17) The economic environment

Question 1

What is macroeconomic policy

Answer 1

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.

Question 2

What are the objectives of the macroeconomic policy

Answer 2

▪ 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.

Question 3

What are the two Trade offs or potential for conflict?

Answer 3

Full employment vs Price stability

Economic growth vs balance of payments

Question 4

Explain

Full employment vs Price stability

Answer 4

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.

Question 5

Explain Economic growth vs balance of payments

Answer 5

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.

Question 6

What is aggregate demand

Answer 6

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.

Question 7

What things does aggregate demand affect?

Answer 7

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.

Question 8

Changes in AD will affect all businesses to varying degrees. Thus effective business planning requires that businesses can: ?

Answer 8

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.

Question 9

Macroeconomic policy may influence the costs of the busines sector in important areas- identify them

Answer 9

Exchange rates
Taxation
Interest rates

Question 10

How are exchange rates impacted?

Answer 10

Most businesses use some imported goods in the production process; hence this leads to a rise in production costs.

Question 11

How are taxation impacted?

Answer 11

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.

Question 12

How are interest rates impacted?

Answer 12

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.

Question 13

What is monetary policy

Answer 13

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.

Question 14

does controlling money supply work and explain

Answer 14

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.

Question 15

What are some examples of governemnt actions relating to monetary policy

Answer 15

Decreasing interest rates in order to stimulate consumer spending

Using official foreign currency reserves to buy the domestic currency

Regulating foreign exchange rates

Question 16

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

Answer 16

1) Investment may be affected more than consumption.

2) Effects are uneven

Question 17

Investment may be affected more than consumption.

explain

Answer 17

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.

Question 18

2) Effects are uneven

explain

Answer 18

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.

Question 19

2) Effects are uneven

explain

Answer 19

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.

Question 20

Explain how exchange rates are affected

Answer 20

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.

Question 21

What is the central banks role?

Answer 21

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

Question 22

What is interest rate smoothing?

Answer 22

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).

Question 23

When does Saving becomes more attractive, spending less attractive

Answer 23

Achieved by increasing interest rates

Question 24

Changes in monetary policy will impact what

Answer 24

Availability of finance
cost of finance
level of consumer demand
exchange rates

Question 25

How is Availability of finance affected from monetary policy

Answer 25

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.

Question 26

How is Availability of finance affected from monetary policy

Answer 26

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.

Question 27

How is cost of finance affected from monetary policy

Answer 27

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.

Question 28

How is level of consumer demand affected from monetary policy

Answer 28

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.

Question 29

How is exchange rates affected from monetary policy

Answer 29

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.

Question 30

What are the two types of inflation

Answer 30

demand-pull inflation – excess demand
cost-push inflation – high production costs.

Both can have a negative impact on cash flows and profits.

Question 31

What is demand pull inflation

Answer 31

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.

Question 32

What is demand pull inflation

Answer 32

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.

Question 33

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

Answer 33

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.

Question 34

What is cost pull inflation

Answer 34

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.

Question 35

What is cost pull inflation

Answer 35

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.

Question 36

What is fiscal policy

Answer 36

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

Question 37

What is fiscal policy

Answer 37

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)

Question 38

What is fiscal policy

Answer 38

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)

Question 39

What does balancing the government budget mean

Answer 39

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.

Question 40

What does balancing the government budget mean

Answer 40

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.

Question 41

What are the two ways that government borrow from?

Answer 41

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.

Question 42

What are the two ways that government borrow from?

Answer 42

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.

Question 43

What are the two problems associated with fiscal policy?

Answer 43

the problem of ‘crowding out’

the incentive effects of taxation.

Question 44

Is balancing the government budget an objective of macro economic policy?

Answer 44

No. Governments may choose to run a surplus or a deficit as appropriate

Question 45

Monetary policy that increases the level of domestic interest rate, this is likely to raise what?

Answer 45

Monetary policy that increases the level of domestic interest rates is likely to raise exchange rates as capital is attracted into the country (statement

Question 46

Monetary policy that increases the level of domestic interest rate, this is likely to raise what?

Answer 46

Monetary policy that increases the level of domestic interest rates is likely to raise exchange rates as capital is attracted into the country

Question 47

Monetary policy that puts restrictions on stock of money or credit will have what effect?

Answer 47

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

Question 48

Monetary policy that puts restrictions on credit and high interest rate will have what effect?

Answer 48

Periods of credit control and high interest rates reduce consumer demand and encourage saving