Here is my master degree thesis on Bitcoin. The topic is :
THE RISK PERCEPTIONS AND TECHNOLOGY ADOPTIONS OF E-COMMERCE USERS
TOWARDS DIGITAL CURRENCY
It is on google drive at the link below :
click at thesis link
Tuesday, December 5, 2017
Wednesday, August 2, 2017
Game Theory
Basic Concepts of Game Theory
Motivating Example
Location Game: setting shop on a beach
On a linear beach, there are two vendors, they charge the same price. Where should the vendors locate their shops?
- in the center, near each other
what if there are three vendors?
- 3 vendors at the same spot, each get 1/3, one vendor moves, it gets more profit
- 3 vendors different positions, one vendor moves to center, it gets more profit
- no equilibrium
Information
Mutual Knowledge vs Common Knowledge
Mutual Knowledge: all players know A
Common Knowledge: everyone knows that everyone knows A
Perfect Information vs Imperfect Information
Perfect Information: the player knows the full history of the game so far
Imperfect Information: the player does not know parts of the history of the game, such as sealed bid auction
Complete Information vs Incomplete Information
Complete Informatio: the player knows the type of other players and rules of the game
Incomplete Information: the incumbent does not know the true type of entrants
Perfect but Incomplete Information Game
- Price negotiation over used car at a dealer shop
Action vs Strategy
Bill has 5 actions and 6 strategies
Normal Form Game (Strategic Form Game)
- simultaneous game
- static setting
- represented by game matrix
Prisoner's Dilemma Game
| C D
---------------------------
C | -8, -8 -2, -15
D | -15, -2 -3, -3
conditions
- each player has dominant strategy
- dominant strategy equilibrium (-8,-8) worse than optimal choice, dominant strategy equilibrium should be pareto inefficient to at least some other outcome (-3,-3)
how to escape from prisoner's dilemma
- price leadership
- price signaling
- focal points
- info agglomeration: online price agglomeration could intensify or mitigate price wars. However, you lower the price, competitor can see it immediately, and copy the rpice, so it is not worth it to lower the price.
- commitment
strictly dominant strategy
u(si, s-i) > u(si, s-i) for all si
weakly dominant strategy
u(si, s-i) >= u(si, s-i) for all si and
u(si, s-i) > u(si, s-i) for some si
Iterated Dominance Equilibrium
- dominated strategy, strategies that will not be played
- eliminate strictly dominated strategy
- eliminate weakly dominated strategy, iterated weak dominance is not robust
Maximin Strategy Equilibrium
- choose the strategy that gives you a max payoff among the min payoff from each strategy
| L R payoff
---------------------------
T | 10, 4 8, 15 8
B | -100, 5 20, 10 -100
payoff 4 10
Nash Equilibrium
(x*, y*) is a NE if
- x* is best choice given 2's choice of y*
- y* is best choice given 1's choice of x*
coordination game
| S R
---------------------------
S | 5, 5 0, 1
R | 1, 0 1, 1
anti-coordination game
| S R
---------------------------
S | -5,- 5 10, 20
R | 20, 10 -3, -3
if multiple NEs:
1. use focal points
- cultural convention
- social convention
- common perception
2. use risk dominance
if (v>=1),(v>=1) at least one of them is strict inequality, then (S,S) payoff dominate (R,R)
| S R
---------------------------
S | v,v 0, 1
R | 1, 0 1, 1
(v-1) > (1-0)
(S,S) risk dominate (R,R)
Mixed Strategy Nash Equilibrium
- assign probabilities to pure strategies
F
| DL (q) CC (1-q) if Nadal choose
-------------------------------
(p) DL | 50,50 80, 20 DL with prob p
N ------------------------------
(1-p) CC | 90,10 . 20,80 CC with prob 1-p
so Federer payoff is
if Federer chooses 50p + 10(1-p) = 20p +80(1-p) => p=0.7
DL with prob q if p> 0.7, q = 1
CC with prob 1-q p < 0.7 , q =0
so Nadal's payoff is p=0.7 , indiff over q
50q + 80(1-q) = 90q + 20(1-q)
q = 0.6
if q<0.6, p =1
q > 0.6, p = 0
q = 0.6, indifference over p
NE (p*, 1-p*) = (0.7, 0.3)
(q*, 1-q*) = (0.6, 0.4)
implications of mixed strategy NE
- each player should mix his pure strategy so that the other player is indifferent among all his pure strategy
choose (p,1-p) so that UDL = UCC
choose (q,1-q) so that UDL = UCC
- assign zero prob to dominated pure strategy
- randomise just right, avoid outguessed by opponent
- each player mix his pure strategies so that the other player is indifferent among all his pure strategies
Oligopoly Games
| compete on quantity compete on price
------------------------------------------------------------------------
simultaneous | Cournot Bertrand
(static) |
| Cournot- Bertrand-
sequential | Stackelberg Stackelberg
substitute: q1 up -> q2 down
- backward induction: for finite dynamic games, start from last stage of the game, not for infinite game
- subgame perfect NE: rule out NE of non credible threat, for finite and infinite game
Sequential Bargaining
Subgame Perfect Equilibrium
Example 1
Example 2
In game theory, having fewer option may be better, because you can manipulate the other player's choices so that outcome is better for you.
Strategic Moves
to influence opponents expectation about your action
to get around prisoner' dilemma
introduced by Thomas Schelling
- cross shareholding
- MFC clause (mutual adoption, 2 period model)
- price matching guarantee policy (mutual adoption)
- entry deterrence:
-- side payment, merge, build a reputation, invest in extra capacity
chicken game
- two gangsters race their cars toward each other , the first one to chicken out loses.
G Gang B
a | Straight Avoid
n --------------------------------
g S | -100,- 100 10, -2
A A | -2, 10 0, 0
- you don't know how to secure the equilibrium that is favorable to you, because they are two NE
- so you use strategic moves to gain advantage
- commitment, play aggressively, scare your opponents
Entry deterrence
- incumbent facing a potential entrant
- entrant moves first, incumbent moves later
- the latter can behave strategically to deter the entry
I Entrant
n | Enter Stay out
c --------------------------------
u E | 100,20 200, 0
m S | 70, -10 130, 0
bent
the NE is (100,20), it is incumbent dominant strategy, but potential entrant will enter
a few options:
- side payment, illegal?
- marge, anti-competitive ?
- build a reputation for being irrational, manipulate rivals choices to your advantage
(incumbent can increase 70 to > 100, or decrease 100 to be < 70)
the SPNE is (100,20)
in chicken game, sequential game, use strategic moves to show commitment and gain advantage
Fudenberg Tirole Taxanomy
How to apply
step 1: calculate your profit as a function of what the other players might do
Ļ€you = f(others actions)
step 2: guess your competitor's profits as a function of what you might do
Ļ€others = f(your actions)
step 3: can legally cooperate?
if yes, use cooperative game theory
if no, use non-cooperative game theory
step 4: create the game's payoff
step 5: pick the game strategies
step 6:strategic moves
step 7: make the moves
(to be continued.)
Motivating Example
Location Game: setting shop on a beach
On a linear beach, there are two vendors, they charge the same price. Where should the vendors locate their shops?
- in the center, near each other
what if there are three vendors?
- 3 vendors at the same spot, each get 1/3, one vendor moves, it gets more profit
- 3 vendors different positions, one vendor moves to center, it gets more profit
- no equilibrium
Information
Mutual Knowledge vs Common Knowledge
Mutual Knowledge: all players know A
Common Knowledge: everyone knows that everyone knows A
Perfect Information vs Imperfect Information
Perfect Information: the player knows the full history of the game so far
Imperfect Information: the player does not know parts of the history of the game, such as sealed bid auction
Complete Information vs Incomplete Information
Complete Informatio: the player knows the type of other players and rules of the game
Incomplete Information: the incumbent does not know the true type of entrants
Perfect but Incomplete Information Game
- Price negotiation over used car at a dealer shop
Action vs Strategy
Normal Form Game (Strategic Form Game)
- simultaneous game
- static setting
- represented by game matrix
Prisoner's Dilemma Game
| C D
---------------------------
C | -8, -8 -2, -15
D | -15, -2 -3, -3
conditions
- each player has dominant strategy
- dominant strategy equilibrium (-8,-8) worse than optimal choice, dominant strategy equilibrium should be pareto inefficient to at least some other outcome (-3,-3)
how to escape from prisoner's dilemma
- price leadership
- price signaling
- focal points
- info agglomeration: online price agglomeration could intensify or mitigate price wars. However, you lower the price, competitor can see it immediately, and copy the rpice, so it is not worth it to lower the price.
- commitment
strictly dominant strategy
u(si, s-i) > u(si, s-i) for all si
weakly dominant strategy
u(si, s-i) >= u(si, s-i) for all si and
u(si, s-i) > u(si, s-i) for some si
Iterated Dominance Equilibrium
- dominated strategy, strategies that will not be played
- eliminate strictly dominated strategy
- eliminate weakly dominated strategy, iterated weak dominance is not robust
Maximin Strategy Equilibrium
- choose the strategy that gives you a max payoff among the min payoff from each strategy
| L R payoff
---------------------------
T | 10, 4 8, 15 8
B | -100, 5 20, 10 -100
payoff 4 10
Nash Equilibrium
(x*, y*) is a NE if
- x* is best choice given 2's choice of y*
- y* is best choice given 1's choice of x*
coordination game
| S R
---------------------------
S | 5, 5 0, 1
R | 1, 0 1, 1
anti-coordination game
| S R
---------------------------
S | -5,- 5 10, 20
R | 20, 10 -3, -3
if multiple NEs:
1. use focal points
- cultural convention
- social convention
- common perception
2. use risk dominance
if (v>=1),(v>=1) at least one of them is strict inequality, then (S,S) payoff dominate (R,R)
| S R
---------------------------
S | v,v 0, 1
R | 1, 0 1, 1
(v-1) > (1-0)
(S,S) risk dominate (R,R)
Mixed Strategy Nash Equilibrium
- assign probabilities to pure strategies
F
| DL (q) CC (1-q) if Nadal choose
-------------------------------
(p) DL | 50,50 80, 20 DL with prob p
N ------------------------------
(1-p) CC | 90,10 . 20,80 CC with prob 1-p
so Federer payoff is
if Federer chooses 50p + 10(1-p) = 20p +80(1-p) => p=0.7
DL with prob q if p> 0.7, q = 1
CC with prob 1-q p < 0.7 , q =0
so Nadal's payoff is p=0.7 , indiff over q
50q + 80(1-q) = 90q + 20(1-q)
q = 0.6
if q<0.6, p =1
q > 0.6, p = 0
q = 0.6, indifference over p
NE (p*, 1-p*) = (0.7, 0.3)
(q*, 1-q*) = (0.6, 0.4)
- each player should mix his pure strategy so that the other player is indifferent among all his pure strategy
choose (p,1-p) so that UDL = UCC
choose (q,1-q) so that UDL = UCC
- assign zero prob to dominated pure strategy
- randomise just right, avoid outguessed by opponent
- each player mix his pure strategies so that the other player is indifferent among all his pure strategies
Oligopoly Games
| compete on quantity compete on price
------------------------------------------------------------------------
simultaneous | Cournot Bertrand
(static) |
| Cournot- Bertrand-
sequential | Stackelberg Stackelberg
substitute: q1 up -> q2 down
collusion outcome less than NE outcome
Application of simultaneous games
Tragedy of the commons
horizontal axis: % of car commuters
vertical axis: payoff for commuters
NE : (q, 1-q)
- q% commute in cars and (1-q)% in busses
still not socially efficient
- all commuting by busses is still Pareto efficient
Sequential Games (Extensive Form Game)
- dynamic setting- backward induction: for finite dynamic games, start from last stage of the game, not for infinite game
- subgame perfect NE: rule out NE of non credible threat, for finite and infinite game
Sequential Bargaining
š¯›æ > 50% , first mover adv ; agreement reached in first round of bargaining
š¯›æ < 50%, second mover adv
0< š¯›æ <100%, š¯›æ is time value
Example 1
SPNE outcome (0, 4)
SPNE strategy:
If B choose R, A will choose (5, -1), so B will choose L, but A will not choose R, A choose L, B choose R, so (0,4) is SPNE outcome.
Strategic Moves
To solve empty promise problem, make 5 worse than 4, cut (5,-1) branch, make 4 better than 5Example 2
Strategic Moves
to influence opponents expectation about your action
to get around prisoner' dilemma
introduced by Thomas Schelling
- cross shareholding
- MFC clause (mutual adoption, 2 period model)
- price matching guarantee policy (mutual adoption)
- entry deterrence:
-- side payment, merge, build a reputation, invest in extra capacity
chicken game
- two gangsters race their cars toward each other , the first one to chicken out loses.
G Gang B
a | Straight Avoid
n --------------------------------
g S | -100,- 100 10, -2
A A | -2, 10 0, 0
- you don't know how to secure the equilibrium that is favorable to you, because they are two NE
- so you use strategic moves to gain advantage
- commitment, play aggressively, scare your opponents
Entry deterrence
- incumbent facing a potential entrant
- entrant moves first, incumbent moves later
- the latter can behave strategically to deter the entry
I Entrant
n | Enter Stay out
c --------------------------------
u E | 100,20 200, 0
m S | 70, -10 130, 0
bent
the NE is (100,20), it is incumbent dominant strategy, but potential entrant will enter
a few options:
- side payment, illegal?
- marge, anti-competitive ?
- build a reputation for being irrational, manipulate rivals choices to your advantage
(incumbent can increase 70 to > 100, or decrease 100 to be < 70)
the SPNE is (100,20)
in chicken game, sequential game, use strategic moves to show commitment and gain advantage
Fudenberg Tirole Taxanomy
| Your
rival's actions |
Your firm commitment | ||
| Tough | soft | ||
| Strategic complement | You
commit tough, your rival tough too (puppy dog) |
You
commit soft your rival soft too (fat cat) |
|
| Strategic substitutes | You
commit tough, your rival soft
(top dog) |
You
commit soft your rival tough (lean & hungry look) |
|
step 1: calculate your profit as a function of what the other players might do
Ļ€you = f(others actions)
step 2: guess your competitor's profits as a function of what you might do
Ļ€others = f(your actions)
step 3: can legally cooperate?
if yes, use cooperative game theory
if no, use non-cooperative game theory
step 4: create the game's payoff
step 5: pick the game strategies
step 6:strategic moves
step 7: make the moves
(to be continued.)
Monday, July 24, 2017
Leverage and Cost of Capital
Leverage
- the effects that fixed costs have on the returns that shareholders earn
- magnify returns and risks
Operating leverage
- relationship between sales revenue and EBIT
Financial leverage
- relationship between EBIT and EPS
Total leverage
- relationship between sales revenue and EPS
operating leverage and financial leverage influence a firm's beta
breakeven point = fixed costs / contribution margin
= fixed costs / (price - variable costs)
When contribution margin (CM) is higher, profit rises faster
The higher the fixed costs, and low variable cost, the higher the beta
Operating leverage
- comes from mix of fixed and variable cost
- the effects that fixed costs have on the returns that shareholders earn
- magnify returns and risks
Operating leverage
- relationship between sales revenue and EBIT
Financial leverage
- relationship between EBIT and EPS
Total leverage
- relationship between sales revenue and EPS
operating leverage and financial leverage influence a firm's beta
breakeven point = fixed costs / contribution margin
= fixed costs / (price - variable costs)
When contribution margin (CM) is higher, profit rises faster
The higher the fixed costs, and low variable cost, the higher the beta
Operating leverage
- comes from mix of fixed and variable cost
| if sales up by 10% | ||||
| Lite | heavy | Lite | heavy | |
| sales volume | 10000 | 10000 | 11000 | 11000 |
| price | 1000 | 1000 | 1000 | 1000 |
| total revenue | 10000000 | 10000000 | 11000000 | 11000000 |
| fixed cost | 5000000 | 2000000 | 5000000 | 2000000 |
| variable cost (per unit) |
400 | 700 | 400 | 700 |
| total cost | 9000000 | 9000000 | 9400000 | 9700000 |
| EBIT | 1000000 | 1000000 | 1600000 | 1300000 |
Degree of Operating leverage = %Ī”EBIT / %Ī”Sales
if sales up by 10%,
DOL of Lite = 60%/10% = 6
DOL of heavy = 30%/10% = 3
- more fixed cost , DOL increases
if DOL > 1, the firm has operating leverage
Financial leverage
- comes from use of debt
- more EBIT goes to investors in levered firm (as in NI + interest)
if sales up by 10%,
DOL of Lite = 60%/10% = 6
DOL of heavy = 30%/10% = 3
- more fixed cost , DOL increases
if DOL > 1, the firm has operating leverage
Financial leverage
- comes from use of debt
| Unlevered | levered | |
| debt | 0 | 10000 |
| equity | 20000 | 10000 |
| asset | 20000 | 20000 |
| tax rate | 0.4 | 0.4 |
| interest rate | 0.12 | 0.12 |
| EBIT | 3000 | 3000 |
| interest(12%) | 0 | 1200 |
| EBT | 3000 | 1800 |
| tax | 1200 | 720 |
| NI | 1800 | 1080 |
| ROE | 9% | 11% |
- for financially leveraged firm, NI is lower, but equity base is lower too, so ROE is higher
Basic Earning Power
BEP = EBIT/total assets
- BEP is not affected by financial leverage, because EBIT is the same whether you borrow or not
- BEP is affected by operating leverage, because change in EBIT is affected by DOL
Implications
- for leverage to be positive (increase ROE), BEP must be > rd
- for firms with high profit , use more debt, to shield the profit using debt (tax shield)
Basic Earning Power
BEP = EBIT/total assets
- BEP is not affected by financial leverage, because EBIT is the same whether you borrow or not
- BEP is affected by operating leverage, because change in EBIT is affected by DOL
Implications
- for leverage to be positive (increase ROE), BEP must be > rd
- for firms with high profit , use more debt, to shield the profit using debt (tax shield)
Sunday, July 23, 2017
Financial Derivatives
Forward and Futures
pricing:
F(t, T) = S(t) e ^ (r + u - d -y) (T-t)
where T: expiration date
r : risk free rate
u : storage cost
d : dividend yield
y : convenience yield
OTC central clearing to lower counterparty risk, such as London clearing house (LCH)
futures contracts are settled by cash settlement
futures contracts are closed by entering into an offsetting position relative to your original position
Interest Rate Forward
notation:
2f1 - 1 year from now, 6 month rate
14f6 - 7 year from now, 3 year rate
By the principle of no arbitrage,
(1+r1/2)(1+1f1 /2) = (1+r2/2)2, solve for 1f1
r1: 6 month spot
r2: 1 year spot
Interest Rate Swap
interest rate is implied in swap
USD/THB spot
USD LIBOR
# of days
swap point = fwd - spot
Ī£ PV (fixed) = Ī£ PV(floating)
money market rate, and bond rate affect swap rate
bank use PV01 to calculate risk
if gap > threshold, bank charge more
DV01 or PVBP
- 30 yr bond with 5.5% coupon
at yield of 5.5%, price = 100
at yield of 5.51%, price = 99.8540
DV01 = 0.146% of par
or DV01(per $1 mm par) = $1460
** take note **
- PV01 is change in market value from bumping the coupon rate by 1 bp
- DV01 is the change in market value for a 1 bp parallel shift of the yield curve
**hedge bond investment with bond futures
- use DV01
DV01 of 6 year bond with coupon of 5.5%: 712.5 per $1million par value
DV01 of 6 year bond with coupon of 5.0%: 613.1 per $1million par value
- the hedge ratio (futures contract to sell) of 6 year bond investment against interest rate risk is
hedge ratio = 712.5/613.1
Cross Currency Swap
- agreement between two parties to exchange principal and interest payments in two currencies over specified period
- may have or my not have initial principal exchange
- interest payments are usually not netted
basis swap (floating vs floating)
FX Forward
EUR/USD ; ieur < iusd
EUR/USD forward, EUR appreciate
=> swap point+ve
=> EUR/USD > spot
AUD/USD forward, AUD depreciate
=> swap point -ve
=> AUD /USD < spot
Case study:
Delox imports machine from Japan. Its revenue is in EUR, while its expense is in JPY. It expects to pay JPY 1000 million in 6 months. How to manage its FX risk?
Ans: one way is to buy JPY forward
EURJPY spot rate 129.45
6 month EURJPY forward rate 128.26
forward: bank charge bid offer spread
swap: bank will not charge bid offer spread
pricing:
F(t, T) = S(t) e ^ (r + u - d -y) (T-t)
where T: expiration date
r : risk free rate
u : storage cost
d : dividend yield
y : convenience yield
OTC central clearing to lower counterparty risk, such as London clearing house (LCH)
futures contracts are settled by cash settlement
futures contracts are closed by entering into an offsetting position relative to your original position
Interest Rate Forward
notation:
2f1 - 1 year from now, 6 month rate
14f6 - 7 year from now, 3 year rate
By the principle of no arbitrage,
(1+r1/2)(1+1f1 /2) = (1+r2/2)2, solve for 1f1
r1: 6 month spot
r2: 1 year spot
Interest Rate Swap
interest rate is implied in swap
USD/THB spot
USD LIBOR
# of days
swap point = fwd - spot
Ī£ PV (fixed) = Ī£ PV(floating)
money market rate, and bond rate affect swap rate
bank use PV01 to calculate risk
if gap > threshold, bank charge more
DV01 or PVBP
- 30 yr bond with 5.5% coupon
at yield of 5.5%, price = 100
at yield of 5.51%, price = 99.8540
DV01 = 0.146% of par
or DV01(per $1 mm par) = $1460
** take note **
- PV01 is change in market value from bumping the coupon rate by 1 bp
- DV01 is the change in market value for a 1 bp parallel shift of the yield curve
**hedge bond investment with bond futures
- use DV01
DV01 of 6 year bond with coupon of 5.5%: 712.5 per $1million par value
DV01 of 6 year bond with coupon of 5.0%: 613.1 per $1million par value
- the hedge ratio (futures contract to sell) of 6 year bond investment against interest rate risk is
hedge ratio = 712.5/613.1
Cross Currency Swap
- agreement between two parties to exchange principal and interest payments in two currencies over specified period
- may have or my not have initial principal exchange
- interest payments are usually not netted
basis swap (floating vs floating)
FX Forward
EUR/USD ; ieur < iusd
EUR/USD forward, EUR appreciate
=> swap point
AUD/USD forward, AUD depreciate
=> swap point -
Case study:
Delox imports machine from Japan. Its revenue is in EUR, while its expense is in JPY. It expects to pay JPY 1000 million in 6 months. How to manage its FX risk?
Ans: one way is to buy JPY forward
EURJPY spot rate 129.45
6 month EURJPY forward rate 128.26
swap: bank will not charge bid offer spread
Friday, July 21, 2017
Financial Options
Options
components of option price
m.v of option = time premium + intrinsic value
intrinsic value: the difference of m.v of underlying and strike price of call option
Minimum value of call
American call : Ca(S0, T, X) >= max(0, S0 - X)
European call : Ce(S0, T, X) >= max(0, S0 - X(1+r)-T)
Minimum value of put
American put : max(0, X - S0 )
European put : max(0, X(1+r)-T - S0 )
Put call parity
S0 = C(S0, T, X) - P(S0, T, X) + X/(1 + r )
ATM european call or ATM european put, which one has higher price?
S = c - p + pv(x)
c - p = S - pv(x) ; S=X for ATM option
c - p = S - pv(S) ; S - pv(S) > 0
So : c > p
Put call forward parity
S0 = C(S0, T, X) - P(S0, T, X) + X/(1 + r )
F = S0(1+r)
S0 = F/(1+r)
So : F/(1+r) = C(S0, T, X) - P(S0, T, X) + X/(1 + r )
P(S0, T, X) = C(S0, T, X) + (X-F)/(1+r)
Binomial Model
- discrete time model
- if infinite samples, converges to BSM model
- if interval time getting smaller, converges to BSM model
p = (1+r-d) / (u -d)
c = [ pCu + (1-p)Cd ] / (1+r)
if stock price up by 20%, and down by 10%, then: u = 1.2, d = 0.9
S+ = Su; S- = Sd, find Cu, Cd, then find c
Black Scholes Model
- continuous time model
- assume rf and vol are constant
- no taxes and transaction fee
- assume options are european
- assume stock price is normally distributed
- S, T, X, rf, vol -> find c
calculate implied vol
- work backwards to find it
- C, S, X, T, rf ->BSM model -> find implied vol
volatility smile
- shows implied vol is not consistent
- implied vol depends on exercise price
- violates the constant vol assumption of BSM
Implied vol > forecast vol
- option overvalued
- sell option
selling options, the trade is short volatility. if actual vol is lower than what he priced it at, he makes money
Interest rate Cap
- series of interest rate call options
Interest rate Floor
- series of interest rate put options
components of option price
intrinsic value: the difference of m.v of underlying and strike price of call option
Minimum value of call
American call : Ca(S0, T, X) >= max(0, S0 - X)
European call : Ce(S0, T, X) >= max(0, S0 - X(1+r)-T)
Minimum value of put
American put : max(0, X - S0 )
European put : max(0, X(1+r)-T - S0 )
Ca(S0, T, X) > Ce(S0, T, X)
but prior to expiration, S0 - X(1+r)-T > S0 - X
early exercise?
- for call , if dividend > time premium, then you exercise the call option
- for put , if interest rat is large enough
Maximum value of put
American put : X
European put: X(1+r)-T
S0 = C(S0, T, X) - P(S0, T, X) + X/(1 + r )
ATM european call or ATM european put, which one has higher price?
S = c - p + pv(x)
c - p = S - pv(x) ; S=X for ATM option
c - p = S - pv(S) ; S - pv(S) > 0
So : c > p
Put call forward parity
S0 = C(S0, T, X) - P(S0, T, X) + X/(1 + r )
F = S0(1+r)
S0 = F/(1+r)
So : F/(1+r) = C(S0, T, X) - P(S0, T, X) + X/(1 + r )
P(S0, T, X) = C(S0, T, X) + (X-F)/(1+r)
Binomial Model
- discrete time model
- if infinite samples, converges to BSM model
- if interval time getting smaller, converges to BSM model
p = (1+r-d) / (u -d)
c = [ pCu + (1-p)Cd ] / (1+r)
if stock price up by 20%, and down by 10%, then: u = 1.2, d = 0.9
S+ = Su; S- = Sd, find Cu, Cd, then find c
Black Scholes Model
- continuous time model
- assume rf and vol are constant
- no taxes and transaction fee
- assume options are european
- assume stock price is normally distributed
- S, T, X, rf, vol -> find c
calculate implied vol
- work backwards to find it
- C, S, X, T, rf ->BSM model -> find implied vol
volatility smile
- shows implied vol is not consistent
- implied vol depends on exercise price
- violates the constant vol assumption of BSM
- option overvalued
- sell option
selling options, the trade is short volatility. if actual vol is lower than what he priced it at, he makes money
Interest rate Cap
- series of interest rate call options
Interest rate Floor
- series of interest rate put options
Wednesday, July 12, 2017
Macroeconomics (Part 2)
Marshall-Lerner condition
A depreciation has two good effects (substitution of imports , more demand for exports) and one bad effects (imports are more expensive). Marshall-Lerner condition is real depreciation leads to an increase in NX if sum of export and import elasticity is > 1. Initially, the condition is not met, devaluation worsens the trade balance. In the long run, trade balance will improve, it is called the J curve effect.
PED (x-m) > 1, devaluation improves current account balance.
PED: price elasticity of demand
Mundell-Fleming model
An extension of IS-LM model, the Mundell–Fleming model describes the short-run relationship between an economy's nominal exchange rate, interest rate, and output. It is used in open economy. This model has been used to argue that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. This principle is frequently called the "impossible trinity," "unholy trinity," or the "Mundell–Fleming trilemma."
It is also known is IS-LM-BoP model. BoP is (Balance of Payments).
In perfect capital mobility, the BoP curve is horizontal.
In perfect capital mobility and fixed exchange rate, the increase in gov spending (expansionary fiscal policy) forces the central bank to supply more local currency, to keep the interest rate unchanged. At the same interest rate, the output has increased.
In perfect capital mobility and fixed exchange rate, the increase in local currency (expansionary monetary policy) will drop the exchange rate. It forces the government to buy local currency to maintain fixed exchange rate. This reduces the money supply. This means monetary policy has no effect.
So it is impossible to have fixed exchange rate, perfect capital movement, and independent monetary policy.
Minimum wage policy
Why minimum wage is not good for the country?
If wage > productivity,
1) Ļ€e ↑ => P↑
w ↑ => C ↑, Pe ↑
Pe => Ļ€e ↑ => P ↑
2) P ↑ => X ↓ & IM ↑ => NX ↓
P ↑ => Īµ = EP/P* => Īµ↑ => NX ↓
Purchasing power of currency and Purchasing power parity
The purchasing power of a currency refers to the quantity of the currency required to purchase a unit of a good, or basket of goods and services. Purchasing power is determined by the relative cost of living and inflation rates in different countries.
Purchasing power parity means equalising the purchasing power of two currencies by taking into account these cost of living and inflation differences. The basis of PPP is law of one price. In the absence of transportation and other transaction costs, competitive markets will make the price of an identical good the same in two countries, expressed in the same currency.
For example, a particular TV set that sells for 400Rp in India should cost 800Rp in Pakistan if the exchange rate between India and Pakistan is 2 Pak/India. If the price of the TV in Pakistan was only 700 Rp, consumers in India would prefer buying the TV set in Pakistan. If this process (called "arbitrage") is carried out at a large scale, the India consumers buying Pakistan goods will bid up the value of the Pakistan Dollar, thus making Pak goods more costly to them. This process continues until the goods are again the same price.
For example again, if we convert GDP in China to US dollars using market exchange rates, relative purchasing power is not taken into account. By adjusting rates to take into account local purchasing power differences, known as PPP adjusted exchange rates, international comparisons are more valid.
Money illusions and Money neutrality
The illusions of money : people think of money in nominal terms, the nominal value of money is mistaken for its purchasing power.
Neutrality of money : change in stock of money affects nominal variables, such as price, wages, exchange rate, doe not affect real variables, such as employment, GDP, consumption.
Microfoundations in Macroeconomics
It is a macro model that is built up from a formal analysis of the behaviour of individual agents in a consistent way. There may be just a single representative agent, or increasingly heterogeneous agents. So this way of macro analysis will involve lots of optimisation by individual agents, to derive aggregate relationships.
Differences between Micro and Macroeconomics
The difference between micro and macro economics is easy to tell. Microeconomics is the study of economics at an individual, group or company level. Microeconomics focuses on issues that affect individuals and companies. Micro looks at supply and demand and the setting of price level.
Macroeconomics, on the other hand, is the study of a national economy as a whole. Macro studies the GDP and how it is affected by national income, unemployment, growth rate.
A depreciation has two good effects (substitution of imports , more demand for exports) and one bad effects (imports are more expensive). Marshall-Lerner condition is real depreciation leads to an increase in NX if sum of export and import elasticity is > 1. Initially, the condition is not met, devaluation worsens the trade balance. In the long run, trade balance will improve, it is called the J curve effect.
PED: price elasticity of demand
Mundell-Fleming model
An extension of IS-LM model, the Mundell–Fleming model describes the short-run relationship between an economy's nominal exchange rate, interest rate, and output. It is used in open economy. This model has been used to argue that an economy cannot simultaneously maintain a fixed exchange rate, free capital movement, and an independent monetary policy. This principle is frequently called the "impossible trinity," "unholy trinity," or the "Mundell–Fleming trilemma."
It is also known is IS-LM-BoP model. BoP is (Balance of Payments).
In perfect capital mobility, the BoP curve is horizontal.
So it is impossible to have fixed exchange rate, perfect capital movement, and independent monetary policy.
Why minimum wage is not good for the country?
If wage > productivity,
1) Ļ€e ↑ => P↑
w ↑ => C ↑, Pe ↑
Pe => Ļ€e ↑ => P ↑
2) P ↑ => X ↓ & IM ↑ => NX ↓
P ↑ => Īµ = EP/P* => Īµ↑ => NX ↓
Purchasing power of currency and Purchasing power parity
The purchasing power of a currency refers to the quantity of the currency required to purchase a unit of a good, or basket of goods and services. Purchasing power is determined by the relative cost of living and inflation rates in different countries.
Purchasing power parity means equalising the purchasing power of two currencies by taking into account these cost of living and inflation differences. The basis of PPP is law of one price. In the absence of transportation and other transaction costs, competitive markets will make the price of an identical good the same in two countries, expressed in the same currency.
For example, a particular TV set that sells for 400Rp in India should cost 800Rp in Pakistan if the exchange rate between India and Pakistan is 2 Pak/India. If the price of the TV in Pakistan was only 700 Rp, consumers in India would prefer buying the TV set in Pakistan. If this process (called "arbitrage") is carried out at a large scale, the India consumers buying Pakistan goods will bid up the value of the Pakistan Dollar, thus making Pak goods more costly to them. This process continues until the goods are again the same price.
For example again, if we convert GDP in China to US dollars using market exchange rates, relative purchasing power is not taken into account. By adjusting rates to take into account local purchasing power differences, known as PPP adjusted exchange rates, international comparisons are more valid.
Money illusions and Money neutrality
The illusions of money : people think of money in nominal terms, the nominal value of money is mistaken for its purchasing power.
Neutrality of money : change in stock of money affects nominal variables, such as price, wages, exchange rate, doe not affect real variables, such as employment, GDP, consumption.
Microfoundations in Macroeconomics
It is a macro model that is built up from a formal analysis of the behaviour of individual agents in a consistent way. There may be just a single representative agent, or increasingly heterogeneous agents. So this way of macro analysis will involve lots of optimisation by individual agents, to derive aggregate relationships.
Differences between Micro and Macroeconomics
The difference between micro and macro economics is easy to tell. Microeconomics is the study of economics at an individual, group or company level. Microeconomics focuses on issues that affect individuals and companies. Micro looks at supply and demand and the setting of price level.
Macroeconomics, on the other hand, is the study of a national economy as a whole. Macro studies the GDP and how it is affected by national income, unemployment, growth rate.
Monday, July 10, 2017
Fiscal Policy
Fiscal policy
- automatic stabilizer: tax revenue, unemployment benefit
- discretionary policy
tax revenue is endogenous, sensitive to the state of economy than spending
fiscal policy is planned with horizon larger than monetary policy
fiscal consolidation may increase AD, eg. expansionry fiscal contraction
- people expect lower debt, lower taxes in future
- spending cut, wage cut -> labor cost down, Investment up , profit up
- structure reform complement fiscal contraction
Interaction of fiscal and monetary policy
use stackelberg game to model the interaction of policy makers
Government Budget Deficit
deficitt = rBt-1 + Gt -Tt
where r: real interest rate
Bt-1: government debt at the end of year t-1
let deficitt = Bt - Bt-1
therefore:
Bt - Bt-1 = = rBt-1 + Gt -Tt
Bt = (1+r)Bt-1 + (Gt -Tt)
-if government spending is unchanged, a decrease in taxes today will have to be offset by an increase in taxes in the future.
-the longer the government waits to increase taxes, the higher the real interest rate, and higher the increase in future taxes
Debt to GDP Ratio
Bt/Yt = (1+r)Bt-1/Yt + (Gt -Tt)/Yt
after mathematics munipulation:
Bt/Yt - Bt-1/Yt-1 = (r-g)Bt-1/Yt-1 + (Gt -Tt)/Yt
where g: GDP growth rate
How countries reduced their debt ratios
- run budget surplus, (Gt -Tt) < 0
- have low real interest rate and high GDP growth, (r - g) > 0, real interest low can be low or even negative when inflation is high.
- a large part of the decrease in debt ratios was achieved by paying bond holders a negative real interest rate on the bonds
Balanced Budget
- It means Gt = Tt
If economy is good, T up -> G up -> cause overheating
If economy is not good, T down -> G down -> econ could not recover
Therefore, balanced budget is not practical
Ricardian Equivalence
David Ricardo developed a theory about government spending and private spending. When government stimulate demand bu debt financed spending, the people will save money to pat for future tax increases (to be used to pay off the debt).
- So overall demand is unchanged
Cyclically Adjusted Deficits
It is used to indicate whether tax/revenue system is going to create deficit at Yn (output at natural full employment). If it is negative at Yn, deficit is *not* going to go down.
- We never know exact Yn, and Yn changes, so Cyclically Adjusted Deficits is not useful
Money Finance
1. Debt Monetization
Fiscal dominance of monetary policy: Central bank must do what the government tells it to do. Government issues bonds and forces CB to buy. The central bank then pays the government with the money it creates, and the government uses that money to finance its deficit. This process is called debt monetization.
2. Seignorage
The amount of good and services that government can obtain by printing money. The revenue from money creation is called seignorage.
seignorage = Ī”H/P = Ī”H/H * H/P
seignorage/ Y = (Ī”H/H * H/P ) / Y
If government uses seinorage to finance budget deficit of 10% of GDP, seignorage/ Y = 10%, so Ī”H/H = 10% and (H/P)/Y = 1, the growth rate of nominal money must be 10%.
- automatic stabilizer: tax revenue, unemployment benefit
- discretionary policy
tax revenue is endogenous, sensitive to the state of economy than spending
fiscal policy is planned with horizon larger than monetary policy
fiscal consolidation may increase AD, eg. expansionry fiscal contraction
- people expect lower debt, lower taxes in future
- spending cut, wage cut -> labor cost down, Investment up , profit up
- structure reform complement fiscal contraction
Interaction of fiscal and monetary policy
use stackelberg game to model the interaction of policy makers
C- cooperation , Pareto efficient equilibrium
OM -monetary leadership, OF -fiscal leadership
Government Budget Deficit
deficitt = rBt-1 + Gt -Tt
where r: real interest rate
Bt-1: government debt at the end of year t-1
let deficitt = Bt - Bt-1
therefore:
Bt - Bt-1 = = rBt-1 + Gt -Tt
Bt = (1+r)Bt-1 + (Gt -Tt)
-if government spending is unchanged, a decrease in taxes today will have to be offset by an increase in taxes in the future.
-the longer the government waits to increase taxes, the higher the real interest rate, and higher the increase in future taxes
Debt to GDP Ratio
Bt/Yt = (1+r)Bt-1/Yt + (Gt -Tt)/Yt
after mathematics munipulation:
Bt/Yt - Bt-1/Yt-1 = (r-g)Bt-1/Yt-1 + (Gt -Tt)/Yt
where g: GDP growth rate
How countries reduced their debt ratios
- run budget surplus, (Gt -Tt) < 0
- have low real interest rate and high GDP growth, (r - g) > 0, real interest low can be low or even negative when inflation is high.
- a large part of the decrease in debt ratios was achieved by paying bond holders a negative real interest rate on the bonds
Balanced Budget
- It means Gt = Tt
If economy is good, T up -> G up -> cause overheating
If economy is not good, T down -> G down -> econ could not recover
Therefore, balanced budget is not practical
Ricardian Equivalence
David Ricardo developed a theory about government spending and private spending. When government stimulate demand bu debt financed spending, the people will save money to pat for future tax increases (to be used to pay off the debt).
- So overall demand is unchanged
Cyclically Adjusted Deficits
It is used to indicate whether tax/revenue system is going to create deficit at Yn (output at natural full employment). If it is negative at Yn, deficit is *not* going to go down.
- We never know exact Yn, and Yn changes, so Cyclically Adjusted Deficits is not useful
Money Finance
1. Debt Monetization
Fiscal dominance of monetary policy: Central bank must do what the government tells it to do. Government issues bonds and forces CB to buy. The central bank then pays the government with the money it creates, and the government uses that money to finance its deficit. This process is called debt monetization.
2. Seignorage
The amount of good and services that government can obtain by printing money. The revenue from money creation is called seignorage.
seignorage = Ī”H/P = Ī”H/H * H/P
seignorage/ Y = (Ī”H/H * H/P ) / Y
If government uses seinorage to finance budget deficit of 10% of GDP, seignorage/ Y = 10%, so Ī”H/H = 10% and (H/P)/Y = 1, the growth rate of nominal money must be 10%.
Friday, July 7, 2017
Unconventional Monetary Policy
Quantitative Easing
QE is Large Scale Asset Purchase (LSAP). The Fed buying a set quantity of bonds from private financial institutions
The goal :
to facilitate bank lending and increase money supply
to increase broad money supply even without further bank lending
to lower interest rates for types of risky financial assets
- enlarge the balance sheet of the Fed
misconceptions about QE
- QE gives banks free money
the money is not free because while banks earns interest on the newly created reserves, it also need to pay interest on the newly created deposit
- QE leads to high quantity of M2
customer can use the money to repay loan, and reduce money supply
( customer borrow cheaply, to repay expensive loan)
Monetary Finance
or helicopter money as coined by Milton Friedman
running fiscal deficit, not financed by debt, but by increase in monetary base
such as CB directly credits gov current account, free of interest
- enlarge the balance sheet of CB
Negative Interest Rates
CB charge banks that hold reserve at CB
bank cannot transfer negative rates to deposits, for fear of losing customers
new loans are priced at lower rates
banks net interest income falls
the profit margin between lending and deposit rates is squeezed
banks unwilling to lend -> less bank income -> bank shares fall
the existence of paper currency makes it difficult for CB to take policy rate below zero
Negative Interest Rates policy could be contractionary, as it is a reduction of money supply
Forward Guidance
Management of expectations
let business estimate how long low interest rates may be around
a way of converting low ST interest rates into lower LT interest rates
time inconsistency can be a problem of forward guidance
Financial Crisis
initial phase (credit boom and bust, asset price boom and bust)
->banking crisis->debt deflation
debt deflation: debt become bigger in real terms during deflation
term spread = 10 yr yield - 2 yr yield (slope of the yield curve)
stock market is poor indicator of recessions
(the link between stock prices and GDP growth is weak)
yield curve is better indicator of recessions
Breakeven inflation
the rate that make you indifferent between TIPS and nominal bond, if CPI inflation averages to that level over the years
eg. 10 yr breakeven rate = 10 yr nominal treasure yield - 10 yr TIPS yield
if CPI inflation > breakeven inflation, buys TIPS
QE is Large Scale Asset Purchase (LSAP). The Fed buying a set quantity of bonds from private financial institutions
The goal :
to facilitate bank lending and increase money supply
to increase broad money supply even without further bank lending
to lower interest rates for types of risky financial assets
- enlarge the balance sheet of the Fed
misconceptions about QE
- QE gives banks free money
the money is not free because while banks earns interest on the newly created reserves, it also need to pay interest on the newly created deposit
As seen in figure above, pension fund sells gov bond, get cash, buy more risky assets (portfolio rebalancing), support asset prices because of search of yields.
- QE leads to high quantity of M2
customer can use the money to repay loan, and reduce money supply
( customer borrow cheaply, to repay expensive loan)
Monetary Finance
or helicopter money as coined by Milton Friedman
running fiscal deficit, not financed by debt, but by increase in monetary base
such as CB directly credits gov current account, free of interest
- enlarge the balance sheet of CB
Negative Interest Rates
CB charge banks that hold reserve at CB
bank cannot transfer negative rates to deposits, for fear of losing customers
new loans are priced at lower rates
banks net interest income falls
the profit margin between lending and deposit rates is squeezed
banks unwilling to lend -> less bank income -> bank shares fall
the existence of paper currency makes it difficult for CB to take policy rate below zero
Negative Interest Rates policy could be contractionary, as it is a reduction of money supply
Forward Guidance
Management of expectations
let business estimate how long low interest rates may be around
a way of converting low ST interest rates into lower LT interest rates
time inconsistency can be a problem of forward guidance
Financial Crisis
initial phase (credit boom and bust, asset price boom and bust)
->banking crisis->debt deflation
debt deflation: debt become bigger in real terms during deflation
initial phase (credit boom and bust, severe fiscal imbalances)
->currency crisis->financial crisis
wholesale deposits: a deposit at a bank made by institutional investors, such as mutual bank, pension, large business, another bank. It involves large amount of money, and usually short term
** if banks use whole funds as a source of funds, and make long term loan. If wholesale funding dries up, banks could have liquidity problem.
Yield Curve->currency crisis->financial crisis
wholesale deposits: a deposit at a bank made by institutional investors, such as mutual bank, pension, large business, another bank. It involves large amount of money, and usually short term
** if banks use whole funds as a source of funds, and make long term loan. If wholesale funding dries up, banks could have liquidity problem.
term spread = 10 yr yield - 2 yr yield (slope of the yield curve)
stock market is poor indicator of recessions
(the link between stock prices and GDP growth is weak)
yield curve is better indicator of recessions
Breakeven inflation
the rate that make you indifferent between TIPS and nominal bond, if CPI inflation averages to that level over the years
eg. 10 yr breakeven rate = 10 yr nominal treasure yield - 10 yr TIPS yield
if CPI inflation > breakeven inflation, buys TIPS
Thursday, July 6, 2017
The Money Supply Process
Players in the money supply process
- Central Bank
- Commercial Bank
- Depositors: individuals and institutions
Monetary Base = Currency + Reserves
(MB: aka High powered money)
Reserves = RR + excess reserves
Reserves are bank's deposit with CB, plus currency in bank's vault
Monetary Base Changes
To change MB, CB uses OMO, or lending to banks
- to increase MB, buy gov bond
- to decrease MB, sell gov bond
Example: Open market purchase from a bank
CB
Asset Liabilities
Securities +100m Reserves +100m
Commercial Bank
Asset L
Securities -100m no change
Reserves +100m
Example: Open market sales to a bank
CB
Asset L
Securities -100m Reserves -100m
Commercial Bank
Asset L
Securities +100m no change
Reserves -100m
Example: CB lends to bank
CB
Asset L
Loans +100m Reserves +100m
Commercial Bank
Asset L
Reserves +100m Loans + 100m
MB = MBn + BR
BR: borrowed reserves by banks, cannot controlled by CB
MBn: non borrowed monetary base
Money Creation
CB control MB, but not the overall money supply
commercial banks are creators of deposit money
Bank A
Asset L
Reserves +100 checkable deposit +100
(after bank A makes a loan to bank B)
Bank A
Asset L
Reserves +100 checkable deposit +100
newloan +90 newdeposit +90
(after borrower withdraws cash)
Bank A
Asset L
Reserves +10 checkable deposit +100
newloan +90
Bank B
Asset L
Reserves +90 checkable deposit +90
R = rr x D ; rr : required reserve ratio, D : deposit, R : reserve
M = m x MB ; m : money multiplier
M = C + D
MB = C + R = C + rrD + ER
m = (C + D) / (C + rrD + ER)
Definition of Money
narrow money
M0: notes and coins in circulation
MB: M0 + reserves
M1: M0 + checkable deposits + traveler cheques
broad money
M2: M1 + savings deposit, time deposits,
- Central Bank
- Commercial Bank
- Depositors: individuals and institutions
Monetary Base = Currency + Reserves
(MB: aka High powered money)
Reserves = RR + excess reserves
Reserves are bank's deposit with CB, plus currency in bank's vault
Monetary Base Changes
To change MB, CB uses OMO, or lending to banks
- to increase MB, buy gov bond
- to decrease MB, sell gov bond
Example: Open market purchase from a bank
CB
Asset Liabilities
Securities +100m Reserves +100m
Commercial Bank
Asset L
Securities -100m no change
Reserves +100m
Example: Open market sales to a bank
CB
Asset L
Securities -100m Reserves -100m
Commercial Bank
Asset L
Securities +100m no change
Reserves -100m
Example: CB lends to bank
CB
Asset L
Loans +100m Reserves +100m
Commercial Bank
Asset L
Reserves +100m Loans + 100m
MB = MBn + BR
BR: borrowed reserves by banks, cannot controlled by CB
MBn: non borrowed monetary base
Money Creation
CB control MB, but not the overall money supply
commercial banks are creators of deposit money
Bank A
Asset L
Reserves +100 checkable deposit +100
(after bank A makes a loan to bank B)
Bank A
Asset L
Reserves +100 checkable deposit +100
newloan +90 newdeposit +90
(after borrower withdraws cash)
Bank A
Asset L
Reserves +10 checkable deposit +100
newloan +90
Bank B
Asset L
Reserves +90 checkable deposit +90
R = rr x D ; rr : required reserve ratio, D : deposit, R : reserve
M = m x MB ; m : money multiplier
M = C + D
MB = C + R = C + rrD + ER
m = (C + D) / (C + rrD + ER)
Definition of Money
narrow money
M0: notes and coins in circulation
MB: M0 + reserves
M1: M0 + checkable deposits + traveler cheques
broad money
M2: M1 + savings deposit, time deposits,
Wednesday, July 5, 2017
Central Bank and Monetary Policy
The Monetary Policy Objectives
Price stability - control inflation
Economic stability - push for sustainable economic growth
Financial stability - efficient payments system
Inflation is bad because:
erode purchasing power
cause uncertainty in economy
reduce country's competitiveness - goods and services become expensive
worse income inequality - the rich can always keep their financial assets in stock market, real estate, foreign assets
other economic costs - rent seeking behavior, inflation make credit cheap
FX intervention is costly
control depreciation - not enough FX reserve
control appreciation - negative carry, FX valuation loss
- negative carry: the difference of interest payment on foreign assets and interest payment on domestic gov bonds
- FX valuation loss: the valuation of FX assets reduce when FX depreciate against domestic currency
FX sterilization: to offset the effect of FX intervention. For example, CB sells domestic currency, and buys foreign currency to support its currency. To mop up excess liquidity in the market , do so by selling gov bonds,
Monetary Policy Tools
Reserve requirement (RR):
for liquidity management and monetary control
increase the cost of operation on banks, distort market system if the reserve does not pay interest (it is a tax on banks)
Open Market Operations (OMO):
- repo, reverse repo
1 day bilateral repo rate: policy rate
7 day, 14 day repo rate, auction
- outright purchase/sale of gov bands
- foreign exchange swap
Discount window and discount rate
- discount window also known as standing facility
lending facility , deposit facility
CB lending rate : policy rate + 0.5%
CB borrowing rate : policy rate - 0.5%
iU (CB lending rate ), iL (CB borrowing rate)
iU - iL : interest rate corridor
important to have corridor, CB wants to influence the market rate around the policy rate
- discount rate is usually set at fed fund rate + 100bp. The purpose is the Fed prefers banks to borrow from each other in the federal funds market, so that they can monitor each other's credit risk.
corridor too wide: more volatility in market rate
corridor too narrow: too little penalty for commercial bank when they come to lend/borrow
standing facility and OMO are market based , RR is not market based. If banks don't transmit well, use RR
Monetary Policy Regime
1. exchange rate targeting:
-CB must have sufficient reserves
-CB and gov must be ready to use capital controls
2. monetary targeting:
-target the supply of money in economy
3. inflation targeting:
-public announcement of medium term inflation target,
-easy to understand
-reduces time inconsistency problem
-stresses transparency and accountability
-take time to have effect ( 6 - 8 quarters)
-too much rigidity, eg. inflation nutter
Monetary Policy and Financial Stability
Time inconsistency problem: CB deviate from a policy after it was announced, destroys CB's creditability
Nominal anchor: money supply or inflation rate
** use nominal anchor because the public can observe nominal variable, such as price increase
** second round effect: if wage goes up, price goes, up, wages goes up, wage-price spiral. If CB can anchor inflation expectations, the second round effect is minimal
**if monetary policy is credible enough to anchor inflation expectation, the inflation overall will be maintained.
Clean vs lean debate:
Lean
besides price stability risk, CB respond to other risk, such as asset bubble risk
because cost of cleaning up is too high
Clean
It is impossible to lean against credit bubbles using monetary policy
difficult to identify asset price bubbles
only clean up after bubble burst
Two types of asset price bubbles:
- credit driven bubble
bank extends BS to investors, debt overhang problem
- "irrational exuberance" bubble
overly optimistic view of the investors
interest rate is a blunt tool, affecting other economic variables
and raising interest rate may not be effective in restraining bubbles
macroprudential policy can be used to reign in asset price bubbles, policy tools such as LTV, leverage ratio, and the below:
countercyclical buffer: good times banks hold more reserves
liquidity ratio: the ratio of liquid assets to total net cash outflows, that banks need to have
It is dangerous to associate easing/tightening of monetary policy with a fall/rise in ST nominal rates. It is important to look at other assets prices as well.
Case study:
In Japan, in the two lost decades, although the nominal rate is low, deflation means real rate remained high. The high real interest rate is reflected in the lower asset prices of real estate and stock valuation.
Monetary Policy and Transmission Channels
Interest rate: real interest rate affects consumers and business, LT interest rate has major impact on spending
Credit supply:
- bank lending channel: policy rate affects banks marginal cost of funds, increase in cost of funds make banks reduce loan
- balance sheets channel: interest rate affects firms balance sheet, firms can borrow more when their balance sheet improves
Asset prices: stock price up, financial wealth up, consumption rises
Exchange rate: FX changes lead to changes in relative prices of domestic and foreign goods and services
Expectations: anchor expectations
Money and Inflation
Nominal Rigidity
- known as price stickiness or wage stickiness
- lags in the adjustment of prices and wages to changes in demand
- so money affects real variables in the short run, and prices in the long run
there are no explicit relationship between money aggregates and inflation but correlation exists
Price stability - control inflation
Economic stability - push for sustainable economic growth
Financial stability - efficient payments system
Inflation is bad because:
erode purchasing power
cause uncertainty in economy
reduce country's competitiveness - goods and services become expensive
worse income inequality - the rich can always keep their financial assets in stock market, real estate, foreign assets
other economic costs - rent seeking behavior, inflation make credit cheap
FX intervention is costly
control depreciation - not enough FX reserve
control appreciation - negative carry, FX valuation loss
- negative carry: the difference of interest payment on foreign assets and interest payment on domestic gov bonds
- FX valuation loss: the valuation of FX assets reduce when FX depreciate against domestic currency
FX sterilization: to offset the effect of FX intervention. For example, CB sells domestic currency, and buys foreign currency to support its currency. To mop up excess liquidity in the market , do so by selling gov bonds,
Monetary Policy Tools
Reserve requirement (RR):
for liquidity management and monetary control
increase the cost of operation on banks, distort market system if the reserve does not pay interest (it is a tax on banks)
Open Market Operations (OMO):
- repo, reverse repo
1 day bilateral repo rate: policy rate
7 day, 14 day repo rate, auction
- outright purchase/sale of gov bands
- foreign exchange swap
Discount window and discount rate
- discount window also known as standing facility
lending facility , deposit facility
CB lending rate : policy rate + 0.5%
CB borrowing rate : policy rate - 0.5%
iU - iL : interest rate corridor
important to have corridor, CB wants to influence the market rate around the policy rate
- discount rate is usually set at fed fund rate + 100bp. The purpose is the Fed prefers banks to borrow from each other in the federal funds market, so that they can monitor each other's credit risk.
corridor too wide: more volatility in market rate
corridor too narrow: too little penalty for commercial bank when they come to lend/borrow
standing facility and OMO are market based , RR is not market based. If banks don't transmit well, use RR
Monetary Policy Regime
1. exchange rate targeting:
-CB must have sufficient reserves
-CB and gov must be ready to use capital controls
2. monetary targeting:
-target the supply of money in economy
3. inflation targeting:
-public announcement of medium term inflation target,
-easy to understand
-reduces time inconsistency problem
-stresses transparency and accountability
-take time to have effect ( 6 - 8 quarters)
-too much rigidity, eg. inflation nutter
Monetary Policy and Financial Stability
Time inconsistency problem: CB deviate from a policy after it was announced, destroys CB's creditability
Nominal anchor: money supply or inflation rate
** use nominal anchor because the public can observe nominal variable, such as price increase
** second round effect: if wage goes up, price goes, up, wages goes up, wage-price spiral. If CB can anchor inflation expectations, the second round effect is minimal
**if monetary policy is credible enough to anchor inflation expectation, the inflation overall will be maintained.
Clean vs lean debate:
Lean
besides price stability risk, CB respond to other risk, such as asset bubble risk
because cost of cleaning up is too high
Clean
It is impossible to lean against credit bubbles using monetary policy
difficult to identify asset price bubbles
only clean up after bubble burst
Two types of asset price bubbles:
- credit driven bubble
bank extends BS to investors, debt overhang problem
- "irrational exuberance" bubble
overly optimistic view of the investors
interest rate is a blunt tool, affecting other economic variables
and raising interest rate may not be effective in restraining bubbles
macroprudential policy can be used to reign in asset price bubbles, policy tools such as LTV, leverage ratio, and the below:
countercyclical buffer: good times banks hold more reserves
liquidity ratio: the ratio of liquid assets to total net cash outflows, that banks need to have
It is dangerous to associate easing/tightening of monetary policy with a fall/rise in ST nominal rates. It is important to look at other assets prices as well.
Case study:
In Japan, in the two lost decades, although the nominal rate is low, deflation means real rate remained high. The high real interest rate is reflected in the lower asset prices of real estate and stock valuation.
Monetary Policy and Transmission Channels
Interest rate: real interest rate affects consumers and business, LT interest rate has major impact on spending
Credit supply:
- bank lending channel: policy rate affects banks marginal cost of funds, increase in cost of funds make banks reduce loan
- balance sheets channel: interest rate affects firms balance sheet, firms can borrow more when their balance sheet improves
Asset prices: stock price up, financial wealth up, consumption rises
Exchange rate: FX changes lead to changes in relative prices of domestic and foreign goods and services
Expectations: anchor expectations
Money and Inflation
Nominal Rigidity
- known as price stickiness or wage stickiness
- lags in the adjustment of prices and wages to changes in demand
- so money affects real variables in the short run, and prices in the long run
there are no explicit relationship between money aggregates and inflation but correlation exists
Tuesday, July 4, 2017
International Financial Systems
Balance of Payments
The BoP accounts record all transactions between residents of a country and residents of all foreign nations.
It is composed of
- current account
- capital and finance account
- official reserve account
- statistical discrepancy : net errors and omission
Current Account
- export/import of goods and services
- net income: interest earned on foreign assets, interest paid on foreign debt
- Unilateral transfers: workers remittances from abroad, official grants
Capital and Finance Account
- capital transfer: debt forgiveness, transfer of ownership of fixed assets (it is in capital account and the amount is small)
- direct investment: greenfield investments, FDI
- portfolio investment: debt and equity securities
- other investments: deposits and loans
- financial derivatives
CA + KA = Ī” reserve
Under a flexible exchange rate regime
CA + KA = 0
BoP is a double entry system of accounts
CA: Surplus + / Deficit -
export + / import -
KA: Net borrowing + / Net lending -
increase in financial assets - ; because money going out
increase in financial liabilities +
Example: import oil
import - ; increase in financial assets +
Example: company export
export + ; increase in financial assets -
Example: borrowing from abroad
increase in financial liabilities +
increase in financial assets -
BoP effect on exchange rate
export ↑ -> CA surplus ↑ -> FX rate ↑
KA surplus ↑ -> demand for local currency ↑ -> FX rate ↑
reduce appreciating pressure on local currency, sell local currency, buy USD
-> reserve ↑
Interpretation of CA
- Trade balance: CA deficits reflect living beyond one's mean
- Difference in national savings and investment
Y = C + I + X - M ; ignore G
Y - C - I = X - M
S - I = X - M
it reflects high investment and low savings rate
- Timing of trade
CA deficit means choose to consume now by borrowing from abroad
CA surplus means choose to consume later by lending to abroad
consumption smoothing
- borrow from future income, and spend today
Role of International Reserves
- reduces currency speculation
- precautionary purpose, as insurance cover to smooth temporary stops in capital flows
FX Intervention
Unsterilized FX intervention
- domestic currency is sold to purchase foreign assets -> increase in international reserves - > increase in money supply -> domestic currency depreciation
Sterilized FX intervention
To counter the effect of FX intervention above, CB sells gov bond, reduces the money supply
Reserves adequacy
Traditional measures:
- Trade based : reserves to monthly import , 3-4 months
- Debt based : reserves to ST external debt , > 100%
- Money based : reserves to M2 ; 5-10% if flexible exchange rate
(flexible exchange rate act as automatic stabilizer)
Drawbacks of Traditional measures
- reserves to months of imports, neglect international financial linkages
- reserves to ST external debt, neglect other liabilities (stock holdings, bond holdings)
- reserves to broad money, neglect external drain on reserves
Having reserves means intervening in FX market?
New approaches:
- BoP stress testing: scenarios looking at all BoP items
- insurance model : cost benefits of holding reserves, eg. negative carry, valuation loss
- balance sheet analysis
**BoP is flow concept, need to look at stock holdings
Case study: China's FX reserves
China's exports are larger than its imports, it is running a positive trade balance. Foreign currency flows into China via trade flows and investment flows. The more foreign currency is floating in its economy, the lower the price of that currency relative to domestic currency will be. This will have appreciation pressure on domestic currency. To offset, the CB will sell domestic currency and buys up the foreign currency. The intervention will build up the FX reserves.
Capital Controls
- produces misallocation and corruption
- not effective in the long run (people will find a way to circumvent the restrictions)
- delay reform, money flow out because domestic investment opportunity maybe not attractive
- better to strengthen econ fundamentals, and improve bank regulation
The BoP accounts record all transactions between residents of a country and residents of all foreign nations.
It is composed of
- current account
- capital and finance account
- official reserve account
- statistical discrepancy : net errors and omission
Current Account
- export/import of goods and services
- net income: interest earned on foreign assets, interest paid on foreign debt
- Unilateral transfers: workers remittances from abroad, official grants
Capital and Finance Account
- capital transfer: debt forgiveness, transfer of ownership of fixed assets (it is in capital account and the amount is small)
- direct investment: greenfield investments, FDI
- portfolio investment: debt and equity securities
- other investments: deposits and loans
- financial derivatives
CA + KA = Ī” reserve
Under a flexible exchange rate regime
CA + KA = 0
BoP is a double entry system of accounts
CA: Surplus + / Deficit -
export + / import -
KA: Net borrowing + / Net lending -
increase in financial assets - ; because money going out
increase in financial liabilities +
Example: import oil
import - ; increase in financial assets +
Example: company export
export + ; increase in financial assets -
increase in financial liabilities +
increase in financial assets -
BoP effect on exchange rate
export ↑ -> CA surplus ↑ -> FX rate ↑
KA surplus ↑ -> demand for local currency ↑ -> FX rate ↑
reduce appreciating pressure on local currency, sell local currency, buy USD
-> reserve ↑
Interpretation of CA
- Trade balance: CA deficits reflect living beyond one's mean
- Difference in national savings and investment
Y = C + I + X - M ; ignore G
Y - C - I = X - M
S - I = X - M
it reflects high investment and low savings rate
- Timing of trade
CA deficit means choose to consume now by borrowing from abroad
CA surplus means choose to consume later by lending to abroad
consumption smoothing
- borrow from future income, and spend today
Role of International Reserves
- reduces currency speculation
- precautionary purpose, as insurance cover to smooth temporary stops in capital flows
FX Intervention
Unsterilized FX intervention
- domestic currency is sold to purchase foreign assets -> increase in international reserves - > increase in money supply -> domestic currency depreciation
Sterilized FX intervention
To counter the effect of FX intervention above, CB sells gov bond, reduces the money supply
Reserves adequacy
Traditional measures:
- Trade based : reserves to monthly import , 3-4 months
- Debt based : reserves to ST external debt , > 100%
- Money based : reserves to M2 ; 5-10% if flexible exchange rate
(flexible exchange rate act as automatic stabilizer)
Drawbacks of Traditional measures
- reserves to months of imports, neglect international financial linkages
- reserves to ST external debt, neglect other liabilities (stock holdings, bond holdings)
- reserves to broad money, neglect external drain on reserves
Having reserves means intervening in FX market?
New approaches:
- BoP stress testing: scenarios looking at all BoP items
- insurance model : cost benefits of holding reserves, eg. negative carry, valuation loss
- balance sheet analysis
**BoP is flow concept, need to look at stock holdings
Case study: China's FX reserves
China's exports are larger than its imports, it is running a positive trade balance. Foreign currency flows into China via trade flows and investment flows. The more foreign currency is floating in its economy, the lower the price of that currency relative to domestic currency will be. This will have appreciation pressure on domestic currency. To offset, the CB will sell domestic currency and buys up the foreign currency. The intervention will build up the FX reserves.
Capital Controls
- produces misallocation and corruption
- not effective in the long run (people will find a way to circumvent the restrictions)
- delay reform, money flow out because domestic investment opportunity maybe not attractive
- better to strengthen econ fundamentals, and improve bank regulation
Saturday, July 1, 2017
Labor Economics (Part 2)
Demand for Labor
Principles
Labor demand = derived demand (product demand comes first, labor demand comes second)
government influences:
- min wages
- welfare laws
- retirement , pension regulation
- safety protection laws
- immigration control
increase the cost of hiring labor
profit maximization
2 preconditions
- price are influenced by the market ( profit max is done thru output decision)
- most decisions are marginal (incremental)
max profit = incrementally optimise output
- if income of one additional input unit > expense of unit => add more input
- if income of one additional input unit < expense of unit => reduce input
2 input factors: labor , capital
marginal product
MPL = dQ/dL ( holding capital constant)
MPK = dQ/dK ( holding labor constant)
marginal revenue
MR = P in competitive mkt
marginal revenue product
MRPL = MPL * MR => MRPL = MPL * P
marginal expense of labor
MEL = w ( forms are wage takers in competitive mkt)
Employee Value Proposition
- what ppl can get out of the company
- why ppl would want to work there
Labor demand in the SR
(capital is fixed, only labor can be adjusted)
assume declining MPL, diminishing marginal returns
from profit max to labor demand, MRPL = MEL
MPL*P = w ; in dollar term
MPL = w/P ; in physical quantity
at E2, MPL < (w/p)0, make a loss, reduce employees
at E1, MPL > (w/p)0, make a profit, increase employees
not making judgement about individual, labor are interchangeable
criticism (to the marginal productivity theory of demand)
- firms don not really understand MPL, firm guess the value added of a worker
- adding labor without increasing capital does not work
(not entirely true: holiday coverage. shift breaks)
Labor demand in the LR
LR: other input factors can be varied and affect the demand for labor
Two equations must be fulfilled:
MPL = W/P ; MPK = C/P
so W/MPL = C/MPK
- marginal cost of producing an extra unit, using capital , same as marginal cost of producing an extra unit, using labor
- to maximise profit, firm must adjust the labor and capital inputs, so that MC of an extra unit is equal, whether using L or K
(to be continued...)
Principles
Labor demand = derived demand (product demand comes first, labor demand comes second)
government influences:
- min wages
- welfare laws
- retirement , pension regulation
- safety protection laws
- immigration control
increase the cost of hiring labor
profit maximization
2 preconditions
- price are influenced by the market ( profit max is done thru output decision)
- most decisions are marginal (incremental)
max profit = incrementally optimise output
- if income of one additional input unit > expense of unit => add more input
- if income of one additional input unit < expense of unit => reduce input
2 input factors: labor , capital
marginal product
MPL = dQ/dL ( holding capital constant)
MPK = dQ/dK ( holding labor constant)
marginal revenue
MR = P in competitive mkt
marginal revenue product
MRPL = MPL * MR => MRPL = MPL * P
marginal expense of labor
MEL = w ( forms are wage takers in competitive mkt)
Employee Value Proposition
- what ppl can get out of the company
- why ppl would want to work there
Labor demand in the SR
(capital is fixed, only labor can be adjusted)
assume declining MPL, diminishing marginal returns
from profit max to labor demand, MRPL = MEL
MPL*P = w ; in dollar term
MPL = w/P ; in physical quantity
at E1, MPL > (w/p)0, make a profit, increase employees
not making judgement about individual, labor are interchangeable
criticism (to the marginal productivity theory of demand)
- firms don not really understand MPL, firm guess the value added of a worker
- adding labor without increasing capital does not work
(not entirely true: holiday coverage. shift breaks)
Labor demand in the LR
LR: other input factors can be varied and affect the demand for labor
Two equations must be fulfilled:
MPL = W/P ; MPK = C/P
so W/MPL = C/MPK
- marginal cost of producing an extra unit, using capital , same as marginal cost of producing an extra unit, using labor
- to maximise profit, firm must adjust the labor and capital inputs, so that MC of an extra unit is equal, whether using L or K
(to be continued...)
Tuesday, June 20, 2017
Labor Economics (Part 1)
Labor Market
It is a special market, the conditions under which services are rented can be as important as the price. it means for labor market, non pecuniary factors are important, such as :
- work environment
- personality of manager
- perception of fair treatment
- flexibility of working house
Nonetheless, it is still a market
- institutions such as employment agencies facilitate contact between buyers and sellers of labor resources
- info about price and quality is exchanged
- formal and informal contracts exists, regulating time and compensation
Positive economic model
- theory of behavior whereby people respond positively to benefits and negatively to costs
Scarcity - we have to make trade offs
Rationality - utility max
(correct vs incorrect)
Normative economic model
- based on some underlying values, what ought to exist
min wage, immigration, welfare program
(good vs bad)
culture is a system of values and norms
values are abstract ideas about what a group believes to be good, right, desirable
norms are social rules and guidelines that prescribe appropriate behavior in situations
two types of transactions
- voluntary , mutually beneficial
- mandatory, based on policy or law, even though one or more parties might lose out, eg. tax
five types of market failure
- ignorance
- transaction barriers
- externalities
- public goods, free rider problem
- price distortion, eg. min wage
gov intervention can correct market failures, such as intervene to promote socially beneficial transactions
Efficiency vs equity
- What is efficient is not necessarily equity. Normative econ stress efficiency, because it can be analysed scientifically. For equity, seek guidance from political systems, not market.
Labor Market Overview
A market with buyers and sellers
Labor force and employment
unemployment rate = number of ppl unemployment /number of ppl in labor force
Wage, earnings, compensation and income
wage rate * unit of time = earnings
earnings + employment benefits (in-kind or deferred) = total compensation
- payment in kind: employer provided health care or insurance
- deferred: social security
total compensation + unearned income (interest, dividend) = income
How it works
two effects
- scale effect: wage ↑, price ↑, product demand ↓ -> employment ↓
- substitution effect: wage ↑, capital intensive production ↑ -> emp ↓
(substitute labor and machine, product market stays the same)
other effects
- demand for product ↑ -> hire more labor
higher demand at any price -> demand for labor ↑
- supply of capital, when capital price ↓
a. scale effect dominates
- more machine -> hire more workers to run the machine -> higher labor demand
b, substitute effect dominates
- same product demands -> substitute labor with machines
Thus, no clear prediction from econ theory
Supply of Labor
- market supply
if salary in other professions remain the same, more people want to become lawyers if lawyer's wages rise
if wage of insurance up, supply of paralegals comes down
- supply to firms
individual firms are wage takers - pay market wage
Wage determination
market clearing wage
w1 -> demand ↑ S ↓
w2 -> demand ↓ S ↑
market clearing wage - wage which supply = demand. at We, everyone is satisfied
The market clearing wage becomes going wage in the market.
disturbing the equilibrium
- demand shift
eg. if there is new regulation, more lawyers need
- supply shift
workers decrease, market wage goes up
barriers to adjustment
- workers: skill change, cost of moving
- employers: search and training cost, firing cost, wage cost
- non market forces: law constraining individual
customs, culture
barrier of adjustment is the reason of unemployment
Discussion
market adjust more quickly for rising wages, because forces keep wages above market
market adjust slowly to decreasing wages, because labor union may protest
- the above market wages implies S of labor greater than D of labor, there will be unemployment
Applications of the theory
company overpay with above mkt wages
- if lower wages (lower than We), less ppl want to work
at individual level, economic rent is the amount where one's wage exceeds one's reservation wage
- reservation wage is the wage below which worker would not want to work
for L0 workers, they receive economic rent of W2 - W0
- employer do not know the reservation wage , so they pay more
- hard to know the fair wage
It is a special market, the conditions under which services are rented can be as important as the price. it means for labor market, non pecuniary factors are important, such as :
- work environment
- personality of manager
- perception of fair treatment
- flexibility of working house
Nonetheless, it is still a market
- institutions such as employment agencies facilitate contact between buyers and sellers of labor resources
- info about price and quality is exchanged
- formal and informal contracts exists, regulating time and compensation
Positive economic model
- theory of behavior whereby people respond positively to benefits and negatively to costs
Scarcity - we have to make trade offs
Rationality - utility max
(correct vs incorrect)
Normative economic model
- based on some underlying values, what ought to exist
min wage, immigration, welfare program
(good vs bad)
culture is a system of values and norms
values are abstract ideas about what a group believes to be good, right, desirable
norms are social rules and guidelines that prescribe appropriate behavior in situations
two types of transactions
- voluntary , mutually beneficial
- mandatory, based on policy or law, even though one or more parties might lose out, eg. tax
five types of market failure
- ignorance
- transaction barriers
- externalities
- public goods, free rider problem
- price distortion, eg. min wage
gov intervention can correct market failures, such as intervene to promote socially beneficial transactions
Efficiency vs equity
- What is efficient is not necessarily equity. Normative econ stress efficiency, because it can be analysed scientifically. For equity, seek guidance from political systems, not market.
Labor Market Overview
A market with buyers and sellers
Labor force and employment
Wage, earnings, compensation and income
wage rate * unit of time = earnings
earnings + employment benefits (in-kind or deferred) = total compensation
- payment in kind: employer provided health care or insurance
- deferred: social security
total compensation + unearned income (interest, dividend) = income
How it works
two effects
- scale effect: wage ↑, price ↑, product demand ↓ -> employment ↓
- substitution effect: wage ↑, capital intensive production ↑ -> emp ↓
(substitute labor and machine, product market stays the same)
other effects
- demand for product ↑ -> hire more labor
- supply of capital, when capital price ↓
a. scale effect dominates
- more machine -> hire more workers to run the machine -> higher labor demand
b, substitute effect dominates
- same product demands -> substitute labor with machines
Thus, no clear prediction from econ theory
Supply of Labor
- market supply
if wage of insurance up, supply of paralegals comes down
- supply to firms
Wage determination
market clearing wage
w2 -> demand ↓ S ↑
market clearing wage - wage which supply = demand. at We, everyone is satisfied
disturbing the equilibrium
- demand shift
- supply shift
workers decrease, market wage goes up
barriers to adjustment
- workers: skill change, cost of moving
- employers: search and training cost, firing cost, wage cost
- non market forces: law constraining individual
customs, culture
barrier of adjustment is the reason of unemployment
Discussion
market adjust more quickly for rising wages, because forces keep wages above market
market adjust slowly to decreasing wages, because labor union may protest
- the above market wages implies S of labor greater than D of labor, there will be unemployment
Applications of the theory
- if lower wages (lower than We), less ppl want to work
at individual level, economic rent is the amount where one's wage exceeds one's reservation wage
- reservation wage is the wage below which worker would not want to work
- employer do not know the reservation wage , so they pay more
- hard to know the fair wage
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