Listing Category: Economics

IS/LM: Deriving Aggregate Demand (Part III: Combining the IS and LM Curves)

Because the IS curve and the LM curves each have real GDP (= real aggregate income) on the horizontal axis and real interest rate on the vertical axes, we can plot them on the same set of axes:

IS/LM: Deriving Aggregate Demand (Part II: the LM Curve)

The key to understanding the Liquidity preference-Money supply (LM) curve is realizing that the underlying assumption is that financial markets are in equilibrium: demand for money equals supply of money.

IS/LM: Deriving Aggregate Demand (Part I: the IS Curve)

There are several steps in creating the Investment-Savings (IS) curve, which has real aggregate income on the horizontal axis and real interest rate on the vertical axis.

IS/LM: Deriving Aggregate Demand (Synopsis)

One of the more complicated ideas in economics is the development of the aggregate demand curve via two other curves: the IS (Investment-Savings) curve and the LM (Liquidity preference-Money supply) curve. I’ll break it down into four articles:

Herfindahl-Hirschman Index (HHI)

The Herfindahl-Hirschman Index (HHI) is a measure of the degree of concentration in an industry; it is defined as:

Currency Exchange Rates

Many candidates find currency exchange rates to be confusing, and for good reason: the notation used is not intuitive at all (and, to boot, contradictory). We’ll discuss the notation, how to use exchange rates in calculations to convert from one currency to another, how to invert exchange rates, and how to derive cross exchange rates.

Currency Exchange: Forward Discount/Premium

Suppose that the spot exchange rate between USD and GBP is USD/GBP 1.5814; i.e., USD1.5814 = GBP1.0. If the 1-year forward exchange rate is USD/GBP 1.5660 (so USD1.5660 = GBP1.0), then we say that the GBP is trading at a (one-year) forward discount (versus the USD): the forward price for GBP1.0 is lower than the spot price for GBP1.0 (both prices in USD).

Covered Interest Rate Parity (IRP) – Pricing Currency Forwards

Pricing currency forward contracts – determining the appropriate future exchange rate to use – is relatively straightforward; it is based on the risk-free interest rates for the currencies involved, and the no-arbitrage condition (i.e., the forward exchange rate should make arbitrage impossible). Because the elimination of arbitrage means that the forward exchange rate has to compensate for inequality in the risk-free interest rates – it has to restore equality, or parity – and because the parity is ensured (or covered) by the forward contract, the approach in known as covered interest rate parity (covered IRP, or CIRP). The formula is: