Economics

Question 1

Economic indicators - Government borrowing - key points:

Answer 1

• Difference between what the gov receives (taxes) and what it spends (public spending) in a given year is referred to as the net cash requirement (NCR).
• This is fiscal policy governed by the elected UK gov.
• Long term, a high NCR may give rise to concerns about inflation as the gov is spending large sums of money and injecting cash into the economy - as it loosens or tightens fiscal policy.
• If the UK gov receives more than it spends and makes debt repament, this is called PSNDR (public sector net debt repayment).
• In classic economics, books have to balance.
• In Keynesian, fiscal policy is prominent.

Question 2

Economic indicators - inflation indices - key points:

Answer 2

• Inflation is general increase in prices and fall in the value of purchasing value of money
• However value of debt is reduced by inflation and could be argued that a period of sustained inflation is good for countries with high debt levels.
• Deflation also an issue; people not spending and not consuming: no consumption (relative to output)
  
  • This means recession and lower GDP, lower net taxes and lower standards of living.

Question 3

What actions can central banks take to tackle the problem of deflation?

Answer 3

• Reduce interest rates - stimulate consumer demand / business investment
• Engage in QE strategy - further increasing money supply in order to stimulate bank lending to individuals and businesses
• Increase gov spending
• Reduce taxes

Question 4

What are the potential causes of inflation?

Answer 4

• Rising cost of raw materials (cost push inflation)
• Increasing cost of labour via wages (demand pull inflation)
• Increase in consumer demand in wider economy (demand pull inflation)
• Lack of capacity in business / industry (demand pull inflation)
• Devaluation. Devaluation in the exchange rate increases domestic demand (exports cheaper, imports more expensive). Devaluation will also cause cost-push inflation (imports more expensive).

Late 80s, early 90s was an example of demand-pull inflation.

During the late 1980s, the rate of economic growth in the UK rose to over 4%. The high rate of economic growth was caused by demand-side factors, such as:

• Rising house prices
• Cut in real interest rates
• Cut in income tax rates.
• Rise in consumer confidence

The inflation of the late 1970s was due primarily to cost-push factors (wages/oil prices of 1970s)

Question 5

RPI vs CPI - key points:

Answer 5

• The Retail Price Index
  
  • Represents average price of a basket of goods purhased by a typical household (mortgage interest)
  • Current RPI series based to January 1987
  • It uses an arithmetic mean, which adds the cost of all of the items together and then divides this by the total number of items.
• Consumer Price Index
  
  • Another key measure of inflation.
  • MPC is responsible for keeping inflation within +/- 1% of the 2% target.
  • CPI took over from RPI in 2003 and many pension funds etc changed over in 2011.
  • CPI excludes housing costs.
  • A geometric mean is then used to calculate the rate of inflation, i.e. the prices of all of the items are multiplied and the nth root is taken of them, where n is the total number of items.

Question 6

Interest rate - effects on economy and use by central banks - key points:

Answer 6

• The BoE base rate is the monetary tool used by the MPC to set interest rates in the UK.
• Consumer confidence and volume of spending are barometers of economy.
• During upturns they start to rise, but can fall off quickly if interest rates rise
  
  • Higher debt servicing
  • More incentive to save
• Interest rates are at historic lows and BoE has limited options to stimulate growth when inflation is imported via a devalued currency.

Question 7

The BoE and any other central bank can use interest rates to control inflation in the economy by:

Answer 7

• Increasing interest rates - making borrowing more expensive
• Increasing interest rates so providing higher interest on saings and cash deposits
• Both consumers and suppliers have less disposable income and profits to invest
• Both consumers and companies will spend and invest less - this, demand should fall

Question 8

Why might the following want interest rates to remain low?

BoE

UK government

Companies

Individuals

Answer 8

• BoE
  
  • Lower cost of debt
• UK Gov
  
  • Lower cost to public borrowing
  • Low interest rates/ low yields = high gilt values (QE implications)
• Companies
  
  • Cheaper borrowing
  • Exports cheaper
• Individuals
  
  • Cheaper borrowing
  • Stimulate housing market
  • Spend more money
  • Start up and investment is cheaper

Question 9

Unemployment - key points:

Answer 9

Monthly unemployment figures are considered a key figure for economy health. If it is too high, may indicate a drop in production and tax receipts; conversely, if unemployment too low it may result in increased labour costs and increased inflation.

• Frictional
  
  • Caused by changed in economy meaning qualified jobseekers temporarily unmatched with job openings
• Structural
  
  • Caused by structural changes i.e. decline in industries
• Cyclical
  
  • Unemployment caused by changes in overall level of economic activity - often associated with business cycle

Question 10

Bond yields / Inflation / Interest rates - key points summary:

Answer 10

• Rising interest rates and high inflation have an inverse relationship with bond prices.
  
  • Bond prices fall and running yield on fixed coupon bonds increase.
• When interest rates rise, bond prices typically fall and when interest rates fall, bond prices generally rise.
• Bond yields can be a useful indicator of market expectations of future inflation and interest rates.

Question 11

Balance of payments and international trade - The Current Account - key points:

Answer 11

The current account consists of transactions in goods (visible) and services (invisible).

The current account divides into four parts, each of which comprises flows of income, in and out of the country.

• Trade in goods - export and import of visible goods
• Trade in services - export and import of services
• Primary income - wages and salaries eaned by UK residents from other countries, investment income and rent, taxes and subsidies
• Secondary income - items such as overseas aid paymets or payments to and from EU institutions

UK normally runs a deficit in good and secondary income, partially offset by surplus in services and investment income.

Question 12

Balance of payments and international trade - The Capital and Fiancial Account - key points:

Answer 12

The capital account of a country’s balace of payments records all movement of money into and out of the country for investment. This may be investment in real assets (such as land and buildings) or financial assets (shares, bonds, loans).

This works as follows:

• Sales of assets earns foreign currency, while purchases uses up foreign currency
• UK capital account has a surplus if overseas investors invest more money in the UK than UK investors do overseas
• Deficit on current account balance must be made up by the capital account in the overall balance of payments

If there is a deficit in both current and capital, official reserve of foreign currency owned by BoE will be used to finance it.

Question 13

What are the official BoE reserves made up of?

Answer 13

• Foreign currency
• Gold
• IMF special drawing rights (SDRs)
• UK’s reserves tranche position at the IMF

Question 14

Exchange rates - key points:

Answer 14

• UK exports create a demand for sterling by foreign buyers, the satisfaction of this demand increases the supply of foreign currencies in the foreign exhange market
• UK imports create a domestic demand for foreign currency with which to pay for imports, meeting this demand decreases supply of foreign currency in exchange market

Real exchange rates are the effective exchange rates between countries’ currencies that have been adjusted to account for their differences in rates of inflation.

In other words, real exchange rate measures the price of domestically produced goods relative to the price of foreign goods, taking into account the exchange rate.

Question 15

Exchange rates - effects of an increase and effects of a fall:

Answer 15

• Increase
  
  • Exports more expensive, fewer goods demanded
  • Imports cheaper and so demand increases
  • Aggregate demand falls, leading to lower growth
  • Inflation falls because of the effect of cheaper prices for imported goods, lower aggregate demand and less demand-pull inflation
• Decrease
  
  • More competitive exports, increase demand for exports
  • Moe expensive imports, reduced demand
  • Higher economic growth and rise in aggregate demand
  • Potential for rising inflation
  • Improvement in the current account balance of payments (more exports of goods/ services)

Question 16

Fiscal Policy - key points:

Answer 16

• FS describes the short-term effect on the economy of altering levels of government spending and taxation. The net summary of such changes is captured by policy induced movements in the budget deficit.

Question 17

Monetary Policy - key points:

Answer 17

• MP attempts to stabilise the economy by controlling interest rates and the supply of money. In the short-term, changes in interest rates have the most significant effect, while changes in expectations concerning future interest rates can also be important.
• The primary function of central banks is to manage the nations money supply through their interest rate setting powers.
• Money supply is the quantity of money available in the economy to purchase goods and services. Commonly measures as M0 (narrow) and M4 (broad).

Question 18

Measures of the money supply - M0 and M4 money:

Answer 18

• M0
  
  • Comprises notes and coins incirculation, plus operational deposits of banks with the BoE
  • M0 is an indicator of consumer spending and retail sales
    
    • growth in m0 indicates buoyant spending
    • contraction suggests cautious consumers
  • M0 reflects change in the economic cyclem but does not cause them as it has little effect on total national output or inflation
• M4
  
  • Comprises notes and coins, plus all instant access and time deposit accounts of UK residents with UK banks and BS
  • M4 is known as broad money
  • Includes depsits created by banks and BS through lending activities, as well as deposits lodged in accounts by people wanting to save
  • Increase in demand for loand will therefore be reflected by faster M4 growth

Question 19

How can central banks set short-term interest rates through open-market operations in the money markets?

Answer 19

This is generally done through the gilt repo market.

The bank can use it’s repo operations to influence short term rates as follows:

• Can provide funds to the market by lending money in exchange for gilts and so inject money into the financial system. In simple terms, this should operate to lower rates by making money more readily available.
• It can reduce money supply, by borrowing money in exchange for gilts and so withdraw money fro the financial system. This should operate to raise rates by reducing the supply of money.

Question 20

Interest rates and investments - effect of interest rates on:

Cash

FI securitis

Equities

Answer 20

• Cash
  
  • Return on cash will fluctuate broadly in line with prevailing rate of interest
• FI Securities
  
  • Inverse relationship between interest rates and price of FI securities
  • FI in competition with other investments for funds and yield must remain competitive
• Equities
  
  • Generally benefit from low interest rates, company profits generally higher due to low borrowing costs and high demand
  • Flight to risk assets as return from interest falls and FI price falls
  • Future dividends become more valuable as interest rates fall

Question 21

Inflation is the rate of change in the general price level or erosion in the purchasing power of money. Typically categorised as one of the following:

Cost-push inflation

Demand-pull inflation

Answer 21

• Cost-push inflation
  
  • if firms face increased costs and inelastic demand for their output, likelihood is that these rising costs will be passed to consumer
  • Consumers in turn demand higher wages, causing a wage-price spiral to develop
• Demand-pull
  
  • when economy operating beyond full employent level of output, prices are pulled up as a result of an inflationary gap.
  • Excess demand can often stem from optimism accompanied by rising asset prices, but may also stem from policitcally motivated tax-cuts!

Question 22

Controlling inflation is the prime focus of economic policy in most countries. Economic costs inflation imposes on society are far-reaching, such as:

Answer 22

• Hinders ability for price mechanism to clear markets
• Reduces spending power of those on fixed incomes
• Individuals not rewarded for saving, borrowers gain at expense of savers.

Question 23

Disinflation - summary:

Answer 23

• Occurs when price of goods and services still rising, but there is a slowing of the rate at which they increase.
• Typically occurs during recession, as sales drop and retailers cannot pass on higher prices to consumers.

Question 24

Deflation - summary:

Answer 24

• Prices decline over time
• Inflation rate becomes negative
• Supply of good rises faster than supply of money, purchasing power of money increases and general price of goods falls
• Consumers reluctant to buy now as may be cheaper in future
• Borrowers committes to making loan repayments that represent more of purchasing power, while price of asset purchased with loan is falling
• Deflation leads to:
  
  • reduced output as demand falls
  • reduced workforce, increased unemployment
  • further reduction in sales

Question 25

Stagflation - summary:

Answer 25

• Combination of stagnant growth and inflation
• Tend to be short-lived periods
• Sign of weak business performance and rising unemployment.
• Cannot be solved by raising interest rates as economy is weak and businesses would suffer further.
• In addition, falling house prices but rising interest rates would put further pressure on those struggling.

Question 26

Inflation and incestments - effect of inflation on:

Cash

Bonds

Equities

Answer 26

• Cash
  
  • Interest rates can only give a positive real return if they exceed inflation
• Bonds
  
  • Investors receive the same fixed income whether inflation rises or falls, inflation can erode purchasing power of interest received
  • Inflation will erode par value at maturity
  • Index linked gilts can provide protection over long-term. Short term their value is driven by market sentiment and the inflation proofed redemption value is only guaranteed at redemption.
• Equities
  
  • Usually seen as a good hedge against inflation as companies can raise prices to counter inflation and maintain dividends / growth in capital value of shares.

Question 27

What are the four phases of the business cycle?

Answer 27

• Recession - two successive quarters of declining GDP
• Upswing - GDP risen compared to last quarter
• Boom - when economy growing at its fastest
• Slowdown - GDP fallen compared to last quarter

Cyclical unemployment caused by changes in the overall level of economic activity and often associated with the business cycle.

Question 28

What does gearing ratio measure?

Answer 28

• The proportion of capital that is borrowed as a % of total capital employed.
• Also called ‘leverage’.

Question 29

M0 and M4 money - key points and differences:

Answer 29

M4 money is:

• Notes and coins in circulation plus
• instant access and timed deposits of UK residents with UK banks and building societies
• BoE definition also includes:
  
  • certificates of deposit, commercial paper and debt securities up to and including 5 years’ original maturity issued by UK banks and BS
  • and claims on UK res banks arising from REPO agreements

M0 money is:

• Notes and coins in circulation plus
• operational deposits held by banks with the BoE
• Narrowest measure of money and no longer in use since 2006

M0 is referred to as the “wide monetary base” or “narrow money”

M4 is referred to as “broad money” or simply “the money supply”.

Question 30

What is the natural rate of unemployemen?

When does it exist?

Answer 30

The natural rate of unemployment is defined as the equilibrium rate of unemployment i.e. the rate of unemployment where real wages have found their free market level and where the aggregate supply of labour is in balance with the aggregate demand for labour.

Exists when there is equilibrium in the labour market

Question 31

In the UK, what investment is used by investors to gauge the level of real interest rates?

Answer 31

Index-linked bonds issued by government

Real interest rates take into account the expected rate of inflation, as opposed to nominal interest rates which are those quoted in the marketplace. For this reason, government issued index-linked bonds, that rise automatically in value with the rate of inflation, are used by investors to gauge the level of real interest rates

Question 32

What is the acid test ratio?

Answer 32

It’s the comparison of current assets, excluding stock, with current liabilities. The acid test is otherwise known as the ‘quick ratio’. It is a measure of a company’s short term liquidity.

‘Comparison of current assets with current liabilities’ describes the CURRENT ratio.

Question 33

If a country’s imports exceed exports, how is the balance financed?

Answer 33

• By foreigners being prepared to hold the £ currency
• By foreigners being prepared to buy investments with the £ currency
• By foreigners being prepared to buy assets with the £ currency

The UK is a typical example of this situation where imports generally exceed exports. This deficit on a country’s current account can be made up through net investment into the country or loans from abroad (benefitting the capital account)

Question 34

How can central banks reduce the supply of money?

Answer 34

Selling bonds removes money from circulation, reducing the supply of money and leading to higher short-term interest rates. These days, in reality, the Bank of England and most central banks use the repo market (short for ‘sale-and-repurchase’ agreements) to effect changes in interest rates

Question 35

How is the stock market (normally) viewed as an economic indicator?

Answer 35

It is a leading indicator of economic recovery. Higher stock markets are driven by increased demand/reduced supply of equities. This increased demand would be driven by increased company profitability. Increased company profitability is generally driven by an increase in demand for the companies’ goods and services in the economy, indicating consumers are spending more and that there’s an increase in the money supply.

Question 36

What two main ways do central banks differ from normal banks?

Answer 36

• The two main ways central banks differ is their degree of independence (i.e. to set interest rates and control the money supply as it sees fit), and;
• their governance (i.e. the key interest rate decisions of the Bank of England are made by the MPC which includes four independent experts nominated by the Chancellor)