GEM II – Q3

You are one finals week away from having survived Darden core.
You got this.
 Exchange Rates
e: real exchange rate; aka enom: the market rate; aka what
nominal exchange rate adjusted the banks gives you when you
for price differences exchange currencies

Exchange Rate Takeaways

Currency Exchange Graph (ie Currency
A/Currency B)
Currency B: follows the change in the graph  If Domestic Costs and Foreign Revenues 
ex) Increase slope in graph = appreciation of Good: Foreign Inflation, Domestic Deflation
Currency B Bad: Foreign Deflation, Domestic Inflation

Real Exchange Rate vs. Nominal Exchange

If Foreign Costs and Domestic Revenues 
Rate 
Good: Foreign Deflation, Domestic Inflation 
e = enom(P/Pforeign)
Bad: Foreign Inflation, Domestic Deflation
ex) e= (€3/$2)($5 burger/€6 burger) =
€15/$12
Appreciating exchange rates hurt your domestic
exports (your domestic exports are more expensive
for foreign buyers relative to the exchange rate)
 PPP: Purchasing Price Parity
The difference between what you got and what you should have gotten
(Not to be confused with the recruiting
process)

Things that Affect PPP Definition: What enom needs to be for e

to equal 1 at P/PFor
Domestic Prices
If e = 1, then enom = (P/PFor)
Increased domestic prices = Increased domestic
inflation = decreased exports = decreased PPP ePPP > enom or e < 1 
Want: low real exchange rate  currency is undervalued, will
appreciate in the future (-PPP)
Foreign Prices 
Appreciates because imports increase,
Increased foreign prices = Increase foreign inflation = exports decrease 
decreased imports
ePPP < enom or e > 1 
currency is overvalued, will
Example Calculations depreciate in the future (+PPP)
X Year’s Inflation Gap % = [(PFor/P) - (PFor PPP)]/(PFor PPP)
ex) [(US/GBP) - (UK PPP Rate)]/(UK PPP Rate)
ex) (1.29-1.46)/(1.46) = -11.48%
5 Year Projection for X Year % =  (Inflation Gap)(.5) 
ex) (-11.48%)(.5) = 5.74%
5 Year Projected Exchange Rate =
(Current Exchange Rate)+ (Current Exchange Rate)(5 Year Projection %)
ex) 1.29 + (5.74%)/2 = 1.32
 BOP & IIP (see GEM 3 Outline)
BOP
BOP: Balance of Payments 
What It Represents: yearly changes
across multiple accounts that a country
uses to gauge its financial standing  Financial Account
Think of it as an income statement
for a country  
IIP
IIP: International Investment Position
What It Represents: the current total
standing of those accounts
Think of it like a balance sheet for
a country
Current Account
+ = trade surplus, net exporter
- = trade deficit, net importer
-Counteracts what’s happening in the current account
- = taking in loans/liabilities from other countries to fund
current account deficit; increasing money within the country
+ = loaning money out to other countries; decreasing money
within the country
Reserves
-Backup money. Countries pull from this when they need extra
money to cover a current account deficit or when they want to pay
of their financial account liabilities
Foreign Currency Reserves: use your currency to buy another’s
currency; equalize supply/demand

Relationships
CA+ = FA+ = tbd Reserves
CA- = FA - = tbd Reserves
Growth-Seeking Flows: Long-term
investment (like FDI)
Yield-Seeking Flows: useful to promote
investment within country, but easy to pull
out of the country
IIPt = IIPt-1 + Financial Flows + Valuation
Changes  
Financial Flows: changes seen on BOP
Valuation Changes: nominal exchange rate
changes, stock price changes, etc
What It Means
Growth Seeking Countries: lots of DI and
portfolio equity 
Yield Seeking: lots of bonds and bank deposits
Why Does a Country Want Foreign Direct
Investment (FDI)?
Promote growth: FDI hits all components of Y
Export more in the future: Herd Effect: the
more FDI you get, the easier it is to get more
Types of FDI
 Vertical: different stages of production in
diff countries; fragments
Diff costs of inputs make it cheaper to work
in multiple countries
 Horizontal: same stages of production in
each country; duplicates
 Too costly for exports
3 Pane Model Part 2
CF Curve (~Financial Account of BOP)
CF: capital outflow (capital leaving the domestic country) IS-LM

Think of it from a yield-seeking perspective: if you wanted IS: Y = C(Y-T) + I(r) + G + NX 
the highest return, would you invest domestically (low CF) or Downward Sloping Because: ↓ r = ↑ I = ↑ C
internationally (high CF)
LM: liquidity of money 
↑ r = ↓ CF
Logic: a relative increase in the domestic rate means
(M/P)^s = L(r,Y)
an investor can get more for their money domestically Upward Sloping Because: increased demand for fixed
than abroad  supply of money is balanced out by increasing interest
↓ r = ↑ CF rates 

Logic: if the domestic r decreases, an investor can get a

higher rate of return abroad
NX Curve  (~Current Account of BOP)
Causes a Shift: NX: net exports = exports - imports 
Downward Sloping Because: as the
 International Rates (r*) nominal exchange rate decreases,
ex) higher r* pushes out the CF curve to new CF spot at exports increase (they’re cheaper to
same ro (domestic rate) foreign consumers), and vice versa 
NX = CF
↑ r* = ↑ CF = ↑ exports = ↓ enom
Causes a Shift: demand for an export
 Investor Flight (CF) or import, tariffs
ex) increased demand abroad for US car
ex) Political concerns scare off investors who pull out moves the NX line up, resulting in a
their cash
higher exchange rate. NXo remains the
↑ CF = ↑ exports = ↓ enom same
Let’s Talk About Solow

Steady State Capital: k*, investment

per worker = depreciation per worker

Impacted by:
• Depreciation per Worker: Rate
you lose capital
• Savings per Worker: Investment
per worker (s) times output per
worker (y)

y = standard of living
= (Y/L) = GDP per capita (worker) = GDP/capita
= (K^α(AL)^(1-α))/(L)
sy = (savings rate)*((K^α(AL)^(1-α))/(L))

Destruction of Capital 
Depreciation of the capital investment. The cap inv you have the
more important this is and the bigger an impact it has 
= (n + δ)k
n = change in population 
k = capital/capita
 Solow Model Part 2
Pathway Examples
Increase Savings Rate = Shift up sy = Increase k* to new equilibrium = Hit increased point on y 
Improve tech/efficiency/A = Shift up sy AND Shift up y
Note: this is why a change in A is so fundamental: it hits both sy and y 
y = (A^(1-δ))(k^δ)
sy = s[(A^(1-δ))((k^δ))]

What is the Source of Growth in a Country?

Countries that are primed for rapid groeth are currently below their steady state (<k*) and thus
grow quickly to hit it
Best Source of Long-Term Growth: increasing A: shifts out sy and y 
Also raises the y for the future
 Fragilitie
s
Check these when trying to evaluate the long-term Capital Inflow potential of a country

Fragilities measure how

likely it is that investors
will flee a country and
decrease the overall
investment within it.

You don’t need to

memorize these. Just
enjoy the cheat sheet
 Steps to Evaluating a Country’s Economy
1. GDP Growth 5. enom vs. e
• For Developed Countries: ~2% • Examine the exchange rate relevant to:
• For Developing: ~10% (but use similar countries • The country’s CA: if net exporter, (+CA), you
as the benchmark) want a low exchange rate so your goods are
cheaper to foreign buyers
2. Inflation • The country’s liabilities: if financial obligations
• For Developed: ~2% are in foreign currency, you want domestic
currency to appreciate so it takes fewer
• For Developing: ~6% (but use similar countries as domestic currencies to pay off foreign currency
the benchmark) debts

3. Unemployment 6. Investment vs. Consumption

• For Developed: want ~3-5%
• For Developing: gauge against similar countries
• Cyclical: can be addressed with monetary policy
changes
• Structural: need to be addressed with fiscal
policy changes
• Manifests in a continually high unemployment rate
4. GDP Gap
• + GDP Gap = Y > YFE = Actual GDP > Potential
GDP = overheating
• Not always the case, but a general rule of
thumb: developing economies want a higher
rate of Investment
• Long-Term Growth: more Investment
7. CAPB (Cyclically Adjusted Primary Balance)
• - = aggressive spending, running a deficit, bad
8. Gov Debt to GDP Ratio
• Evaluate against fragility indicator
• 50%+ = bad
 Big Picture
 Don’t use 100 words if 10 will do
 State the shock, State the end result
 Don’t walk them through the models. They should theoretically know it better than us
(unless it’s Dan and the IS-LM model and then just give him a second)
 Don’t be the Economist:
 “You should already know this because you read the first sentence. Ask, why is the Economist
redundant?”
 Use the models to guide yourself through the shocks to determine their end effects
 Defend what the data says, not what you believed about the country before opening
the case
 Answer every part of the questions and answer every question
 Check for (in)consistencies in your logic. Think through the steps you’re taking
 Don’t include a graph
 Remember that Dan isn’t teaching anything Q4 or second year so you’ll never need to
make eye contact with him again if this doesn’t go well. You’re in a low risk state.
Prime for investment. For the other professors…well you don’t have to take their
classes…
Dan: “This stuff is complicated. But
once we understand it, it will
become second nature just like
IS/LM.”

Class laughs.
Resources (aka the appendix for all you consulting
nerds)

 GEM 3 Outline
 Quiz 1 Summary
 Quiz 2 Summary
 Quiz 3 Summary
 Crash Course Economics
(if you’re more of an audio-visual learner)
 Khan Academy Economics
(more detailed if you’re struggling with the n
uances)