Final Exam Prep Notes

Economic Growth & Productivity | Exchange Rate Determination

Compiled study guide with Q&A and MCQs
PART 1: Economic Growth & Productivity
1. Why Economic Growth Matters
Learning outcomes for this chapter:
• What are the facts about living standards and growth rates around the world?
• Why does productivity matter for living standards?
• What determines productivity and its growth rate?
• How can public policy affect growth and living standards?

Selected Poverty Statistics

• In the poorest one-fifth of countries, daily caloric intake is 1/3 lower than in the richest fifth.
• Infant mortality rate: 200 per 1,000 births in the poorest fifth vs. 4 per 1,000 in the richest fifth.
• In Pakistan, 85% of people live on less than $2/day.
• One-fourth of the poorest countries have had famines in the past 3 decades (none of the richest countries did).
• Poverty is associated with the oppression of women and minorities.

Estimated Effects of Economic Growth

• A 10% increase in income is associated with a 6% decrease in infant mortality.
• Income growth also reduces poverty significantly over time.
Growth theory's lessons help us understand why poor countries are poor, design policies to help them grow, and understand
how our own growth is affected by shocks and government policy.

2. Standard of Living & Growth

• A country's standard of living depends on its ability to produce goods and services.
• Within a country, living standards change a lot over time.
• Living standards (measured by real GDP per person) vary significantly among nations.
• Compounding: small annual growth rates become large when compounded over many years.

3. Why Productivity Matters

Productivity = the amount of goods and services a worker can produce from each hour of work. It plays the key role
in determining living standards for all nations — to understand differences in living standards across countries, we
must focus on the production of goods and services.

4. The Four Factors of Production

Factors of production directly determine productivity.
Factor Definition
Physical Capital A produced factor of production — the stock of equipment and structures used
to produce goods/services (e.g., tools, office buildings, schools). It was itself an
output of past production.
Human Capital Knowledge and skills workers acquire through education, training, and
experience. Raises a nation's ability to produce, just like physical capital.
Natural Resources Inputs provided by nature — land, rivers, mineral deposits. Renewable
(trees/forests) or nonrenewable (petroleum, coal). Helpful but NOT necessary
for high productivity.
Technological Knowledge Society's understanding of the best ways to produce goods and services. Human
capital is the resource used to transmit this knowledge to the labor force.
Mnemonic: P-H-N-T — Physical capital, Human capital, Natural resources, Technological knowledge.

5. The Production Function

A production function describes the relationship between the quantity of inputs used and the quantity of output produced.
Y = A × F(L, K, H, N)
• Y = quantity of output
• A = available production technology
• L = quantity of labor
• K = quantity of physical capital
• H = quantity of human capital
• N = quantity of natural resources
• F( ) = a function showing how inputs combine to produce output

Returns to Scale
A production function has constant returns to scale if, for any positive number x: xY = A F(xL, xK, xH, xN) — that is,
doubling all inputs doubles output.
• Constant returns to scale — output changes proportionally with inputs
• Increasing returns to scale (economies of scale) — output increases more than proportionally
• Decreasing returns to scale (diseconomies of scale) — output increases less than proportionally

Implication of Constant Returns to Scale

Setting x = 1/L in the production function gives:
Y/L = A F(1, K/L, H/L, N/L)
• Y/L = output per worker (productivity)
• K/L = physical capital per worker
• H/L = human capital per worker
• N/L = natural resources per worker
Key exam line: Productivity (Y/L) depends on physical capital per worker, human capital per worker, natural
resources per worker, and the state of technology (A).

6. Government Policies That Raise Productivity & Living Standards

1. Encourage saving and investment
2. Encourage investment from abroad
3. Encourage education and training
4. Establish secure property rights and maintain political stability
5. Promote free trade
6. Promote research and development
Mnemonic: S-I-E-P-F-R — Saving/investment, Investment abroad, Education, Property rights, Free trade, R&D.

A. Saving & Investment / Diminishing Returns

Investing more current resources in producing capital raises future productivity. But:
• Diminishing returns: as the capital stock rises, the extra output from an additional unit of capital falls.
• Because of diminishing returns, a higher saving rate raises growth only for a while — in the long run it raises the
LEVEL of productivity/income, not the long-run growth rate.
• Catch-up effect: countries that start off poor tend to grow more rapidly than countries that start off rich.
B. Investment from Abroad
• Foreign Direct Investment (FDI) — capital investment owned AND operated by a foreign entity.
• Foreign Portfolio Investment — investment financed with foreign money but operated by domestic residents.

C. Education and Training

• For long-run growth, education is at least as important as physical capital investment.
• In the U.S., each year of schooling raises a person's wage by about 10% on average.
• Externality: an educated person may generate new ideas that add to society's pool of knowledge, benefiting others.
• Brain drain: the emigration of highly educated workers from poor countries to rich countries — a problem for
developing nations.

D. Property Rights & Political Stability

• Property rights = the ability of people to exercise authority over resources they own.
• Respect for property rights is essential for the price system to work, and for investors to feel secure.

E. Free Trade
• Trade is, in some ways, a type of technology.
• Eliminating trade restrictions can spur growth similar to a major technological advance.
• Inward-oriented policies avoid interaction with other countries; outward-oriented policies encourage it.

F. Research and Development

• Advances in technological knowledge raise living standards.
• Most technological advance comes from private research by firms and individual inventors.
• Government can encourage new technology via research grants, tax breaks, and the patent system.

7. Population Growth
Population growth interacts with the factors of production in three ways:
7. Stretching natural resources (more people sharing fixed resources)
8. Diluting the capital stock (same capital spread over more workers)
9. Promoting technological progress (more people, potentially more ideas)

8. Discussion Concepts (GDP vs GNP)

Discussion 1:
If foreigners buy newly issued stock in a company and the company uses the proceeds to build new plant and equipment
domestically — GDP rises more, since GDP measures production within the country regardless of ownership. This is Foreign
Portfolio Investment (the money is foreign, but the company itself operates the investment domestically).
Discussion 2:
A foreign-owned auto company opens a new factory in another country. This is Foreign Direct Investment. It raises the host
country's GDP (production happens there). The effect on GNP is smaller than on GDP, because GNP counts output produced
by that country's own residents/companies — and profits from the foreign-owned factory flow back to the parent country, not
counted in the host country's GNP.
PART 2: Exchange Rate Determination
Chapter Objectives
• To explain how exchange rate movements are measured
• To explain how the equilibrium exchange rate is determined
• To examine the factors that affect the equilibrium exchange rate

1. Measuring Exchange Rate Movements

An exchange rate measures the value of one currency in units of another currency.
• Depreciate — when a currency declines in value
• Appreciate — when a currency increases in value
• “Mixed in trading” — when some currencies appreciate while others depreciate against the dollar on the same day

Formula for Percentage Change

The percentage change (%Δ) in the value of a foreign currency is computed as:
%Δ = (Sₜ − Sₜ₋₁) / Sₜ₋₁
where Sₜ denotes the spot rate at time t.
• Positive %Δ = appreciation of the foreign currency
• Negative %Δ = depreciation of the foreign currency

2. Types of Exchange Rate Systems

System Description
Floating Exchange Rate Determined freely by supply and demand in the foreign exchange (forex)
market, e.g., the USD/EUR rate.
Fixed Exchange Rate A government sets a specific value for its currency, often pegged to another
currency or gold.
Hybrid / Managed Float Most countries use this: market forces largely determine the rate, but the
central bank may intervene occasionally to prevent extreme fluctuations or
instability.

The appropriate system depends entirely on a country's specific economic situation and goals.

3. Exchange Rate Equilibrium

An exchange rate represents the PRICE of a currency, determined by the demand for that currency relative to its
supply.
4. Factors That Influence Exchange Rates
A. Relative Inflation Rates
If U.S. inflation rises relative to Britain's:
• U.S. demand for British goods rises → demand for £ rises (D shifts right)
• British desire for (now relatively pricier) U.S. goods falls → supply of £ falls (S shifts left)
• Result: the value of £ rises (from r₀ to r₁) — i.e., the pound appreciates / the dollar depreciates.

B. Relative Interest Rates

If U.S. interest rates rise relative to Britain's:
• U.S. demand for British bank deposits falls → demand for £ falls (D shifts left)
 • British desire for U.S. bank deposits rises → supply of £ rises (S shifts right)
• Result: the value of £ falls (from r₀ to r₁) — i.e., the pound depreciates / the dollar appreciates.

The Fisher Effect (important caveat)

A relatively high interest rate may actually reflect expectations of relatively high inflation, which discourages foreign
investment rather than attracting it. So it's more useful to look at real interest rates rather than nominal ones.
real interest rate = nominal interest rate − inflation rate
This relationship is called the Fisher effect.

C. Relative Income Levels

If U.S. income levels rise:
• U.S. demand for British goods rises → demand for £ rises (D shifts right)
• No expected change in the supply of £
• Result: the value of £ rises (from r₀ to r₁).
D. Government Controls
Governments may influence the equilibrium exchange rate by:
[Link] foreign exchange barriers
[Link] foreign trade barriers
[Link] directly in the foreign exchange market
[Link] macro variables such as inflation, interest rates, and income levels

E. Expectations
• Foreign exchange markets react to any news that may have a future effect.
• Institutional investors often take currency positions based on anticipated interest rate movements in various countries.
• Because of speculative transactions, foreign exchange rates can be very volatile.

Chapter Summary — Factors That Influence Exchange Rates

Factor (↑ in U.S.) Demand for £ Supply of £ Value of £ (r)
U.S. inflation ↑ Rises Falls Rises (£ appreciates)
U.S. interest rates ↑ Falls Rises Falls (£ depreciates)
U.S. income ↑ Rises No change Rises (£ appreciates)
Quick Q&A Review
Economic Growth & Productivity
Q: What does productivity mean and why does it matter?
A: Productivity is the amount of goods and services a worker can produce per hour of work. It's the key determinant of living
standards across nations.
Q: What are the four factors of production?
A: Physical capital, human capital, natural resources, and technological knowledge.
Q: What is physical capital?
A: The stock of equipment and structures used to produce goods and services; it is itself a produced input (an output of past
production).
Q: What is human capital?
A: The knowledge and skills workers acquire through education, training, and experience.
Q: Are natural resources necessary for high productivity?
A: No — they can be important but are not necessary for an economy to be highly productive.
Q: Write the general production function.
A: Y = A F(L, K, H, N), where Y = output, A = technology, L = labor, K = physical capital, H = human capital, N = natural
resources.
Q: What does 'constant returns to scale' mean?
A: Doubling all inputs (L, K, H, N) causes output (Y) to double as well: xY = A F(xL, xK, xH, xN).
Q: What does productivity (Y/L) depend on?
A: Physical capital per worker (K/L), human capital per worker (H/L), natural resources per worker (N/L), and the state of
technology (A).
Q: What is the diminishing returns property of capital?
A: As the capital stock rises, the extra output from an additional unit of capital falls.
Q: Why does a higher saving rate raise growth only temporarily?
A: Because of diminishing returns — in the long run, a higher saving rate raises the LEVEL of productivity/income, not the
long-run growth RATE.
Q: What is the catch-up effect?
A: Countries that start off poor tend to grow more rapidly than countries that start off rich.
Q: Differentiate Foreign Direct Investment from Foreign Portfolio Investment.
A: FDI is capital investment owned and operated by a foreign entity. Foreign Portfolio Investment is financed with foreign
money but operated by domestic residents.
Q: What is the 'brain drain'?
A: The emigration of highly educated workers from poor countries to rich countries.
Q: List six government policies that raise productivity and living standards.
A: Encourage saving/investment, encourage investment from abroad, encourage education/training, establish secure property
rights and political stability, promote free trade, promote R&D.
Q: How does population growth interact with factors of production?
A: It stretches natural resources, dilutes the capital stock, but can also promote technological progress.
Exchange Rate Determination
Q: What is an exchange rate?
A: It measures the value of one currency in units of another currency.
Q: Define appreciate and depreciate.
A: A currency appreciates when its value increases; it depreciates when its value declines.
Q: What does it mean when 'the dollar is mixed in trading'?
A: Some currencies appreciate while others depreciate against the dollar on the same day.
Q: Give the formula for percentage change in a currency's value.
A: %Δ = (Sₜ − Sₜ₋₁) / Sₜ₋₁, where Sₜ is the spot rate at time t.
Q: Name the three types of exchange rate systems.
A: Floating exchange rate, fixed exchange rate, and hybrid/managed floating exchange rate.
Q: What determines the equilibrium exchange rate?
A: The demand for a currency relative to its supply.
Q: How does a rise in U.S. inflation affect the value of the pound?
A: It increases U.S. demand for British goods (raising demand for £) and reduces British desire for U.S. goods (lowering
supply of £), so the pound appreciates.
Q: How does a rise in U.S. interest rates affect the value of the pound?
A: It reduces U.S. demand for British deposits (lowering demand for £) and increases British desire for U.S. deposits (raising
supply of £), so the pound depreciates.
Q: What is the Fisher effect?
A: The relationship: real interest rate = nominal interest rate − inflation rate. It cautions that high nominal rates may just
reflect high expected inflation, not necessarily attractive real returns.
Q: How does a rise in U.S. income affect the value of the pound?
A: It raises U.S. demand for British goods (raising demand for £), with no expected change in supply, so the pound
appreciates.
Q: List four ways governments can influence exchange rates.
A: Imposing foreign exchange barriers, imposing foreign trade barriers, intervening directly in the forex market, and
affecting macro variables like inflation, interest rates, and income.
Q: Why can exchange rates be very volatile?
A: Because forex markets react to any news with a future effect, and speculative/institutional transactions based on
anticipated rate movements amplify swings.
Multiple Choice Questions (MCQs)
Economic Growth & Productivity
1. Productivity is best defined as:
a) Total national output
b) Goods/services a worker produces per hour of work
c) The unemployment rate
d) GDP growth rate
Answer: b) Goods/services a worker produces per hour of work
2. Which is NOT one of the four factors of production?
a) Physical capital
b) Human capital
c) Government spending
d) Natural resources
Answer: c) Government spending
3. Physical capital is called a 'produced' factor of production because:
a) It grows naturally
b) It was itself an output of past production
c) It cannot be measured
d) It is always imported
Answer: b) It was itself an output of past production
4. In the production function Y = A F(L,K,H,N), 'A' represents:
a) Labor
b) Available production technology
c) Natural resources
d) Human capital
Answer: b) Available production technology
5. A production function has constant returns to scale if:
a) Output doubles when only labor doubles
b) Doubling all inputs doubles output
c) Output always increases faster than inputs
d) Output is unaffected by input changes
Answer: b) Doubling all inputs doubles output
6. Productivity per worker (Y/L) depends on all of the following EXCEPT:
a) Physical capital per worker
b) Human capital per worker
c) Total population size
d) State of technology
Answer: c) Total population size
7. Diminishing returns to capital means:
a) Extra output from an additional unit of capital falls as the capital stock rises
b) Capital always produces more output over time
c) Labor productivity is irrelevant
d) Saving rates have no effect on growth
 Answer: a) Extra output from an additional unit of capital falls as the capital stock rises
8. The catch-up effect suggests:
a) Rich countries grow faster than poor countries
b) Poor countries tend to grow faster than rich countries
c) All countries grow at the same rate
d) Growth rates are unrelated to starting income
Answer: b) Poor countries tend to grow faster than rich countries
9. Foreign Direct Investment is defined as:
a) Investment financed with foreign money but operated by domestic residents
b) Capital investment owned and operated by a foreign entity
c) Government-issued foreign bonds
d) Domestic investment in local firms
Answer: b) Capital investment owned and operated by a foreign entity
10. The 'brain drain' refers to:
a) Increased local research funding
b) Emigration of highly educated workers to rich countries
c) A decline in university enrollment
d) Government restrictions on education
Answer: b) Emigration of highly educated workers to rich countries
11. Which is an example of an inward-oriented trade policy?
a) Promoting free trade
b) Avoiding interaction with other countries
c) Encouraging foreign investment
d) Signing international trade agreements
Answer: b) Avoiding interaction with other countries
12. A higher saving rate leads to higher long-run growth in output because of diminishing returns.
a) True
b) False — it raises the level of output/productivity but not the long-run growth rate
c) It always leads to hyperinflation
d) It has no effect on productivity
Answer: b) False — it raises the level of output/productivity but not the long-run growth rate

Exchange Rate Determination

1. An exchange rate measures:
a) The inflation rate of a country
b) The value of one currency in units of another currency
c) A country's GDP growth
d) The interest rate spread between two countries
Answer: b) The value of one currency in units of another currency
2. When a currency declines in value, it is said to:
a) Appreciate
b) Depreciate
c) Float
d) Peg
Answer: b) Depreciate
3. A floating exchange rate is:
 a) Set by the government
b) Determined freely by supply and demand in the forex market
c) Always pegged to gold
d) Fixed permanently
Answer: b) Determined freely by supply and demand in the forex market
4. Most countries today actually use:
a) A pure fixed exchange rate
b) A pure floating exchange rate
c) A managed floating (hybrid) exchange rate
d) A gold standard
Answer: c) A managed floating (hybrid) exchange rate
5. The equilibrium exchange rate is determined by:
a) Government decree alone
b) The demand for a currency relative to its supply
c) The stock market index
d) Fixed international treaties only
Answer: b) The demand for a currency relative to its supply
6. If U.S. inflation rises relative to Britain's, the value of the pound (£) tends to:
a) Fall
b) Rise
c) Stay exactly the same
d) Become fixed
Answer: b) Rise
7. If U.S. interest rates rise relative to Britain's, the value of the pound (£) tends to:
a) Rise
b) Fall
c) Be unaffected
d) Double
Answer: b) Fall
8. The Fisher effect describes the relationship:
a) Nominal interest rate = real interest rate − inflation rate
b) Real interest rate = nominal interest rate − inflation rate
c) Inflation rate = nominal + real interest rate
d) Exchange rate = GDP / population
Answer: b) Real interest rate = nominal interest rate − inflation rate
9. If U.S. income levels rise, holding other factors constant, the demand for British pounds will:
a) Fall
b) Rise
c) Be unaffected
d) Become negative
Answer: b) Rise
10. Which of these is NOT a way governments influence exchange rates?
a) Imposing foreign exchange barriers
b) Intervening in the forex market
c) Publishing weather forecasts
d) Affecting macro variables like inflation and interest rates
Answer: c) Publishing weather forecasts
11. Foreign exchange rates can be very volatile mainly because of:
a) Fixed government pegs
b) Speculative transactions based on anticipated news/rate movements
c) Lack of any market participants
d) Legal restrictions on all currency trading
Answer: b) Speculative transactions based on anticipated news/rate movements
12. A positive %Δ in the value of a foreign currency represents:
a) Depreciation
b) Appreciation
c) No change
d) A fixed peg
Answer: b) Appreciation