 Most likely relied on to determine policy because it avoids overreactions to
short-term fluctuations in food and energy, whose prices tend to vary more
than other goods
o Cost-push inflation
 Caused by excessive demands for inputs and increasing cost of inputs
 Wages are the single biggest cost to businesses, therefore usually focusing on
wage-push inflation
 Unemployment rate – the lower the unemployment rate, the higher
likelihood that shortage of labour will develop to drive up wages
 Non-accelerating inflation rate of unemployment (NAIRU) – below which
there will be a shortage of labour to drive up wages
 Productivity – the higher the productivity, the lower price firms need to
charge
 If productivity growth rate proportionally exceeds wage increases, product
price is less likely to increase
o Demand-pull inflation
 Caused by excessive demands for goods and increasing prices
 Market is satisfying demand beyond the economy’s potential capacity
 Monetary inflation: surplus of money increases liquidity and ultimately
increases demand – too much money chasing too few goods
Monetary and Fiscal Policy
- Monetary policy
o Central bank activities that seek to influence the macroeconomy by influencing
quantity of money and credit in an economy
o Money creation
 Assumption: fractional reserve banking – not all customers will want all of their
money back
 Money created = new deposit/reserve requirement
 Money multiplier = 1/reserve requirement
o Money definition
 In general, money includes notes and coins, plus deposits in banks and other
financial institutions that can be readily used to purchase goods or to repay
debts
o Quantity theory of money
 MV = PY
 V: velocity of circulation of money – number of times money changed hands
 V is approximately constant
 Money neutrality in the long run – increase in money supply will not affect real
output; so that increase in money supply will only cause price level to increase
o Demand for money
 Transactional – to use in purchase of goods and services
 Precautionary – as a buffer against unforeseen events; increases when GDP
increases
 Speculative – held as opposed to other financial instruments
o Monetary policy
 Objective – to maintain price stability, i.e. associated with controlling inflation
 Assumption – money is not neutral in the short term
 Operational independence (free to decide level of interest rate) and target
independence (free to decide target inflation rate)
 Expected inflation
 Menu costs – to change the advertised prices of goods and services
 Shoe leather costs – to withdraw cash more frequently
 Unexpected inflation
 Inequitable transfer of wealth between borrowers and lenders
 Giving rise to risk premium in borrowing rates and prices of other assets
 Reducing information content of market prices
 Monetary policy tools
 Open market operations – purchase (sale) of government bonds from (to)
commercial banks or designated market makers
 Official interest rate/policy rate – public announcement of the rate at
which it is willing to lend money to commercial banks
o Can also be achieved by setting short-term collateralised lending rates,
i.e. repo rates in repurchase agreement with commercial banks
 Reserve requirements
 Monetary transmission mechanism – how central bank’s official interest rate
gets transmitted through the economy to affect inflation expectations
  Commercial banks’ base rates (and thus lending rates) – cost of borrowing
of individuals and firms – will increase with an increase in official interest
rate
 Asset prices – discount rate for future cash flows – will decrease with an
increase in official interest rate
 Exchange rate – relative price of exports and imports – will appreciate with
an increase in official interest rate
 Expectations of future official interest rate
 Inflation targeting – central banks may target low inflation instead of zero
percent inflation, which runs a higher risk of a deflationary outcome
 Exchange rate targeting – central banks may peg the country’s currency to that
of an economy with a good track record on inflation, which effectively imports
the inflation experience of the low inflation economy
 Interest rates and economic conditions must adapt to accommodate the
target exchange rate, so that domestic interest rates and money supply can
become more volatile
 E.g. When inflation rate increases above the level of target country, the
country will need to reduce it, for example, by increasing short-term
interest rates
 Contractionary and expansionary monetary policy
 Neutral rate of interest = trend GDP growth + inflation target
 At neutral rate, it neither stimulates nor slows down the economy,
promoting stable long-run inflation
 Contractionary – official interest rate higher than neutral rate
 Expansionary – official interest rate lower than neutral rate
 Limitations
 Central banks cannot always control money supply – they cannot control
the amount of money households and firms deposit with banks, nor can
they control the willingness of banks to create money by extending credit
 Deflation poses challenge, as once the central bank has cut nominal
interest rate to zero to stimulate economy, it cannot be further cut
- Fiscal policy
o Government’s decisions that seek to influence the macroeconomy by taxation and
spending (which can also be used to redistribute income and wealth)
o Fiscal multiplier = 1/(1-marginal propensity to consume*(1-tax rate))
o Fiscal policy tools
 Transfer payments
 Current government spending
 Capital expenditure
 Slow to plan and execute, and thus limited role in short-term stabilising
 Direct taxes
 More difficult to adjust without considerable notice
 Indirect taxes
 Can be adjusted almost immediately
o Contractionary and expansionary fiscal policy
 Budget surplus/deficit – difference between government revenue and
government expenditure
  Contractionary fiscal policy (discretionary) – increase in budget surplus
 Expansionary fiscal policy (discretionary) – increase in budget deficit or
balanced budget
 Increase in taxes will only reduce aggregate spending by the factor of
marginal propensity to consume; while increase in government spending
will directly add to aggregate spending
 Distinguished from automatic stabilizer – when economy slows, social insurance
and unemployment benefits will raise and automatically add to aggregate
demand; when economy booms, income and profit taxes will raise and
automatically reduce aggregate demand
o Limitations
 Recognition lag – government will take time to realise economic conditions
 Action lag – government will take time to implement policies
 Impact lag – policies will take time to become evident
 Monetary policy will face these lags too, but usually fewer delay, especially
when the central bank is independent
 Fiscal deficit means more government borrowing, which reduces the ability of
the private sector to access investment funds, crowding out private sector
investment
 Ricardian equivalence – reduction in taxation may have no impact on spending
at all, as individuals save more in anticipation of higher future taxes
- Relationship between monetary and fiscal policy
o Easy fiscal policy/easy monetary policy – highly expansionary, growing private and
public sectors
o Tight fiscal policy/tight monetary policy – highly contractionary, shrinking private
and public sectors
o Easy fiscal policy/tight monetary policy – growing public sector, shrinking private
sector
o Tight fiscal policy/easy monetary policy – growing private sector, shrinking public
sector

International Trade and Capital Flows

- Autarky – closed economy that does not trade with other countries
- Free trade – no governmental trade restrictions
- Trade protection – governmental trade restrictions
- Foreign direct investment – direct investment of a firm in one country in productive
assets in a foreign country, becoming multinational corporation
- Foreign portfolio investment – shorter-term investment in foreign financial instruments

o Excess demand → imports

 o Excess supply → exports
- Benefits of international trade
o Gains from trade due to exchange and specialisation – overall benefits of trade
outweigh losses; not necessarily all stakeholders will benefit
o Greater economies of scale as market expands
o Households and firms enjoy greater product variety
o Greater efficiency due to increased competition from foreign firms
o More efficient resource allocation
- Costs of international trade
o Greater income inequality
o Loss of jobs in developed countries
o Less efficient domestic firms forced to exit the industry, which may in turn lead to
higher unemployment
- Comparative advantage
o Absolute advantage – produce a good with fewer resources than trading partner;
produce more of the good with the same amount of resources
o Comparative advantage – lower opportunity cost of producing a good
o Even if a country does not have an absolute advantage in producing any goods, it
can still gain from trade by exporting goods in which it has a comparative advantage
o With international trade, post-trade output level will increase

 Absolute advantage: (Machinery) UK; (Cloth) India

 Opportunity cost of UK: (Machinery) 2C; (Cloth) 0.5M
 Opportunity cost of India: (Machinery) 8C; (Cloth) 0.125M
 Comparative advantage: (Machinery) UK; (Cloth) India
 Terms of trade such that both countries gain from trade:
2C < 1M < 8C
o Ricardian’s Model of Comparative Advantage
 Labour is the only variable factor of production
 Differences in technology (that affects labour productivity), are the source of
comparative advantage
 A country with a lower opportunity cost in producing a good has a comparative
advantage in the good and will specialise in its production
 Smaller countries may specialise completely, but may not be able to satisfy total
demand for the good, and thus the larger countries may specialise incompletely
o Heckscher-Ohlin Model of Comparative Advantage
 Both capital and labour are variable factors of production
 Differences in the relative endowment of these factors are the source of
comparative advantage, assuming technology in each industry is the same
among countries
 A country in which labour is relatively abundant will export relatively labour-
intensive goods
- Trade protection (restrictions)
o Tariff

 Consumers will suffer a loss of consumer surplus from a higher price (ABCD)
 Local producers will gain producer surplus from a higher price (A)
 Government will gain tariff revenue (C)
 Deadweight loss occurs (BD)
 Tariff imposed by a small country will not change the price of goods in the
exporting country
 A large country can possibly benefit from tariff, which improves the terms of
trade by enough to outweigh welfare loss
o Import Quota
 Greater welfare loss than tariff, if quota rent is not captured by importing
country
 Better off than tariff for importers, who can capture a share of the quota rents
 Voluntary export restraint (VER) – exporting country agrees to limit exports to
trading partners
 VER brings greatest welfare loss to importing country when compared to
tariff and import quota, as all of the quota rents will be captured by
exporting countries
o Export Subsidy

o Trading blocs
  Regional trading bloc is a group of countries that have signed an agreement to
reduce and progressively eliminate barriers to trade and movement of factors
of production among the members
 Free trade areas – allow free flow of goods and services, e.g. North American
Free Trade Agreement among US, Canada and Mexico
 Customs union – extend free trade areas by also creating common trade policy
against non-members
 Common market – extend customs union by also allowing free movement of
factors of production
 Economic union – extend common market by also requiring common economic
institutions and coordination of economic policies among members, e.g.
European Union
 Monetary union – extend economic union by adopting common currency
o Capital restriction – restrict inward and outward flow of capital
- Balance of Payments
o Double-entry bookkeeping system that summarises a country’s economic
transactions with the rest of the world
o Current account (CA)
 Trade of goods and services
 Income from ownership of assets, e.g. dividends and interests
 Unilateral transfers, e.g. remittances, aids
o Capital account
 Capital transfers, e.g. debt forgiveness, migrants’ transfer
 Trade of non-produced, non-financed intangible assets, e.g. copyrights
o Financial account
 Trade of financial assets
o Sp + Sg = I + CA
 Savings can be used for both domestic investment and foreign investment
o CA = Sp + Sg – I
 Current account deficit tends to result from low private saving, low government
saving (government deficit) and high private investment, or a combination of
three
- Trade organisations
o International Monetary Fund
 Ensure stability of international monetary system, system of exchange rates and
international payments that enables countries to trade with each other
 Keep country-specific market risk and global systematic risk under control
o World Bank Group
 Help developing countries fight poverty and enhance environmentally sound
economic growth
o World Trade Organisation
 Foster free trade
 Regulate cross-border exchange globally

Currency Exchange Rates

- Direct exchange rates: D/F – units of D (domestic currency) to buy 1 unit of F (foreign
currency)
- Indirect exchange rates – reciprocal of direct exchange rates
- For any exchange rate quote as X/Y – X: price currency; Y: base currency
- Appreciation and depreciation
o Percentage appreciation is not equal to percentage depreciation
o E.g. USD/EUR increases from 1.25 to 1.3
o EUR appreciates by 1.3/1.25 – 1 = 4%
o USD depreciates by (1/1.3)/(1/1.25) – 1 = 1.25/1.3 – 1 = -3.85%
- Two-sided price – bid is always smaller than offer
- Real exchange rate

- Spot transactions
o Exchange of currencies for immediate delivery
o Spot exchange rate
o Only make up a minority of global FX market
- Forward calculation
o Forward premium – forward rate higher than spot rate
o Forward discount – forward rate lower than spot rate
o Forward points = difference between forward rate and spot rate*10,000 only if the
spot exchange rate is quoted with 4 decimal places
 If rate quoted with 2 decimal places; *100
o Forward premium quoted in % = forward premium/spot price*100%

 Forward premium only indicates that foreign interest rate is higher than
domestic interest rate
 Forward price tells nothing about expectation of appreciation or depreciation
- Currency regime
o Ideal currency regime
 Exchange rate between any two currencies would be credibly fixed, to eliminate
exchange rate risk
 All currencies would be fully convertible
 Each country would be able to undertake fully independent monetary policy
o Independently floating rates
o No separate legal tender
 Dollarisation – domestic country uses currency of another nation
 Monetary union – whose members share the same legal tender
o Currency board system
 Explicit commitment to exchange domestic currency for a specified foreign
currency at a fixed exchange rate
  Combined with the restrictions on the issuing authority to ensure fulfilment of
legal obligation, i.e. domestic currency can only be issued fully backed by
foreign exchange reserves
o Fixed parity
 Similar to currency board system, but
 with no legislative commitment to maintaining specified parity
 target level of foreign exchange reserves is discretionary
o Target zone
 Fixed parity, where exchange rate will be allowed to vary within a fixed band
o Active and passive crawling pegs
 Common during high inflation periods, where exchange rate is adjusted
frequently (passive), or pre-announced for the coming weeks (active), to keep
pace with inflation rate