17) The economic environment Flashcards
What is macroeconomic policy
Macroeconomic policy is the management of the economy by government in such a way as to influence the performance and behaviour of the economy as a whole.
What are the objectives of the macroeconomic policy
▪ Achieving a certain level of economic growth e.g. 2% each year
▪ Keeping inflation below a certain level e.g. 3%
▪ Redistribution of wealth and income
▪ full employment of resources- especially labour force; Maintaining high levels of employment
▪ The balance of payments; the ratio of imports to exports. A payment surplus would mean the value of exports exceeds that of imports. A payment deficit would occur where imports exceed exports.
What are the two Trade offs or potential for conflict?
Full employment vs Price stability
Economic growth vs balance of payments
Explain
Full employment vs Price stability
Full employment vs Price stability ( suggested that Inflation and employment are inversely related) The achievement of full employment may therefore lead to excessive inflation through an excess level of aggregate demand in the economy.
Explain Economic growth vs balance of payments
Rapid economic growth may, in the short-term at least, have damaging consequences for the balance of payments since rapidly rising incomes may lead to a rising level of imports.
What is aggregate demand
The aggregate demand is the total demand for goods and services in an economy.
If aggregate demand is too low this can lead to unemployment. If aggregate demand is too high this can lead to a rise in inflation.
What things does aggregate demand affect?
the level of AD is central to the determination of the level of unemployment and the rate of inflation. If AD is too low, unemployment might result; if AD is too high, inflation induced by excess demand might result.
Changes in AD will affect all businesses to varying degrees. Thus effective business planning requires that businesses can: ?
predict the likely thrust of macroeconomic policy in the short- to medium-term
predict the consequences for sales growth of the overall stance of macroeconomic policy and any likely changes in it.
Macroeconomic policy may influence the costs of the busines sector in important areas- identify them
Exchange rates
Taxation
Interest rates
How are exchange rates impacted?
Most businesses use some imported goods in the production process; hence this leads to a rise in production costs.
How are taxation impacted?
e.g. a change in the employers’ national insurance contribution (NIC) will have a direct effect on labour costs for all businesses.
Changes in indirect taxes (e.g. a rise in sales tax or excise duties) will either have to be absorbed or the business will have to attempt to pass on the tax to its customers.
How are interest rates impacted?
Costs of servicing debts will change, especially for highly-geared firms.
the viability of investment will be affected since all models of investment appraisal include the rate of interest as one, if not the main, variable.
What is monetary policy
Monetary policy is concerned with influencing the overall monetary conditions in the economy in particular:
the volume of money in circulation – the money supply
the price of money – interest rates.
does controlling money supply work and explain
In practice, attempts by governments to control the economy by controlling the money supply have failed and have been abandoned. However, growth in the money supply is monitored, because excessive growth could be destabilising.
What are some examples of governemnt actions relating to monetary policy
Decreasing interest rates in order to stimulate consumer spending
Using official foreign currency reserves to buy the domestic currency
Regulating foreign exchange rates
When interest rates are changed, it is expected that the general level of demand in the economy will be affected. Thus, a rise in interest rates will discourage expenditure, by raising the cost of credit. However, the effects will vary:
Mention the ways
1) Investment may be affected more than consumption.
2) Effects are uneven
Investment may be affected more than consumption.
explain
The rate of interest is the main cost of investment by businesses,
However, most consumption (by individuals) is not financed by credit and hence is less affected by interest rate changes.
Since the level of investment in the economy is an important determinant of economic growth and international competitiveness there may be serious long-term implications arising from high interest rates.
2) Effects are uneven
explain
Even where consumption is affected by rising interest rates, the effects are uneven.
The demand for consumer durable goods and houses is most affected since these are normally credit-based purchases.
Hence active interest policy may induce instability in some sectors of business.
2) Effects are uneven
explain
Even where consumption is affected by rising interest rates, the effects are uneven.
The demand for consumer durable goods and houses is most affected since these are normally credit-based purchases.
Hence active interest policy may induce instability in some sectors of business.
Explain how exchange rates are affected
High interest rates attracts foreign investment -> increase in exchange rates:
exports dearer
imports cheap
There is now a very high degree of capital mobility between economies: large sums of short-term capital move from one financial centre to another in pursuit of higher interest rates.
Changes in domestic interest rates relative to those in other financial centres will produce large inflows and outflows of short-term capital.
Inflows of capital represent a demand for the domestic currency and hence push up the exchange rate. Outflows represent sales of the domestic currency and hence depress the exchange rate.
This may bring about unacceptable movements in the exchange rate.
What is the central banks role?
the central bank has been given responsibility by the government for controlling short-term interest rates. Short-term interest rates are controlled with a view to influencing the rate of inflation in the economy over the long-term.
Central governments can control short-term interest rates through their activities in the money markets. This is because the commercial banks need to borrow regularly from the central bank. The central bank lends to the commercial banks at a rate of its own choosing. This borrowing rate for banks affects the interest rates that the banks set for their own customers.
Action by a central bank to raise or lower interest rates normally results in an immediate increase or reduction in bank base rates
What is interest rate smoothing?
the policy of some central banks to move official interest rates in a sequence of relatively small steps in the same direction, rather than waiting until making a single larger change.
This is usually for the following reasons:
economic (e.g. to avoid instability and the need for reversals in policy) and
political (e.g. higher rates are broken to the electorate gently).
When does Saving becomes more attractive, spending less attractive
Achieved by increasing interest rates
Changes in monetary policy will impact what
Availability of finance
cost of finance
level of consumer demand
exchange rates
How is Availability of finance affected from monetary policy
Credit restrictions achieved via the banking system or by direct legislation will reduce the availability of loans. This can make it difficult for small- or medium-sized new businesses to raise finance. The threat of such restrictions in the future will influence financial decisions by companies, making them more likely to seek long-term, stable finance for projects.
How is Availability of finance affected from monetary policy
Credit restrictions achieved via the banking system or by direct legislation will reduce the availability of loans.
This can make it difficult for small- or medium-sized new businesses to raise finance.
The threat of such restrictions in the future will influence financial decisions by companies, making them more likely to seek long-term, stable finance for projects.
How is cost of finance affected from monetary policy
Any restrictions on the stock of money, or restrictions on credit, will raise the cost of borrowing, making fewer investment projects worthwhile and discouraging expansion by companies.
Also, any increase in the level of general interest rates will increase shareholders’ required rates of return so unless companies can increase their return, share prices will fall as interest rates rise.
Thus, in times of ‘tight’ money and high interest rates, organizations are less likely to borrow money and will probably contract rather than expand operations.
How is level of consumer demand affected from monetary policy
Individuals find it more difficult and more expensive to borrow to fund consumption, whilst saving becomes more attractive. The lowering of demand for goods and services is another reason for organizations to have to contract operations.
How is exchange rates affected from monetary policy
Monetary policy which increases the level of domestic interest rates is likely to raise exchange rates as capital is attracted into the country.
Very many organisations now deal with both suppliers and customers abroad and thus cannot ignore the effect of future exchange rate movements.
Financial managers must consider methods of hedging exchange rate risk and the effect of changes in exchange rates on their positions as importers and exporters.
What are the two types of inflation
demand-pull inflation – excess demand
cost-push inflation – high production costs.
Both can have a negative impact on cash flows and profits.
What is demand pull inflation
Demand-pull inflation might occur when excess aggregate monetary demand in the economy and hence demand for particular goods and services enable companies to raise prices and expand profit margins.
What is demand pull inflation
Demand-pull inflation might occur when excess aggregate monetary demand in the economy and hence demand for particular goods and services enable companies to raise prices and expand profit margins.
One would expect that with demand pull, profits and cash flow might be increased at least in the short run. However, there may still be negative effects on profits and cash flow
Demand-pull inflation may in any case work through cost. This is especially true if companies use pricing strategies in which prices are determined by cost plus some mark-up.
– Excess demand for goods leads companies to expand output.
– This leads to excess demand for factors of production, especially labour, so costs (e.g. wages) rise.
– Companies pass on the increased cost as higher prices.
– In most cases inflation will reduce profits and cash flow, especially in the long run.
What is cost pull inflation
Cost-push inflation will occur when there are increases in production costs independent of the state of demand, e.g. rising raw material costs or rising labour costs.
The initial effect is to reduce profit margins and the extent to which these can be restored depends on the ability of companies to pass on cost increases as price increases for customers.
What is cost pull inflation
Cost-push inflation will occur when there are increases in production costs independent of the state of demand, e.g. rising raw material costs or rising labour costs.
The initial effect is to reduce profit margins and the extent to which these can be restored depends on the ability of companies to pass on cost increases as price increases for customers.
What is fiscal policy
Fiscal policy is the manipulation of the government budget in order to influence the level of aggregate demand and therefore the level of activity in the economy. It covers:
government spending
taxation
government borrowing
What is fiscal policy
Fiscal policy is the manipulation of the government budget in order to influence the level of aggregate demand and therefore the level of activity in the economy. It covers:
government spending
taxation
government borrowing
public expenditure = taxes raised + government borrowing (+ sundry other income)
What is fiscal policy
Fiscal policy is the manipulation of the government budget in order to influence the level of aggregate demand and therefore the level of activity in the economy. It covers:
government spending
taxation
government borrowing
public expenditure = taxes raised + government borrowing (+ sundry other income)
What does balancing the government budget mean
All governments engage in public expenditure, although levels vary somewhat from country to country. This expenditure must be financed either by taxation or by borrowing.
There are three budget positions
o A balanced budget: total expenditure is matched by total taxation income.
o Deficit budget: total expenditure exceeds total taxation income and the deficit must be financed by borrowing. UK the budget deficit was known as the public sector borrowing requirement (PSBR) but has been renamed to the (PSNCR) public sector net cash requirement.
o Surplus budget: total expenditure is less than total taxation income and the surplus can be used to pay back public debt incurred as a result of previous deficits.
What does balancing the government budget mean
All governments engage in public expenditure, although levels vary somewhat from country to country. This expenditure must be financed either by taxation or by borrowing.
There are three budget positions
o A balanced budget: total expenditure is matched by total taxation income.
o Deficit budget: total expenditure exceeds total taxation income and the deficit must be financed by borrowing. UK the budget deficit was known as the public sector borrowing requirement (PSBR) but has been renamed to the (PSNCR) public sector net cash requirement.
o Surplus budget: total expenditure is less than total taxation income and the surplus can be used to pay back public debt incurred as a result of previous deficits.
What are the two ways that government borrow from?
o From the public by issuing relatively illiquid debt. This includes National Savings certificates, premium bonds, and long-term government bonds. This is referred to as ‘funding’ the debt.
o from the banking system by issuing relatively liquid debt such as Treasury bills. This is referred to as ‘unfunded’ debt.
Long-term government bonds (gilts) are issued for long-term financing requirements, whereas Treasury bills are issued to fund short-term cash flow requirements.
What are the two ways that government borrow from?
o From the public by issuing relatively illiquid debt. This includes National Savings certificates, premium bonds, and long-term government bonds. This is referred to as ‘funding’ the debt.
o from the banking system by issuing relatively liquid debt such as Treasury bills. This is referred to as ‘unfunded’ debt.
Long-term government bonds (gilts) are issued for long-term financing requirements, whereas Treasury bills are issued to fund short-term cash flow requirements.
What are the two problems associated with fiscal policy?
the problem of ‘crowding out’
the incentive effects of taxation.
Is balancing the government budget an objective of macro economic policy?
No. Governments may choose to run a surplus or a deficit as appropriate
Monetary policy that increases the level of domestic interest rate, this is likely to raise what?
Monetary policy that increases the level of domestic interest rates is likely to raise exchange rates as capital is attracted into the country (statement
Monetary policy that increases the level of domestic interest rate, this is likely to raise what?
Monetary policy that increases the level of domestic interest rates is likely to raise exchange rates as capital is attracted into the country
Monetary policy that puts restrictions on stock of money or credit will have what effect?
Any restrictions on the stock of money, or restrictions on credit, will raise the cost of borrowing, making fewer investment projects worthwhile and discouraging expansion by companies
Monetary policy that puts restrictions on credit and high interest rate will have what effect?
Periods of credit control and high interest rates reduce consumer demand and encourage saving
