Chapter 2: The Economic Environment Flashcards
1
Q
Which factors determine the level of economic activity?
A
- State-Controlled economies
- Market economies
- Mixed economies
- Open economies
2
Q
What is a State-Controlled economy?
A
Where the state decides what is produced and how it’s produced and distributed (command or planned economy).
3
Q
What is a Market Economy?
A
Forces of supply and demand determine how resources are allocated.
4
Q
What is a Mixed Economy?
A
Combines market economy with state control.
5
Q
What is an Open Economy?
A
Relates to current economic relationship with outside countries.
6
Q
What are the stages of the economic cycle?
A
- Peak
- Contraction
- Trough
- Expansion
7
Q
Characteristics of a Peak?
A
- GDP at its highest point.
- Any growth in output stops.
- GDP expected to decline, i.e. contraction of economy is expected.
8
Q
Characteristics of a Contraction?
A
- GDP declines as economic activity slows.
- Potentially a recession.
9
Q
Characteristics of a Trough?
A
- GDP at its lowest point.
- Contraction phase is over.
10
Q
Characteristics of an Expansion?
A
- Economic activity picks up and GDP grows.
- Early expansion usually has moderate increase in GDP, whereas late expansion increases higher.
11
Q
What is a Recession?
A
Two consecutive quarters of declining GDP or ‘negative growth’.
12
Q
What is Macroeconomic Policy?
A
Management of economy by gov’t to influence performance and behaviour of the economy as a whole.
13
Q
What are the main Macroeconomic Objectives?
A
- Full employment
- Economic growth
- Low inflation
- Balance of payments equilibrium
14
Q
What is meant by Full employment?
A
All factors of production, i.e. land, labour, capital and enterprise, should be fully utilised.
15
Q
What is meant by Economic growth?
A
Measured by increases in GDP.
16
Q
What is meant by Low inflation?
A
Achieving price stability (2% target)
17
Q
What is meant by Balance of payments equilibrium?
A
Imports > Exports - trade deficit might be damaging for the prospect of economic growth.
18
Q
What is Fiscal Policy?
A
Any action by gov’t to spend money, or collect money in taxes, with the purpose of influencing the condition of the economy.
19
Q
What tools do gov’t use to influence the level of spending in the economy?
A
- Taxation
- Budget
20
Q
How does Tax influence spending in the economy?
A
Tax can be direct, e.g. income, and indirect, e.g. VAT. Gov’t can influence spending:
- Reduced tax means firms and households have more disposable income, therefore stimulates demand.
- Higher tax reduces disposable income, goods are demanded less, reducing expenditure.
21
Q
What is meant by a Budget?
A
Gov’t budget is a statement of public income and expenditure over a period of a year.
22
Q
What is the difference between a balanced budget, surplus and deficit?
A
- Balanced budget: income = expenditure
- Budget deficit: expenditure > income
- Budget surplus: income > expenditure
23
Q
What is PSBR?
A
Public Sector Borrowing Requirement occurs when there is budget deficit (i.e. public expenditure > public income). Borrowing is required to make up the difference.
24
Q
What are the implications of fiscal policy for business?
A
- Planning: since FP influences AD, businesses need to take this account when planning output levels, future employment levels and investing (easier to plan with stable gov’t policy).
- Costs: Tax, especially employers NI, affects total labour costs, hence the total cost of products. Also, indirect tax rise means cost would either be absorbed by firm or past onto consumer as higher prices.
25
What is Monetary Policy?
Regulation of economy through control of money supply, interest rates, and availability of credit.
26
How does controlling the Money Supply influence the economy?
Supply of money influences the volume of expenditure in the economy, thus influences the level of output and prices, e.g. more money = more demand for G&S = higher prices.
27
How does controlling the availability of Credit influence the economy?
'Credit squeeze' controls the level of spending and reduces inflation. Also, gov'ts may impose minimum reserve requirements on banks, e.g. Min Cash Reserve Ratio.
28
How do Interest Rates influence the economy?
It's assumed that there is a direct relationship between interest rate and level of spending in the economy:
- Increased rates = discouraged spending, reducing aggregate spending.
28
What is Interest?
The reward for saving and cost of borrowing.
29
How might higher rates discourage spending?
- Encouraged to save.
- Mortgage payments rise, leaving less disposable income.
- Higher cost of credit deterring borrowing, thus spending.
- Level of corporate investment decline due to higher borrowing costs.
- Corporate sector lose confidence in economy and become pessimistic about future prospects.
30
How might higher rates not discourage spending?
- Higher interest = greater income for savers. May increase spend.
- Demands for higher wages could arise out of need to make higher mortgage payments.
- Higher interest rates attract capital inflows (more FDI): Leads to appreciation in exchange rate, making imports cheaper and more attractive - contribute to BoP deficit.
- Lower demand results in higher unemployment and lower tax income for gov't, more unemployment benefits.
- Low investment now means poor prospects for future economic growth.
31
What is a Central Bank?
Responsible for setting nation's short term interest rate, controlling money supply, acting as banker and lender of last resort to the banking system and managing national debt.
32
What are the Central Banks responsibilities?
- Banker to the banking system by accepting deposits from, and lending to, commercial banks.
- Banker to the gov't.
- Manage national debt.
- Regulate domestic banking system.
- Lender of last resort in crises to prevent systemic collapse of banking system.
- Set short term interest rate.
- Control money supply.
- Issue notes and coins.
- Hold nation's gold and foreign currency reserves.
- Influence value of nation's currency through activities such as interventions in currency markets.
- Provide depositors' protection scheme for bank deposits.
33
What is the UK's CB?
Bank of England
34
When was the BoE founded?
1964
35
What is the BoE's two core purposes?
- Monetary Stability
- Financial Stability
36
What is Monetary Stability?
Stable prices (meet inflation target of 2%) and confidence in currency. This is done by setting the base rate.
37
What is the base rate?
UK's administratively set short-term interest rate.
38
What is Financial Stability?
Detecting and reducing threats to financial system as a whole - having a stable financial, system is important to have an efficient conduct of monetary policy.
39
What is the MPC?
Monetary Policy Committee
40
What is the role of the MPC?
Interest rate decisions
41
Who's the MPC made up of?
9 members:
- Governor of BoE
- 3 Deputy Governors for Monetary Policy
- Financial Stability and Markets and Banking
- Chief Economist
- 4 external members appointed by the Chancellor
42
Why are external members appointed?
Make sure MPC benefits from expertise that exists outside of BoE. Each member has expertise in field of economics, and are independent. They serve fixed terms, and can be replaced or reappointed.
43
A Treasury representative also sits in MPC meetings. What is their role?
- Discuss policy issues.
- Can't vote.
- Make sure MPC is fully briefed on fiscal policy developments and other aspects of gov'ts economic policy.
- Make sure chancellor is fully informed about monetary policy.
44
What is the MPCs primary focus?
- Ensure inflation is kept within gov't range to support gov't economic objectives, inc those for growth and employment. MPC does this by setting base rate which is otherwise known as 'official bank rate'.
- Formulates monetary policy within the bank and QE.
45
What must the MPC be mindful of when setting the base rate?
- Impact any changes have on sustainability of economic growth and employment.
- Time lag between a change in rate and effects it will have on the economy.
46
What is Quantitative Easing?
QE involves the CB creating money, which is then used to buy assets such as gov't bonds and high quality debt from private companies, resulting in more money in the wider economy.
47
What does the CB do to create more money?
CB buys assets from private sector institutions and credits the seller's bank account, so the seller has more money in their bank account, while the CB holds assets as part of its reserves. The objective is to move money out in the wider economy.
48
What is the objective of QE?
Inject cash directly into the economy to stimulate demand and return inflation to target. Often used to prevent a depression/recession.
49
What effects does injecting money into the economy through the purchase of bonds have on the economy?
- Seller of bonds ends up with more money so may spend it (boosts growth).
-
50
What effects does injecting money into the economy through the purchase of bonds have on the economy?
- Seller of bonds ends up with more money so may spend it (boosts growth).
- Seller of bonds could buy other assets, boosting prices and providing liquidity to other sectors of economy. Results in people feeling better off and spending more.
- Buying assets means higher asset prices and lower yields, brings down cost of borrowing for businesses and households, encouraging a further boost to spending.
- Banks hold more reserves, which might lead them to boost their lending to consumers and business; borrowing increases, so does spending.
51
What is the purpose of preserving Financial Stability?
To maintain 3 vital functions which the financial system performs in the economy:
- Providing main mechanism for paying for goods, services and financial assets.
- Intermediating between savers and borrowers, and channeling savings into investment via debt and equity instruments.
- Insuring against and dispersing risk.
52
In 2011, what committee was established at the BoE?
Financial Policy Committee (FPC)
53
What is the FPCs task?
- Monitor stability and resilience of the UKs financial system and using its power to tackle those risks.
- Gives direction and recommendation to the Prudential Regulation Authority (PRA) and Financial Conduct Authority (FCA)
54
What is the PRA?
Prudential Regulation Authority (PRA) - UK body responsible for prudential regulation of all deposit-taking institutions, insurers and investment banks.
55
What are the FPCs 2 policy levers?
Its powers of...
- Direction
- Recommendation
56
What are FPCs directions?
Binding instructions on PRA and FCA who will then make banks, building societies and other investment firms carry out the resulting actions.
57
What are FPCs recommendations?
Can be 'comply or explain' basis to regulators - if regulators decided not to implement a comply or explain a recommendation, they're required to explain publicly their reasons for not doing so. FPC can also make general recommendations to other bodies.
58
What other responsibilities does the BoE have?
All other traditional central bank activities, with the exception of:
- Managing national debt (done by DMO - debt management office)
- Providing a depositors' protection scheme for bank deposits (done by FSCS - financial services compensation scheme).
59
What are some facts about the FED?
Federal Reserve:
- 1913
- Comprises of 12 regional FED banks (each monitors activities of, and provides liquidity, banks in the region.
- Free from political interference.
- Governed by 7 board appointed by the President.
- Lender of last resort (prevents financial contagion)
60
What is the FOMC?
Federal Market Open Committee
61
Who makes up the FOMC?
Governing board with 5 presidents of the 12 FED banks.
62
What are the responsibilities of the Chairman?
Appointed by president. Responsible for committees decisions, which are directed towards its statutory duty of promoting price stability and sustainable economic growth.
63
How often does the FOMC meet?
Every 6 weeks to examine latest economic data to gauge health of economy and determine whether FED fund rates should be altered.
64
What is Contagion?
When systemic risk and panic spreads throughout the financial system.
65
What are the responsibilities of the ECB?
European Central Bank responsibilities are:
- Setting monetary policy for Eurozone - objective of maintaining internal price stability
- Keep Inflation (defined by CPI) close to 2% in medium term (by influencing factors, e.g. value of euro and money supply).
- Lender of last resort (due to Eurozone crisis)
- Supervisory role to monitor financial stability of banks in Eurozone states.
66
How does ECB set monetary policy?
Through president and council.
67
What does the ECB council comprise of?
Governors of each of the Eurozone's national CBs.
68
What is SSM?
Single Supervisory Mechanism
69
What is the purpose of SSM?
Framework for banking supervision in Europe and comprises the ECB and national supervisory authorities of participating EU countries.
70
What are the main aims of SSM?
- Ensure safety of European banking system.
- Increase financial integration and stability in Europe.
71
What examples are there of economic data?
- GDP
- Balance of Payments
- Budget deficit/surplus
- Level of unemployment
- Exchange rates
- Inflation/Deflation
72
What is Inflation?
Persistent increase in the general price level.
73
Issues of having high levels of inflation?
- Businesses have to continually update prices to keep up with inflation.
- Real value of wages erodes.
- Those on fixed levels of income, e.g. pensioners, suffer as price increases not matched with their incomes.
- Exports may become less competitive (cheaper abroad).
- Real value of future pensions and investment income becomes difficult to assess, which might act as a disincentive to save.
74
Positives of high levels of inflation?
- Rising house prices contribute to feel-good factor (although might contribute to further inflation as house-owners become eager to borrow and spend).
- Borrowers benefit - value of borrowers debt falls in real terms (i.e. after adjusting for inflation).
- Inflation erodes real value of country's national debt and can benefit an economy in difficult times.
75
What is Deflation?
General fall in price levels.
76
Why is deflation bad?
It can turn a bad situation worse, e.g. recession into depression.
- Deflation can spiral: creates circle of reduced spending and reluctance to borrow as the real burden of debt in an environment of falling prices increases.
- Then becomes self-reinforcing loop - falling prices create circumstances for prices to continue falling, leading to depression.
77
When can falling prices be beneficial?
If they're result of:
- Positive supply shock (e.g. rising productivity growth, or greater price competition).
78
How do CPIs measure inflation?
Consumer Price Indices measure changes in prices to estimate how goods and services are changing over time. Over time, prices of G&S rise and fall so inflation measures present a picture of what's happening with avg. price levels in the economy.
i.e. if inflation is rising, this implies the cost of goods and services is rising, thus a fall in purchasing power of money.
79
What 3 measures of inflation do the ONS use?
1. Consumer Price Index (CPI)
2. CPI inc occupier's housing costs (CPIH)
3. Retail Price Index (RPI)
80
What is the annual rate of inflation?
Percentage change in the latest index compared with the value recorded 12 months previously.
81
What 3 ways can be used to measure economic activity?
- Total income paid by firms to individuals.
- Individuals' total expenditure on firms' output.
- Value of total output generated by firms.
82
What is GDP and what does it measure?
Gross Domestic Product measures economic activity on an expenditure basis and is typically calculated quarterly.
83
What is the formula for GDP?
GDP = Consumer spend + Gov't Invest + Gov't Spend + (Exports - Imports)
OR
C + I + G + (X-M)
84
In the LR, rate of sustainable growth depends on what?
- Growth and productivity of labour force.
- Rate at which economy efficiently channels domestic savings, and capital attracted from overseas into new tech (which replaces old equipment).
- Extent to which economy's infrastructure is maintained and developed to cope with growing transport, communication and energy needs.
85
In a mature economy, how much does the labour force grow?
1% pa
86
What is LR productivity growth dependent on?
- Education
- Training
- Utilisation of labour-saving new tech.
(Productivity gains are more difficult to extract in a post-industrialised economy than in one with a large manufacturing base).
87
What is LR productivity growth dependent on?
- Education
- Training
- Utilisation of labour-saving new tech.
(Productivity gains are more difficult to extract in a post-industrialised economy than in one with a large manufacturing base).
88
What is the Economic Cycle?
The course an economy conventionally takes as economic growth fluctuates over time (business cycle).
89
What are the different stages of the economic cycle?
- Recovery
- Acceleration
- Boom
- Deceleration
- Recession
90
What is the Balance of Payments?
Summary of all transactions between a country and the rest of the world (difference between a country's imports and exports).
91
What's the difference between a balance of payments surplus and deficit?
UK Imports > Exports = Deficit
UK Exports > Imports = Surplus
92
What are the main components of the balance of payments?
- Trade balance
- Current account
- Capital account
93
What's the difference between Visible and an Invisible trade balance?
Visible = difference between value of imported and exported goods, such as those arising from trade of raw materials and manufactured goods.
Invisible = difference between value of imported and exported services, arising from services.
94
What's the difference between a trade deficit and surplus?
Trade deficit = imports > exports
Trade surplus = exports > imports
95
What is the Current Account?
Used to calculate total value of goods and services that flow into and out of a country. Comprises the trade balance figures for visibles and invisibles. Other receipts are added to this, e.g. dividends from overseas assets and remittances from nationals working abroad.
96
What do the results of current accounts show?
Provide details of the balance of trade a country has with the rest of the world.
97
What current account does the UK run?
- Post-industrial economy, typically runs a deficit on visible trade but and invisible trade surplus.
- Open economy, so imports and exports combined total over 50% of UK GDP.
98
What is the Capital Account?
Records international capital transactions related to investment in business, real estate, bonds and stocks. Inc transactions relating to ownership of fixed assets and the purchase and sale of domestic and foreign investment assets.
99
What categories are Capital account records usually divided into?
- FDI (foreign firm acquires new plant or existing business)
- Portfolio investment (trading stocks and bonds)
- Other investments (transactions in currency and bank deposits)
100
What must happen for the balance of payments to balance?
Current account = capital account +/- balancing item +/- any change in central banks foreign currency reserves.
(Balancing item used to rectify errors in compiling balance of payments)
101
What factor is critical to the level of international trade undertaken?
Exchange rate
102
How does ER affect international trade?
If a country's ER alters...
- SPICED: Value of currency rises, exports become dearer so less competitive unless producers reduce prices. Imports are cheaper, thus more competitive and demand more - reduces trade surplus and worsens deficit.
- WIDEC: Value falls, exports are cheaper thus more competitive, and imports are more expensive thus less competitive. Both trade surplus and deficit will improve.
103
What are the 2 main types of economic indicators?
- Government debt
- Budget deficit
104
What's Gov't Debt?
What the gov't owes (public sector net debt)
105
What's Budget Deficit?
Shortfall between what gov't receives in tax receipts and what it spends (PNSCR).
106
What's PSNCR?
Public Sector Net Cash Requirement - difference each year between gov't expenditure and gov't income.
- In a buoyant economy gov't spend < less gov't income, with substantial tax rev generated from corp profits and high levels of employment (Enables gov't to reduce public sector borrowing).
107
How does level of unemployment indicate the health of the economy?
Always going to be some unemployment - people lack skills/live in employment black spots. Higher levels of unemployment indicate low demand in economy for goods and services produced and sold to consumers, thus slow demand for people in the Uk to provide for them.
108
How does high unemployment have negative impact on gov't finances?
- Increase social security payments
- Gov't income falls due to lack of tax rev
109
Why is the pattern of unemployment rapidly changing?
Increase of 'Gig Economy'
110
What is the Gig Economy?
Economy where temp positions are common and organisations contract with independent workers for short-term engagements as opposed to permanent jobs.
111
What are the issues of the Gig Economy?
Workers classed as independent contractors, thus have fewer employment rights which cuts gov't tax 'take'.
112
What is an Exchange rate?
Price of one currency in terms of another and is quoted for pairs of currencies.
- If currency A can buy more of currency B, shows appreciation of currency A and depreciation of B.
113
What affects does the exchange rate have on the economy?
Volatile ERs create uncertainty and affect economic activity as well as investment decisions that involve foreign assets.
- e.g. investor in UK may have property in US. If USD depreciated relative to sterlingm the investor would experience a decrease in value of asset even tough property prices in US may not have changed.
114
The ER regime that the CB follows affects volatility of exchange rates. What two extremes are there?
- Fixed rate system
- Floating rate system
115
What is a Fixed rate system?
Exchange rate is pegged to a particular currency, e.g. USD or a basket of currencies. This ensures rate stays 'fixed', the CB will intervene in the currency market to offset natural forces of demand and supply by spending its foreign currency reserves or buying foreign currency.
116
What is a Floating rate system?
ER determined by natural forces of demand and supply. No intervention from CB. (Free floating rate system).
117
What examples of ER regimes that fall within the two extremes are there?
- Target zone
- Crawling peg
- Managed float
118
What is Target zone?
Similar to fixed rate system, but ER managed within a band (upper and lower limit). Means rate can fluctuate; the CB will only intervene if upper and lower limits for the rate are breached.
119
What is Crawling peg?
Similar to target zone, but upper and lower limit bands gradually widen. generally used as a strategy for moving away from a fixed rate system.
120
What is Managed float?
'Dirty float'. ER is largely a floating rate, but with occasional intervention fromCB to alter direction of rate or speed with which the rate changes.
