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41. Current account

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This article is about the macroeconomic current account. For the day to day bank account, see current account (banking).

Capital exports in 2006

Capital imports in 2006

The current account of the balance of payments is the sum of the balance of trade (exports minus imports of goods and services), net factor income (such as interest and dividends) and net transfer payments (such as foreign aid). A current account surplus increases a country's net foreign assets by the corresponding amount, and a current account deficit does the reverse. Both government and private payments are included in the calculation. The balance of trade is typically the most important part of the current account. This means that changes in the patterns of trade are key drivers of the current account. However, for the few countries with substantial overseas assets or liabilities, net factor payments may be significant. It, with Net Capital Outflow, is a major metric of how much a nation invests or is invested in.

The current account and the capital and financial account and change in official reserves each sum up to an offsetting equality (are opposite in sign but same in magnitude) after errors and omissions are taken into account. This is a result of a floating exchange rate system, where demand for a currency is equal to supply for a currency. This result can be proven with simple algebra:

Demand for a Currency = Supply for a Currency

Exports + Income and Current Transfer Credits + Capital Inflow = Imports + Income and Current Transfer Debits + Capital Outflow

ie. EX + IT Credits + Ki = IM + IT Debits + Ko

(EX - IM) + (IT Credits - IT Debits) = Ko - Ki

Alternatively,

A deficit on the current account = A surplus in the capital account

Or in the other case,

A surplus on the current account = A deficit on the capital Account

This sum is known as the balance of payments. Typically, the changes in official reserves is very small.

Capital account

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Information in this article or section has not been verified against sources and may not be reliable.
Please check for inaccuracies and modify as needed, citing the sources against which it was checked.

Note: The name of the "capital account" was changed in the US in 1999. It is now referred to as the financial account

The capital account is one of two primary components of the balance of payments, the other being the current account.

The capital account records all transactions between a domestic and foreign resident that involves a change of ownership of an asset. It is the net result of public and private international investment flowing in and out of a country. This includes foreign direct investment, plus changes in holdings of stocks, bonds, loans, bank accounts, and currencies.

From a domestic point of view, a foreign investor acquiring a domestic asset is considered a capital inflow, while a domestic resident acquiring a foreign asset is considered a capital outflow.

Along with transactions pertaining to non-financial and non-produced assets, the capital account may also include debt forgiveness, the transfer of goods and financial assets by migrants leaving or entering a country, the transfer of ownership on fixed assets, the transfer of funds received to the sale or acquisition of fixed assets, gift and inheritance taxes, death levies, patents, copyrights, royalties, and uninsured damage to fixed assets.

Foreign-Exchange Risk
/ 1.The risk of an investment's value changing due to changes in currency exchange rates.
2. The risk that an investor will have to close out a long or short position inaforeign currency at a lossdue to an adverse movement in exchange rates. Also known as "currency risk" or "exchange-rate risk".
/ This risk usually affects businesses that export and/or import, but it can also affect investors making international investments.For example, if money must be converted to another currency to make a certain investment, then any changes in the currency exchange ratewill cause that investment's valueto either decrease or increase when the investment is sold and converted back into the original currency.

Arbitrage

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In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets: a combination of matching deals are struck that capitalize upon the imbalance, the profit being the difference between the market prices. When used by academics, an arbitrage is a transaction that involves no negative cash flow at any probabilistic or temporal state and a positive cash flow in at least one state; in simple terms, a risk-free profit. A person who engages in arbitrage is called an arbitrageur. The term is mainly applied to trading in financial instruments, such as bonds, stocks, derivatives, commodities and currencies. Search Arbitrage is also another way of leveraging online advertising using this market theory.

Hedge (finance)

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In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity. Typically, a hedger might invest in a security that he believes is under-priced relative to its "fair value" (for example a mortgage loan that he is then making), and combine this with a short sale of a related security or securities. Thus the hedger is indifferent to the movements of the market as a whole, and is interested only in the performance of the 'under-priced' security relative to the hedge. Holbrook Working, a pioneer in hedging theory, called this strategy "speculation in the basis,"[1] where the basis is the difference between the hedge's theoretical value and its actual value (or between spot and futures prices in Working's time).

Some form of risk taking is inherent to any business activity. Some risks are considered to be "natural" to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Someone who has a shop, for example, can take care of natural risks such as the risk of competition, of poor or unpopular products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency. Banks and other financial institutions use hedging to control their asset-liability mismatches, such as the maturity matches between long, fixed-rate loans and short-term (implicitly variable-rate) deposits.

Production function

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In microeconomics, a production function asserts that the maximum output of a technologically-determined production process is a mathematical function of input factors of production. Considering the set of all technically feasible combinations of output and inputs, only the combinations encompassing a maximum output for a specified set of inputs would constitute the production function. Alternatively, a production function can be defined as the specification of the minimum input requirements needed to produce designated quantities of output, given available technology. It is usually presumed that unique production functions can be constructed for every production technology.

By assuming that the maximum output technologically possible from a given set of inputs is achieved, economists using a production function in analysis are abstracting away from the engineering and managerial problems inherently associated with a particular production process. The engineering and managerial problems of technical efficiency are assumed to be solved, so that analysis can focus on the problems of allocative efficiency. The firm is assumed to be making allocative choices concerning how much of each input factor to use, given the price of the factor and the technological determinants represented by the production function. A decision frame, in which one or more inputs are held constant, may be used; for example, capital may be assumed to be fixed or constant in the short run, and only labour variable, while in the long run, both capital and labour factors are variable, but the production function itself remains fixed, while in the very long run, the firm may face even a choice of technologies, represented by various, possible production functions.

The relationship of output to inputs is non-monetary, that is, a production function relates physical inputs to physical outputs, and prices and costs are not considered. But, the production function is not a full model of the production process: it deliberately abstracts away from essential and inherent aspects of physical production processes, including error, entropy or waste. Moreover, production functions do not ordinarily model the business processes, either, ignoring the role of management, of sunk cost investments and the relation of fixed overhead to variable costs. (For a primer on the fundamental elements of microeconomic production theory, see production theory basics).

The primary purpose of the production function is to address allocative efficiency in the use of factor inputs in production and the resulting distribution of income to those factors. Under certain assumptions, the production function can be used to derive a marginal product for each factor, which implies an ideal division of the income generated from output into an income due to each input factor of production.

Purchasing power parity

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Gross domestic product (by purchasing power parity) in 2006

The Purchasing power parity (PPP) theory was developed by Gustav Cassel in 1920. It is the method of using the long-run equilibrium exchange rate of two currencies to equalize the currencies' purchasing power. It is based on the law of one price, the idea that, in an efficient market, identical goods must have only one price.

Purchasing power parity is often called absolute purchasing power parity to distinguish it from a related theory relative purchasing power parity, which predicts the relationship between the two countries' relative inflation rates and the change in the exchange rate of their currencies.

A purchasing power parity exchange rate equalizes the purchasing power of different currencies in their home countries for a given basket of goods. These special exchange rates are often used to compare the standards of living of two or more countries. The adjustments are meant to give a better picture than comparing gross domestic products (GDP) using market exchange rates. This type of adjustment to an exchange rate is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries.

Market exchange rates fluctuate widely, but many believe that PPP exchange rates reflect the long run equilibrium value. The distortions caused by using market rates are accentuated because prices of non-traded goods and services are usually lower in poorer economies. For example, a U.S. dollar exchanged and spent in the People's Republic of China will buy much more than a dollar spent in the United States.

The differences between PPP and market exchange rates can be significant. For example, the World Bank's World Development Indicators 2005 estimates that one United States dollar is equivalent to approximately 1.8 Chinese yuan by purchasing power parity in 2003. [1]. However, based on nominal exchange rates, one U.S. dollar is currently equal to 7.6 yuan. This discrepancy has large implications; for instance, GDP per capita in the People's Republic of China is about US$1,800 while on a PPP basis it is about US$7,204. This is frequently used to assert that China is the world's second largest economy, but such a calculation would only be valid under the PPP theory. At the other extreme, Japan's nominal GDP per capita is around US$37,600, but its PPP figure is only US$30,615.

Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared.

When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects.

Marginal revenue product

The marginal revenue product of labor can also be expressed as:

MRP = MR x MP

where MR (marginal revenue) equals the additional revenue resulting from the sale of an additional unit of output and MP (marginal product, also known as marginal physical product or MPP in many micro principles texts) is the additional output resulting from the use of an additional unit of labor, holding the use of other inputs constant. Suppose, for example, that you wished to compute the marginal revenue product of labor when MR = 4 and MPP = 5. In this case, the employment of an additional worker results in a 5 unit increase in output (holding other inputs constant) while revenue increases by $4 when an additional unit of output is sold. In this case, the marginal revenue product of labor will equal $20 (= $4 x 5).

Using a little bit of algebra, the marginal revenue product can be defined as: