02. The Financial Management Environment

Question 1

Define macroeconomic policy.

Answer 1

The setting of economic objectives by the government (e.g. full employment, economic growth, the avoidance of inflation) and the use of control instruments to achieve those objectives (e.g. fiscal policy and monetary policy).

Question 2

Define monetary policy and state two ways monetary policy may may regulate demand in the economy.

Answer 2

The set actions taken by the government or the central bank to achieve economic objectives using monetary instruments.

Monetary policy actions may either:

1. directly control the amount of money in circulation (the money supply) or
2. Attempt to reduce the demand for money through its price (interest rates).

Question 3

What are four ways that governments or central banks can use to directly control the money supply?

Answer 3

1. Open market operations - the central bank sells government securities, contracting the money supply leading to less bank deposits and thus lessening banks’ ability to loan funds (multiplier effect).
2. Reserve asset requirements (cash reserve ratio) - the central bank sets minimum level of liquid assets banks must hold.
3. Special deposits - the central bank can have the power to call for special deposits. These deposits do not count as part of the bank’s reserve base against which it can lend.
4. Direct control - central bank sets specific limits on the amount which banks may lend. Credit controls are difficult to impose as, with fairly free international movement of funds, they can be easily circumvented.

Question 4

What are four problems associated with monetary policy?

Answer 4

1. There is often a significant time lag between the implementation of a policy and its effects.
2. Credit control is ineffective in the modern global economy.
3. The relationship between interest rates, level of investment and consumer expenditure is not actually stable and predictable.
4. Increasing interest rates produces undesirable side effects, including:
   - less investment, leading to reduced industrial capacity, leading to increased unemployment (as higher interest rates increase the cost of capital for a company using debt finance).
   - a downward pressure on share prices, making it more difficult for companies to raise fund from new share issues.
   - decreases in consumer demand.
   - an overvalued currency, which reduces demand for exports.

Question 5

Define fiscal policy.

Answer 5

Government actions to achieve economic objectives through the use of the fiscal instruments of taxation, public spending and the budget deficit or surplus. Governments can use public expenditure and taxation to regulate the level of demand within the economy.

Question 6

State two ways in which fiscal policy may be used to relate an economy in recession.

Answer 6

1. Increase government spending in order to directly increase the level of demand in the economy (e.g. if a government agrees a number of large road-building projects or establishes training schemes for sections of the population, the demand for goods and services in the economy is increased); and/or
2. Reduce taxation in order to boost both consumption and investment.

Question 7

List five drawbacks of using fiscal policies to reflate the economy.

Answer 7

1. Government spending is an intervention into the free market and it can lead to the misallocation of resources (e.g. support for inefficient industries).
2. There is often a significant time lag between the authorisation of additional spending and its actual occurrence.
3. Tax cuts are not efficient at boosting domestic demand, as in times of recession some of the extra disposable income made available will be saved, and some of the extra monies actually spent will be on imports.
4. A large budget deficit is likely to occur, which will lead to a large public sector net cash requirement (PSNCR). This is the difference between the public sector’s income and expenditure. A deficit is financed by borrowing - principally via the sale of government gilt-edged stocks (gilts).
5. The rate of inflation is likely to rise, as demand may increase for resources which are in limited supply and their prices rise.

Question 8

List two ways fiscal policy may be used to deflate an overheating economy.

Answer 8

1. Reduce government spending in order to decrease directly the level of demand in the economy.
2. Increase taxation in order to reduce consumption and to assist with the redistribution of wealth.

Question 9

What are two drawbacks of depressing demand using fiscal policy?

Answer 9

1. It is not possible to cut government spending dramatically in sectors such as health care or education.
2. Increasing taxation discourages enterprise.

Question 10

What are supply-side policies?

Answer 10

Policies which focus on creating the right conditions in which private enterprise can grow and therefore raise the capacity of the economy to provide the output demanded.

Adherents to this believe the private sector, being driven by profit motive, is more efficient at providing the output required than the public sector.

Question 11

Give some examples of supply-side policies.

Answer 11

1. Low corporate tax rates to encourage private enterprise.
2. Promoting a stable, low inflation economy with minimal government intervention.
3. Limited government spending.
4. A balanced fiscal budget.
5. Deregulation of industries.
6. A reduction in the power of trade unions.
7. An increase in the training and education of the workforce.
8. An increase in infrastructure required by business (e.g. business parks).
9. A reduction in planning legislation.

Question 12

What are two problems associated with supply-side policies?

Answer 12

1. There is a time delay before the policies have any impact.
2. The private sector will not provide all the goods and services required by society.

Question 13

What is an exchange rate policy?

Answer 13

The way a government manages its currency in relation to foreign currencies. It is closely related to monetary policy and both generally depend on many of the same factors.

Question 14

What are some reasons for controlling exchange rates?

Answer 14

1. To rectify a balance of trade deficit. If inflation in one country is higher than in others, its export prices will become uncompetitive in overseas markets and so its trade deficit will grow. The government may therefore try to bring about a fall in the exchange rates to make exports less expensive.
2. To prevent a balance of trade surplus. A government may try to bring about a limited rise in exchange rates to make imports less expensive.
3. To stabilise the exchange rate. Importers and exporters will therefore face less exchange rate risk, confidence in the currency will improve and international trade is facilitated.

Question 15

Differentiate between the following exchange rates:

1. Floating
2. Fixed
3. Crawling peg

Answer 15

Floating - a freely floating FX rate means that the value of the currency is allowed to move freely with supply and demand market forces.

A fixed FX rate regime is one in which the rate is kept fixed against that of another currency, or basket of currencies. No fluctuations are permitted; the central bank intervenes to maintain the exchange rate.

3. In a crawling peg system, a currency is allowed to fluctuate but only within a relatively narrow range around the target rate. The target rate may have to be reset due to factors such as inflation.

Question 16

Define what are the two major causes of inflation according to Keynesians?

Answer 16

1. Demand-pull inflation - inflation arises due to demand exceeding the maximum output of the economy with full employment.
2. Cost-push inflation - increases in the cost of raw materials or the cost of labour lead to increases in the unit costs of production, and therefore inevitably lead to an increase in prices as these higher costs are passed on to the consumer. The increased costs suffered by industry may be as a result of the increase in the cost imported goods, in which case the term imported cost-push inflation is used.

Question 17

What are some of the general economic consequences of inflation?

Answer 17

1. The redistribution of income from those in a weak bargaining position to those in a strong bargaining position, with those in a strong position being able to maintain the real value of their income.
2. A disincentive to save, as the purchasing power of investments may be reduced.
3. When inflation reaches very high levels, money is no longer able to carry out its key functions of being a medium of exchange and a store of value.
4. A fall in the FX rate.
5. A need for higher nominal interest rates (ie interest rates that incorporate inflation).

Question 18

What are some of the consequences of inflation for businesses?

Answer 18

1. Entrepreneurial activity is reduced, as it is harder to estimate the likely returns from a new venture and higher interest rates make borrowing more expensive.
2. International competitiveness suffers where prices rise faster than those of foreign competitors.
3. Increased uncertainty reduces new investment by existing businesses.
4. Higher interest rates reduce the number of profitable investment opportunities and therefore the level of investment.
5. In periods of rapid inflation, significant costs are added to industry because of the need to:
   -search for the best price currently available for goods and services.
   - be constantly updating selling prices.
6. Conventional historical cost accounts have the following problems during periods of significant inflation:
   - historical cost of assets understates the value of the assets.
   - changes in asset values are ignored until they are realised.
   - gains arising from holding assets are treated as being fully distributable.
7. The results of the above is that profits become overstated (current revenues being charged with a measure of historical cost) and capital becomes understated. Therefore, the ROCE is overstated.

Question 19

What are some reasons government intervene in the Free Market?

Answer 19

1. Monopolies, mergers or restrictive practices operate against the public interest.
2. An industry is of key national strategic importance.
3. The free market creates social injustice.
4. Companies fail to take into account how their actions affect others outside of the company (externalities e.g. pollution).
5. The free market fails to provide sufficient public goods, such as health care or education.
6. The free market is unable to provide the amount of capital required (e.g. when a large infrastructure project, such as the construction of a new tunnel or bridge, is being undertaken).

Question 20

What are some key components of competition policies developed by government to increase the efficiency in the economy?

Answer 20

1. Monopolies and merger legislation prevents the development of monopolies, which would have the power to act against the public interest.
2. Restrictive practices legislation has eliminated practises such as the setting of retail prices by manufacturers.
3. Deregulation in certain industries has removed regulations that restrict competition in the industry. E.g. the deregulation of the UK stock market in 198), which caused dealing costs to reduce eand therefore the volume of trading to increase greatly.
4. The creation of internal markets within certain areas of the public sector (eg hospitals or schools). The providers of public sector services must compete for the resources they require based on the services they provide to their users.

Question 21

What are 4 arguments in favour of privatisation?

Answer 21

1. An increase in competition where a state monopoly is split into a number of operating companies prior to sale or where the monopoly position is removed.
2. A short-term boost to government revenues and therefore a favourable impact on the PSNCR.
3. A widening of share ownership, thereby increasing individuals’ stake in the economy as a whole.
4. Reduction in the PSNCR in the future, as borrowings by the newly privatised industries are no longer public borrowings.

Question 22

What are 3 arguments against privatisation?

Answer 22

1. Many privatisations have replaced state monopolies with private sector monopolies, which have then required regulation to ensure that their monopoly position is not abused.
2. The breaking-up of large businesses into smaller companies results in the loss of economies of scale.
3. The quality of service may deteriorate.