03. Economic environment Flashcards
What 3 ways can economic activity be measured?
- By the total income paid by firms to individuals.
- By individuals’ total expenditure on firms’ output.
- By the value of total output generated by firms.
What is the business/economic cycle?
Cyclical fluctuations in the economic levels of activity.
How is GDP calculated?
By adding together the total value of all goods and services produced within the economy each year.
When GDP levels fall compared with the previous quarter, the economy is said to be ~.
contracting.
What is a recession?
2 successive quarters of declining GDP.
How long does a typical economic cycle last?
Around 10 years.
What are the 4 main phases of the economic cycle?
- Recession
- Recovery then expansion.
- Boom… overheating.
- Contraction
What is the Public Sector Net Cash Requirement (PSNCR)?
The difference between the UK Government’s expenditure and revenues.
In recession, what happens to:
- tax revenues
- government spending on unemployment
- PSNCR
- tax revenues will fall
- government spending on unemployment will rise
- PSNCR likely to grow
What will happen to interest rates if the economy:
- is slowing down.
- is expanding and booming.
- They will be reduced to encourage borrowing which will stimulate consumer demand & limit risk of recession.
- They will be increased to slow down the economy as a way to reduce inflationary pressures.
What happens to fixed-interest securities when the market is booming?
People will pay more, prices rise, generates inflation & higher interest rates, fixed-interest securities yields will need to be higher so their prices will fall.
What happens to fixed-interest securities when inflation & interest rates are low and falling?
The income from fixed-interest securities becomes more attractive. In recession the prices of fixed-interest securities should increase due to falling interest rates.
When the economy contracts what happens to equity prices and why?
They fall due to higher interest rates and declining corporate earnings.
Over the longer term, what has more influence on equity prices: the prospects for corporate profitability or interest rates?
The prospects for corporate profitability.
Key economic indicator: earnings growth.
What does this measure and how is it quoted?
- The increase in average employment earnings.
- Usually quoted in UK using a three-month average compared with a similar period the year before.
What is the Producer Prices Indices (PPI)?
A set of indices that measures the prices of goods bought & sold by UK manufacturers.
What is the Purchasing Manager’s Index (PMI) and how is it scored?
- An indicator of the health of the manufacturing sector.
- > 50 = expansion, < 50 = contraction.
What are the 3 types of economic indicator?
- Leading indicators.
- Coincident indicators.
- Lagging indicators.
What are leading indicators? Example?
These usually change before the economy as a whole changes. e.g. stock markets.
What are coincident indicators? Example?
These indicators change at approximately the same time as the economy as a whole and so provide information about the current state of the economy. e.g. GDP.
What are lagging indicators? Example?
These usually change after the economy does e.g. unemployment.
What is the balance of payments for a country?
A record of the country’s trade transactions with the rest of the world, measured in terms of receipts and payments.
What 2 components does the balance off payments consist of and what do they deal with?
- Current account, imports and exports of goods and services; and
- Capital and financial account, foreign investments in the UK and UK investment abroad, as well as loans.
With respect to the BoP current account, what is “visible trade”?
Transactions in goods.
With respect to the BoP current account, what is “invisible trade”?
Services.
What are the 4 parts that make up the BoP current account?
- Trade in goods.
- Trade in services.
- Investment income.
- Transfer payments.
What does a BoP capital account record?
All movement of money into and out of the country for investment e.g. investment in real assets such as land and buildings or financial assets such as shares, bonds and loans.
When would the BoP capital account have a surplus?
If overseas investors invest more money in the UK than UK investors invest overseas.
What happens if there is a net deficit of the combined BoP current & capital accounts?
The official reserves of foreign currencies owned by the Bank of England will have to be used to finance it.
What 4 things make up the UK’s official international reserves?
- Foreign currencies.
- Gold.
- IMF Special Drawing Rights (SDR).
- The UK’s reserves tranche position at the IMF.
CPI vs CPIH
CPIH includes owner occupiers’ housing costs (OOH), along with council tax. Both are significant household expenses.
What is an exchange rate?
The price at which two currencies trade on the foreign exchange market.
UK exports create a demand for what and how does this demand affect the supply of foreign currencies in the foreign exchange market?
- For sterling by foreign buyers.
- It increases the supply.
UK imports create a demand for what and how does this demand affect the supply of foreign currencies in the foreign exchange market?
- For foreign currencies to pay for the imports.
- It decreases the supply.
What are real exchange rates?
The effective exchange rates between countries’ currencies that have been adjusted to incorporate the differences in their rates of inflation.
Real exchange rates are a good indicator of what?
A country’s competitiveness.
What happens to the price of domestic goods if the real exchange rate rises?
They become more expensive relative to foreign goods adversely affecting domestic production.
What happens to the price of domestic goods if the real exchange rate falls?
They become relatively cheaper and demand for them increases.
If the exchange rate rises what happens to:
1. exports (price & demand)
2. imports (price & demand)
3. aggregate demand
4. inflation
- become more expensive, demand falls.
- becomes cheaper, demand rises.
- falls.
- falls because of cheaper import prices & lower aggregate demand.
If the exchange rate falls what happens to:
1. exports (price & demand)
2. imports (price & demand)
3. aggregate demand
4. inflation
- become cheaper, demand rises.
- becomes more expensive, demand falls.
- rises, higher economic growth.
- potential for rising inflation
* also an improvement in the current account BoPs.
What is the effect of a rising pound on:
1. the profitability of exports
2. the share price of major exporters
3. the value of profits earned overseas by UK companies when translated into sterling-based profits
- reduces
- reduces
- reduces (dollars earned in USA will buy fewer pounds).
What is the benefit of s strong currency?
It reduces the cost of imports which in turn helps keep domestic inflation down.
What is fiscal policy?
The use of government spending and taxation to influence both the level of demand in the economy and the level of economic activity.
How might the government use fiscal policy in times of recession to stimulate demand?
- increase spending; and/or
- cut taxation.
How might the government use fiscal policy in times of boom to stimulate demand?
- reduce spending; and/or
- increase taxation.
Under fiscal policy, what has more impact on the economy: an increase in government spending or a corresponding decrease in taxation. Why?
- an increase to government spending.
- because most of that will be spent on domestically produced goods & services whereas a large part of taxation cuts will leak out the domestic economy.
Name 5 potential problems caused by fiscal deficits.
Sustained deficits can:
1. Result in rising interest rates & slow the economy.
2. Cause a rise in total gross govt. debt so interest payments on debt become significant.
3. Reduce private sector investment.
4. Reduce total national savings.
5. Lead to higher taxes / spending cuts to eventually make good the deficit.
What is monetary policy?
Monetary policy attempts to stabilise the economy by controlling interest rates and the supply of money.
Through monetary policy, what has the most significant effect in the short term?
Changes in interest rates.
An increase in interest rates should do what to the demand for money?
Reduce the demand for it.
What are the 2 measure of money supply?
- M0 ‘narrow money’.
- M4 ‘broad money’.
M0 is an indicator of ___ [2] whereas M4 is an indicator of ___.
- consumer spending & retail sales
- the economy.
Globalisation has generally helped to ___ the rate of increase in the costs of consumer goods
reduce
Growth in M0 indicates that consumer spending is ___ whereas a contraction in M0 suggests consumers are behaving ___.
- buoyant
- more cautiously.
Inflation on services has tended to be ___ than on consumer goods
higher
What will be reflected in a faster growth in M4?
An increase in the demand for loans.
What is a key ratio related to money supply?
The velocity of money circulation - the ratio of nominal GDP to the stock of money.
How long do most economists think it takes for the full effect of a change in interest rates to alter the rate of inflation?
Between 18 months & 2 years.
What is quantitative easing (QE)?
Injecting money directly into the economy by purchasing govt. bonds from investors.
What is quantitative tightening (QT)?
A process where the banks sell the bonds previously acquired under QE.
What do falling interest rates usually signal the economy will do in the medium term?
Expand as a result of the lower cost of borrowing.
What do falling interest rates usually mean for the demand for goods & services?
It will rise because consumers & businesses can afford to borrow more to make purchases.
The relationship between the prices of fixed-interest securities and interest rates is ___
an inverse one. As one goes down, the other goes up.
Equities benefit from low interest rates because?
Company profits are usually higher as a result of the reduced cost of borrowing and higher demand for the company’s goods & services.
Which inflation measure is the key one used in the govt.’s target for inflation of 2%?
CPI.
What does CPI measure?
The average change from month to month in the prices of consumer goods & services bought by consumers in the UK.
What does CPIH include which CPI doesn’t?
Owner occupiers’ housing costs (OOH) & council tax.
What is seen as the cause of inflation?
Rising demand fuelled by expanding money supply.
What is disinflation and when does disinflation occur?
- When there is a decrease in the rate of inflation. Prices are still rising, but at a slower rate.
- Typically occurs during a recession, as sales drop and retailers can’t pass higher prices on to customers.
What is deflation and in what situation might it occur?
- The opposite of inflation and occurs as prices decline over time and the inflation rate becomes negative.
- If supply of goods rises faster than supply of money, purchasing power of money increases & general price level of goods falls.
Once deflation occurs it is ___ .
self-perpetuating as reduced output & profits will lead to businesses cutting their workforce and therefore more unemployment.
What is stagflation?
A combination of rising prices* and a *stagnant economy.
If inflation expectations diminish, fixed-interest security prices tend to ___.
rise.
What happens to the demand, the price & the redemption yield for longer term gilts if a rise in future inflation is expected?
- demand is suppressed
- the price falls
- meaning a higher redemption yield
What will a fall in oil prices likely do to share prices?
Raise them due to lower operating costs & higher profitability for industry.
Which types of industries are at a disadvantage because of the effects of globalisation?
Low-skilled, labour-intensive industries in the developed
world that compete with developing countries.
When do financial bubbles occur?
When investors lose sight of fundamental values and buy shares or other assets simply because they expect prices will continue to rise. (a.k.a.‘greater fool theory’).
Pensioners experience a ___ effective rate of inflation than the population as a whole as they tend to need more ___.
- higher
- personal services.
In what phase do share prices grow at their fastest rate?
Recovery phase
What is M0 essentially a measure of?
And what is it an indicator of regarding the nation?
- Notes and coins in circulation.
- The nation’s spending patterns.
What is M4 essentially a measure of?
And what is it an indicator of regarding the nation
- The notes and coins in circulation plus instant access bank accounts.
- The nation’s lending patterns.
