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CIMA BA1 Fundamentals of Business Economics > 7 Macroeconomic Context of Business II > Flashcards

7 Macroeconomic Context of Business II Flashcards

1
Q

What is the retail price index (RPI)?

A

The RPI compares the basket of goods against a similar basket in 1987 (base year).
- Includes range of different products
= Weighted Price-based Index

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2
Q

What is the Bank of England monetary policy committee (MPC)?

A

This sets interest rates with view to meeting inflation target over the next two years.
- If the RPIX inflation moves 1% either side of the 2% target, the governor has to write an open letter to the Chancellor explaining the reasons for the inflation movement.

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3
Q

What are the main consequences of inflation?

A
  1. Wealth redistribution - ppl on fixed inc suffer when high inflation, borrowers benefit at expense of savers (real value of debt decrease for them)
  2. Impact on balance of payments - Higher inflation in UK compared to other countries => foreign goods cheaper => adverse effect on exports
  3. Creates uncertainty - makes it difficult to plan for the future. Hold back on investment => postpone projects => uncertainty
  4. Costs associated with changing prices - shopkeepers have to keep changing price levels - consumers have tougher task comparing prices
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4
Q

What are the two main causes of inflation?

A
  1. Cost Push Inflation

2. Demand Pull Inflation

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5
Q

What is cost-push inflation?

A

This is when a firm increase prices to maintain or protect profit margins.

  • costs of production increase => supply decrease => inward shift of SRAS curve => contraction in AD => fall in real output => Increase in price level
  • Common costs = wages, oil prices and imported goods (import cost push inflation)
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6
Q

What is the wage price spiral?

A

Prices are expected to rise further => Workers demand greater wage increases => Firms increase prices to maintain margins

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7
Q

What is demand-pull inflation?

A
  • When total demand for goods and services exceeds total supply
  • Results from excessive growth in AD and an inflationary gap.
  • Often monetary in origin, authorities allow money supply to grow faster than the ability of the economy to supply goods & services.
  • AD is at level AD1 where we effectively have excess demand in the economy - prices will be set at P1
    => national income in real terms will be same since economy is full employment - excess demand level AD1 we see higher prices (look at graph on pg 84)
  • Excess prices of P1 to P2 which are caused by excess demand = inflationary gap.
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8
Q

What is the conflict between the two objectives of inflation and unemployment?

A

The Phillips Curve

  • inverse relationship => during periods of low inflation unemployment was high and vice versa.
  • Unemployment pushed under natural rate => inflationary pressures (Non-accelerating inflation rate of unemployment) NAIRU
  • Phillips doesn’t allow for inflation and unemployment = stagflation e.g. mid to late 1970s

=> expectations augmented Phillips curve
(graphs on page 85)

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9
Q

What are the main examples of fiscal policy that the government use?

A
  1. Govt spending
  2. Taxation
  3. Borrowing

=> influence output and economic growth
- Changes in fiscal policy affect both AD and AS

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10
Q

How does fiscal policy effect AD?

A
  • Traditionally seen as an instrument of demand management
  • Help smooth out some of the volatility of real national output when economy experienced external shock.

Keynesian = fiscal policy has powerful effects on AD, output and employment where economy operating below full capacity & need to provide demand-stimulus. (justified to make active use of fiscal policy)

Monetarist Economists - govt spending an tax changes - only have temporary effect on AD, output & jobs & monetary policy is more effective for controlling demand and inflationary pressure.

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11
Q

How does fiscal policy lead to increased output and growth?

A

Expansionary fiscal policy
=> cut in personal income tax -> boost disposable income -> adds to consumer demand

=> cut in indirect taxes -> lower prices - leads to higher real incomes -> adds to consumer demand

=> cut in corporation tax -> higher “post tax” profits for business -> adds to business capital spending

=> cut in tax on interest from saving -> boost to disposable income of ppl with net savings -> adds to consumer demand

  • Multiplier effects of expansionary fiscal policy depend on how much spare productive capacity the economy has - how much any increase of disposable inc is spent & effects of fiscal policy on variables e.g. interest rates.
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12
Q

What are the three main areas for public government spending?

A
  1. Transfer payments: govt welfare payments made available through social security system e.g. job seekers allowance. Provide basic floor of income.
  2. Current govt spending: e.g. state provided goods & services provided on a recurrent basis every week. These services have to be provided day to day throughout the country.
  3. Capital spending: e.g. infrastructure spending, investment spending adds to economy’s capital stock and have supply/demand side effects in medium to long-term
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13
Q

What are the 4 main ways we justify govt spending?

A
  1. Provide socially efficient level of public and merit goods
  2. Provide safety-net system of welfare benefits to supplement incomes of the poorest (process of redistributing income and wealth)
  3. Provide necessary infrastructure via capital spending - important part of country’s long-run AS
  4. Managing the level and growth of AD - meet govt’s main macroeconomic policy objectives
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14
Q

What are the canons of taxation?

A
  1. Certainty - taxpayers should be able to predict tax they will have to pay
  2. Convenience - payments should be easy to make
  3. Equity - based on ability to pay
  4. Economy - collection by govt should be cost effective
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15
Q

What is direct taxation?

A

levied on income, wealth and profit e.g. income tax, national insurance contributions, capital gains tax & corporation tax

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16
Q

What is indirect taxation?

A

Tax on spending e.g. duties on fuel, cigs etc and VAT

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17
Q

What is progressive taxation?

A
  • The marginal rate of tax rises as income rises => rise in average rate of tax (income paid in tax).
  • UK income tax system is progressive.
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18
Q

What is proportional taxation?

A

The marginal tax rate is constant e.g. 25% across all incomes => average rate is constant. E.g. national insurance contributions

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19
Q

What is regressive taxation?

A
  • The rate of tax falls as incomes rise - average rate of tax is lower for ppl with higher incomes. E.g. in UK excise on cigarettes/alcohol.
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20
Q

What does the Laffer curve show?

A
  • As tax increases, tax revenue increases - however there would be a point where ppl would not regard it as worth working so hard.
    => fall in income & tax revenue
    (look at Laffer curve on pg 88)
  • Higher levels of tax => reduce incentive for ppl to go out and get work or that high tax levels => increased avoidance of tax
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21
Q

What does it mean to balance the budget?

A
  • This is when govt spending = govt taxation
  • If G>T => budget deficit and govt need to borrow.
  • Excess spending = Public Sector Net Cash Requirement (PSNCR)
  • If T>G => budget surplus - PSNCR would be negative & govt can repay some national debt

Government debt = amounts outstanding on GILTS

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22
Q

What are 5 examples of how fiscal policy can affect AS?

A

a) Labour Market Incentives: cuts in income tax might be used to improve incentives for ppl to seek work.
- some argue welfare benefit reforms are more important than tax cuts => provide a “wedge” or gap between the incomes of those ppl in work and those who are in voluntary unemployment.
b) capital spending - e.g. on national infrastructure => investment in whole economy. Also lower corporation tax => more business investment.
c) Entrepreneurship and new business creation
d) Research and development and innovation - improve international competitiveness
e) Human capital of the workforce: higher govt spending on education and training & investment in health and transport => transport infrastructure essential

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23
Q

What do free market economists think of fiscal policy in relation to supply-side of the economy?

A
  • Sceptical of the effects - say that lower taxation and tight control of govt spending required to allow private sector of economy to flourish.
    => in long-run burden of taxation reduce
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24
Q

What effect does targeted government spending have?

A
  • Positive impact although take a long time to feed through.
  • Key is to provide right incentives for individuals & businesses
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25
Q

What is monetary policy?

A

Use of interest rates and level of money supply to manage economy.
Interest rates set by bank of england & sets targets for inflation.
- Used to reflate/deflate economy

26
Q

What are the monetary policies used to reflate economy?

A
  1. If inflation falling => cut interest rates => encourage more borrowing. Ppl with mortgages have to repay less per month => increased consumption and investment => economic growth.
  2. Allow money supply to increase - if allowed too much could => inflation.
27
Q

What are the monetary policies used to deflate economy?

A
  1. Increasing interest rates
  2. Reducing money supply
  3. Exchange rates - govt could seek to strengthen the £ if UK find purchasing abroad more attractive
28
Q

What is the “quantity theory of money”?

A 
MV (monetary value of demand) = PT (monetary value of supply)
M = Money Supply
V = Velocity of circulation
P = Price level
T = Number of transactions
  • Monetarists assume that T is fixed and money value of all transactions be calculated as PT.
  • Velocity is constant and not affected by money supply
  • Premise = if V and T are constant, any changes in money supply will have a direct effect on prices
29
Q

How can a business manage risks associated to interest rates?

A
  1. Forward rate agreement (FRA) = contract which fixes target interest rate. Hedges adverse and favourable movements.
    => separate from a basic loan agreement
    - If interest paid on loan is higher then bank will pay back and vice versa
  2. IRG (interest rate guarantee) can be obtained - option to buy a FRA with a particular target int rate for a period of time.
    - Then if adverse movement of int rates => exercise the IRG and buy FRA. If beneficial movement - IRG can lapse.
    - IRGs expensive as give company flexibility
30
Q

What are supply-side policies?

A
  • Enhance long-term growth prospects in an economy by adopting policies that improve efficiency and AS in economy. (look at graph on pg 92)
  • Economy is initially in equilibrium at price level P1/ Y1.
  • Supply-side policies increase the efficiency of supply it can be seen that there can be growth in output and income without inflationary pressure. Producers become more efficient.

Main policies =

  1. Increasing competition (deregulation, privatisation)
  2. Increase efficiency of labour (training incentives, reduce union power, reduced taxation)
  3. Encourage firms to invest (tax incentives)
31
Q

What are the benefits of fiscal, monetary and supply-side policy?

A

Fiscal Policy Benefits =

  1. Effective for short term impact on demand
  2. Can be targeted at certain sectors

Monetary Policy Benefits =
1. Effective at controlling key policy target of inflation

Supply-side Policies

  1. Not inflationary
  2. Doesn’t automatically => increases in govt borrowing
  3. Increase competitive standing in the world
32
Q

What are the drawbacks of fiscal, monetary and supply-side policy?

A

Fiscal Policy Drawbacks =

  1. Potential inflationary tendencies
  2. Potential impact on debt burden of the economy

Monetary Policy Drawbacks =
1. Not as flexible at targeting individual market sectors (interests rates effect everyone)

Supply-side Policies =

  1. Long term policy
  2. Tax cuts in the short term may => inflation
33
Q

What is globalisation?

A

Increasing integration of national economies in terms of trade, financial flows, ideas, information and technology.
- Developing economies can gain through Foreign Direct Investment (FDI)

34
Q

What are the factors for driving globalisation?

A
  1. Improved communications
  2. Political re-alignment
  3. Growth in global industries and institutions (multinational corps)
  4. Cost differentials (reduction in transport costs and differences in industry costs - some countries have comparative advantage)
35
Q

What is the impact of globalisation?

A
  1. Relocation of certain industries to places where more favourable (cheap labour etc)
  2. Increased Competition => better value for consumers
  3. Increased cross border merger and acquisition activity and other cross national alliances. => increase in Multinational Corporations (MNC)
  4. Widening of economic divisions between countries, developed countries will be in a better position to take advantage of free trade
  5. Emergence of new growth markets
36
Q

What does the current account consist of on the balance of payments?

A
  • Goods and services
  • Income
  • Current Transfers
37
Q

What does the capital and financial account consist of on the balance of payments?

A
  • Capital transfers (capital a/c)
  • The net acquisition/disposal of non-financial assets
  • Transaction in financial assets and liabilities

Current a/c and capital a/c items are generally shown on a gross basis.

38
Q

What is within the goods and services section of the current account?

A
  1. Goods and services - Goods = most movable goods that change ownership between UK residents
    Services = Services transactions between UK residents and non-residents
  2. Income - income earned by UK residents from non-residents and vice versa. Employees e.g. wages, salaries and other benefits earned. Investment income which is income earned from provision of financial capital and is classified as direct income
  3. Transfers - provision of resources between residents and non-residents with no quid pro quo in economy value. e.g. food aid.
    Current transfers represent the offset provision of resources that are normally consumed within a short period after the transfer is made.
39
Q

What does the capital a/c consist of?

A

Both capital transfers and acquisition & disposal of non-produced, non-financial assets. Inc’s land purchases and sales associated with embassies etc.
- Capital transfers = required where there is no quid pro quo to offset the transfer of ownership of fixed assets, or forgiveness of debt.

40
Q

What does the financial a/c consist of?

A
  • Transactions associated with changes of ownership of the UK’s financial assets and liabilities.
  • International investment measures UK’s stock of external financial assets and liabilities, whereas the b of p financial a/c measures transactions in these assets and liabilities.
41
Q

What is the balance of payments deficit?

A
  • B of P a/c will balance to zero and therefore the accounts overall cannot be in deficit or surplus.
  • When economists talk about a surplus or deficit in the balance of payments they are referring to a surplus or deficit in the CURRENT A/C ONLY
  • Sometimes referred to as a trade surplus or trade deficit => this is only trade in goods and not services that is being referred to.
  • Deficit = when country is importing more goods and services than it is exporting. (when more £ is sold buy UK individuals and firms to buy FX than vice versa.
42
Q

What are the implications of more £ being sold by UK individuals/firms to buy FX than vice versa?

A
  • Central bank use its FX reserves to buy £ in order to support the £ - not sustainable in the long term as reserves eventually run out & country will have to borrow to finance the deficit.
  • Home country may look to sell more of its assets to foreign owners.
  • Pressure on the £ to weaken/depreciate. Policy to reduce XR may actually help restore more favourable balance of payments position.
43
Q

What are the causes of a deficit and action to eliminate?

A

Cause 1:
UK goods not offering value for money (poor quality, poor productivity) => consider policies for better efficiency and quality or protectionist policies

Cause 2:
Booming UK economy creates an extra demand for imports as UK consumers buy not only more UK goods but also foreign goods => dampen UK demand to lower import demand

Cause 3:
The £ is expensive then UK customers find overseas goods attractively cheaper and foreign buyers find UK goods more expensive => Reduce XR subject to the J Curve effect

44
Q

What is the J-Curve effect?

A
  • Devaluation or depreciation of the XR may not improve the current a/c deficit of the B of P. Due to low price elasticity of demand for imports/exports and immediate aftermath of XR change. (look at curve on pg 97)
    => worsen the balance of payments in the short term
  • Providing that the elasticities of demand for imports and exports are greater than one in the long-term then the trade balance will improve over time
    = Marshall-Lerner condition.
45
Q

What is the balance of payments surplus?

A
  • If export of goods & services are greater in financial terms than the imports => surplus on the current a/c. Long-term surplus => impacts on dynamics of world economy
  • If a significant world trading country has persistent b of p surplus then other nations will likely have a deficit
  • Surplus can be used to invest in overseas assets or repay some existing national debt
46
Q

What is the balance of trade is affected by?

A
  1. The amount/volume of exports and imports

2. The relative prices of exports and imports

47
Q

What are terms of trade?

A

These are defined as a measure of relative prices of a country’s exports to its imports & can be calculated as:

Terms of trade = unit value of exports/ unit value of imports

48
Q

What is free trade?

A

Refers to the ability for companies in different countries to buy and sell goods from each other without intervention

49
Q

What are the benefits of free trade?

A
  • Injection into the circular flow of income (exports of g&s)
  • Improvement in economic welfare if countries specialise in the products they have comparative advantage in
  • Allows firms to exploit scale economies by operating in larger markets e.g. EU has 450million consumers with massive purchasing power. E of S => lower average cost of production
  • International competition => higher efficiency
  • Free trade provides greater choice for consumers and competition helps keep prices down
  • Imports help satisfy excess demand from consumers (safety valve for the economy) Trade deficit can help reduce demand-pull inflation.
  • Trade in ideas stimulates product and process innovations => better products
  • Political benefits of global trade
50
Q

What is the concept of comparative advantage?

A
  • How it can be beneficial for two parties to trade if one has a lower relative cost of producing some good.
  • Opportunity cost matters - how much production of one good is reduced to produce one more unit of the other good.
  • Comparative advantage is a key economic concept in free trade.
51
Q

What does specialisation in certain products or market areas lead to?

A
  • This means where countries specialise in certain products it leads to an increase output of goods
    => mutually beneficial trade taking place on acceptable terms of trade.
52
Q

What are the 3 main international trade institutions?

A
  1. World Trade Organization (WTO)
    - deals with global rules of trade between nations - est in 1995 by General Agreement on Tariffs and Trade (GATT).
    - Encourages multi-national trade in goods & services by liberalising world trade for member countries and reducing tariffs and quotas.
    - Adjucates trade disputes between countries
  2. EU
    - Democratic countries working for prosperity - 28 members (now 27 members).
    - oversees co-operation amongst it’s members
  3. G8
    - has no formal HQ but an exclusive body whose members set out to tackle global challenges - comprises of world’s leading industrialised nations.
    - have an annual summit
    Leaders of the G8 countries aim to -
    a) boost cooperation over trade and finance
    b) strengthen global economy
    c) promote peace
    d) prevent and resolve conflicts
53
Q

What are bilateral free trade agreements?

A
  • Involve two countries in a trade agreeement e.g. (CUSTA between US & Canada)
54
Q

What is a multilateral free trade agreement?

A
  • Involves more than two countries e.g. NAFTA
55
Q

What are the aims of free trade agreements?

A
  • Lower barriers between participating countries => increase degree of economic integration between participants
  • Reduction in trade barriers (not complete removal neces)
  • To form free trade area as an economic integration. Trade barriers with the rest of the world differ among members and determined individually.
56
Q

What is a customs union, common market and economic union?

A
  • Trade barriers are eliminated and identical barriers to trade with non-members established.
  • Common market = customs union where there is free movement of goods & services, labour and capital permitted.
  • Economic union = most complete form of economic integration. National agriculture, social, taxation, fiscal & monetary policies are unified, and a common currency may be adopted.
57
Q

What is protectionism?

A

Where its sensible to adopt policies to protect the home country and implement protectionist measures

58
Q

What are the arguments in favour of protectionist policies?

A
  1. Infant industry argument: certain industries possess a potential comparative advantage but not yet exploited the e of s
    - Short-term protection: foreign competition allows infant industry to develop comparative advantage.
    Protection can be relaxed => industry trade freely on international market. May not be efficient if free from comp though.
  2. Protection against ‘dumping’ - sale of goods below its cost of production. Force firms out of business.
  3. Improving b of p in goods & services - vehicle to control growth of demand for goods & services. Import controls don’t help issues of a lack of int )
  4. Externalities and import controls
    - dealing with demerit goods - impose high tariffs and ban importation of the good.
  5. Non-economic reasons
    a) country not wanting to over-specialise in goods they have comparative advantage in
    b) protect domestic employment
    c) prevent trade on political grounds
59
Q

What are the main examples of protectionist policies?

A
  1. Tariffs = tax on imports used to restrict imports and raise revenue
  2. Import Quotas = reduce quantity of product that is imported => domestic producers face less competition
  3. Voluntary Export Restraint = similar to import quota - restricts number of shipments sent to its trading partner
  4. Export subsidy - payment to domestic producer who exports a good abroad, firm can remain competitive abroad by exporting up to the foreign price. Yet receive higher price domestically.
  5. Trade Embargoes - this is prohibition of commerce and trade with a certain country => if govt wants to make country suffer economically.
  6. Administrative controls - country could impose onerous red tape and administrative procedures on exporters from abroad if they want to bring their goods into the country.
60
Q

What is within the PESTEL framework

A

POLITICAL - Govt take to intervene in an economy e.g. taxation
ECONOMIC - Factors e.g. interest rates, exchange rates, inflation
SOCIAL - cultural issues, e.g. age of popln
TECHNOLOGICAL - technical factors e.g. degree of mechanism
ENVIRONMENTAL = e.g. climate change
LEGAL = law and regulation e.g. employment or health & safety law

CIMA BA1 Fundamentals of Business Economics (8 decks)

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