Chapter 11 - The Economic Environment For Business

Question 1

Potential for conflict

Answer 1

1. There may be conflict between full employment and price stability. Inflation and employment are inversely related. The achievement of full employment may therefore lead to excessive inflation through an excessive level of aggregate demand in the economy.
2. Rapid economic growth may have damaging consequences for the balance of payments since rapidly rising incomes may lead to a rising level of imports.
3. Government reputation and business confidence will both be damaged if the government is seen to pursue incompatible policy targets.
4. Policy objectives may conflict and hence have to consider trade offs between objectives.

Question 2

Making an impact - Aggregate demand

Answer 2

The total demand for goods and services in the economy.

1. The main objective of macroeconomic policy is to influence the level of aggregate demand (AD) in the economy. If AD is too low, unemployment might result, if AD is too high, inflation induced by excess demand might result.
2. Business costs
   Macroeconomic policy may influence the costs of the business sector.
   The demand for goods and services will be affected and have important implications for the costs and revenues of businesses.

• Exchange rates
  May have the effect of raising the domestic price of imported goods.
  Most businesses use some imported goods in the production process hence this leads to a rise in production costs.
• Taxation
  Fiscal policy involves the use of taxation e.g. A change in the employers NIC will have a direct effect on labour costs for all businesses. Changes in indirect taxes will have to be absorbed or the business will have to pass on the tax to its customers.
• Interest rates
  Monetary policy involves changes in interest rates.
  1. Costs of servicing debts will change especially for highly geared firms.
  2. 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 3

Monetary policy

Answer 3

Monetary policy is concerned with influencing the overall monetary conditions in the economy.

Two problems are:

The choice of targets -
The ultimate objective of monetary policy is to influence some important variable in the economy e.g. The level of demand, the rate of inflation, the exchange rate for the currency.
However monetary policy has to do this by targeting some intermediate variable.

The broad choice is between targeting the stock of money or the rate of interest.
- The stock of money in the economy is believed to have important effects on the volume of expenditure in the economy. This may influence the level of output in the economy or the level of prices.

• The price of money is the rate of interest. If governments wish to influence the amount of money held in the economy or the demand for credit, they may attempt to influence the level of interest rates.

The effects of interest rates
If governments choose to target interest rates as the principal means of conducting monetary policy, this may have a series of undesirable effects.

When interest rates are changed, it is expected that the general level of demand in the economy will be affected. However the effects will vary,

1. Investment may be affected more than consumption.
   Most consumption is not financed by credit and is less affected by interest rate changes. There may be long term implications arising from high interest rates.
2. When consumption is affected by rising interest rates, the effects are uneven. Most affected are the demand for consumer durable goods and houses. Hence active interest policy may induce instability.

Question 4

Monetary policy in the UK

Answer 4

1. The central bank has been given the responsibility by the government for controlling short term interest rates.
   - An increase in interest rates is likely to reduce demand in the economy and lower inflationary pressures.
   - A reduction in interest rates should give a boost to spending in the economy but could result in more inflation.

The aim of economic policy is to find a suitable balance between economic growth and the risks of inflation.

2. Central governments can control short term interest rates through activities in the money markets as 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 which effects 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 5

Impact of monetary policy

Answer 5

1. The availability of finance.
   - Credit restrictions 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 which makes them more likely to seek long term finance for projects.
2. The cost of finance.
   - Any restrictions on the stock of money or restrictions on credit will raise the cost of borrowing making fewer investment projects worth while and discouraging expansion by companies.
   - Any increase in the level of general interest rates will increase shareholders required rate of return so unless companies can increase their return share prices will fall as interest rates rise.
   - Organisations are less likely to borrow money and will probably contract rather than expand operations.
3. The level of consumer demand.
   - Periods of credit control and high interest rates reduce consumer demand.
   - Individuals find it more difficult and more expensive to borrow to fund consumption whilst saving becomes more attractive.
4. The level of exchange rates.
   - Monetary policy which increases the level of domestic interest rates is likely to raise exchange rates as capital is attracted into the country.
   - Organisations deal with both suppliers and customers abroad.
   - 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.
5. The level of inflation.
   - Rising price levels and uncertainty as to future rates of inflation make financial decisions more difficult and more important.

Question 6

Impact of inflation on business cash flows and profits.

Answer 6

1. Demand pull inflation.
   - Might occur when excess aggregate monetary demand in the economy and demand for goods and services enable companies to raise prices and expand profit margins.
2. Cost pull inflation.
   - Occurs when there are increases in production costs independent of the state of demand e.g. Rising raw materials 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.
   - One would expect the effect of cost push inflation on company profits and cash flow to be negative.
   - Demand pull inflation may in any case work through cost if companies use pricing strategies in which prices are determined be cost plus some mark-up.
3. Excess demand for goods leads companies to expand output.
4. This leads to excess demand for factors of production.
5. Companies pass on the increased cost as higher prices.
6. In most cases inflation will reduce profits and cash flow, especially in the long run.

Question 7

Fiscal policy

Answer 7

Fiscal policy is the manipulation of the government budget in order to influence the level of aggregate demand and therefore the level in the economy.

Question 8

Balancing the budget

Answer 8

1. This expenditure must be financed either by taxation or by borrowing. The existence of public expenditure itself raises issues of policy, notably how to tax and whom to tax and in addition the process of expenditure and taxation permits the use of fiscal policy in a wider sense.

Three budget positions can be identified.

1. A balanced budget: Total expenditure is matched by total taxation income.
2. A deficit budget: Total expenditure exceeds total taxation income and the deficit must be financed through borrowing.
3. A 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 9

Taxation

Answer 9

1. Direct taxes.
   Taxes levied directly on income receivers whether they are individuals or organisations. These include income tax, NICs, corporation tax and inheritance tax.
2. Indirect taxes.
   Taxes levied on one set of individuals or organisations but may be partly or wholly passed on to others and are related to consumption not income. These include VAT and excise duties and generally have a greater impact on individuals with lower incomes.

Question 10

Government borrowing

Answer 10

The government can undertake two types of borrowing:

1. It can borrow directly or indirectly from the public by issuing relatively illiquid debt. This includes National Savings certificates, premium bonds and long term government bonds.
2. It can borrow from the banking system by issuing relatively liquid debt such as Treasury bills referred to as unfounded debt.

Gilts are issued for long term financing requirements whereas Treasury bills are issued to fund short term cash flow requirements.

Question 11

Problems of fiscal policy

Answer 11

1. Crowding out.
   - Government borrowings leads to a fall in private investment.
   - Occurs because increased borrowing leads to higher interest rates by creating a greater demand for money and loanable funds hence a higher price.
   - The private sector will then reduce investment due to a lower rate of return.
   - A fall in fixed investment by a business can hurt long term economic growth.
   - When the economy is depressed, government spending programmes could help to give a boost to the economy.
2. Incentives.
   - Taxes on spending are used to alter the pattern of consumption
   e. g. High excise duties on alcohol and tobacco products reflect social and health policy priorities.
   e. g. Policies to use excise duties to raise the real price of petrol over time are designed to discourage the use of private cars because of the environmental effects.

• However there has been a growing concern among some economists that taxes have undesirable side effects on the economy especially incentives.
  e. g. National insurance payments raise the cost of labour and probably reduce employment.

Question 12

Government assistance

Answer 12

1. The political and social objectives of a government as well as its economic objectives could be pursued through grants and subsidies.
2. The government provides support to the business such as grants and access to networks of expert advice and information for e.g.
   - Boost enterprise
   - Encourage innovation
   - Speed urban renewal
   - Revive flagging industries
   - Train labour force
   - Sponsor important research

Question 13

Green policies

Answer 13

1. When a firm appraises a project, it may only include those costs it will itself incur. However external costs need to be taken into account.
   This leads to
   - Green legislation
   - Punitive taxation on damaging practices

which force companies to consider the negative impacts of potential projects in any appraisals.

2. Externalities are costs (benefits) which are not paid (received) by the producers or consumers of the product but by other members of society.
3. Green policies arises from the existence of external environmental costs associated with some forms of production or consumption.
   e. g. Production: River pollution from various manufacturing processes.
   e. g. Consumption: Motor vehicle emissions causing air pollution health hazards.
4. If large external costs and benefits exist in the production or consumption process, the price system may be a poor mechanism for the allocation of resources as private producers and consumers ignore the external effects of the activities. The price system may lead to a misallocation of resources.
5. Policies to control damage to the environment will become more and more common as concern for the environment increases.

Question 14

Corporate governance

Answer 14

Defined as the system by which companies are directed and controlled and covers issues such as ethics, risk management and stakeholder protection.

Question 15

Regulation

Answer 15

A variety of rules have been introduced in different countries but the principles common to all contain regulations on

• Separation of the supervisory function and the management function
• Transparency in the recruitment and remuneration of the board
• Appointment of non-executive directors
• Establishment of an audit committee and a remuneration committee
• Establishment of risk control procedures to monitor strategic, business and operational activities.

Question 16

Key issues in corporate governance

Answer 16

1. Membership of the board to achieve a suitable balance of power. The chairman and CEO should not be the same. There should be a sufficient number of non-executive directors on the board and most of these should be independent.
2. NEDs on the board should prevent the board from being dominated by the executive directors. The role of NEDs is seen as preventing a listed company from being run by the personal benefit of its senior executive directors.
3. A remuneration committee should be established to decide on the remuneration of the directors.
4. The role of the audit committee should consist of NEDs and should work with external auditors.
5. The role of the board of directors for monitoring all aspects of risk.

Question 17

Audit committees

Answer 17

1. A committee of the board of directors (3-5 persons).
2. Made up of NEDs with no operating responsibility.
3. Primary function is to assist the board to fulfil its stewardship responsibilities by reviewing:
   - Systems of internal control
   - Audit process
   - Financial information which is provided to shareholders

Question 18

Macroeconomic policy

Answer 18

The management of the economy by government in such a way as to influence the performance and behaviour of the economy as a whole.

Objectives:-
1. The full employment of resources applies in particular labour force. The aim is both full and stable employment.

2. Price stability means little or no inflation putting upward pressure on prices.
3. Economic growth is measured by changes in national income from one year to the next and is important for improving living standards.
4. The balance of payments relates to the ratio of imports to exports. A payment surplus means the value of exports exceeds that of imports. A payment deficit would occur where imports exceed exports.
5. An appropriate distribution of income and wealth depends on the prevailing political view at the time.