The Economic Enviroment

Question 1

What is the main purpose of a central bank?

Answer 1

Central banks typically have responsibility for setting a country’s or a region’s short-term interest rate, controlling the money supply, acting as banker an lender of last resort to the banking system and managing the national debt.

Question 2

What is a State controlled economy?

Answer 2

A state-controlled economy is one in which the state (in the form of the government) decides what is produced and how it is distributed; they are also known as planned economies or command economies.

Question 3

What are the characteristics of a Stated controlled economy?

Answer 3

Sometimes, these economies are referred to as ‘planned economies’, because the production and allocation of resources is planned in advance rather than being allowed to respond to market forces. The perceived advantage of a planned economy is suggested to be low levels of inequality and unemployment, with the common good replacing profit as the primary incentive of production. However, this may not be the case and large inequalities can arise, as seen in countries such as Russia and Venezuela. The need for careful planning and control can bring about excessive layers of bureaucracy, and state control inevitably removes a great deal of individual choice.

Question 4

What are Market Economies?

Answer 4

In a market economy, the forces of supply and demand determine how resources are allocated.
Businesses produce goods and services to meet the demand from consumers. The interaction of demand from consumers and supply from businesses in the market will result in the market-clearing price – the price that reflects the balance between what consumers will willingly pay for goods and services, and what suppliers will willingly accept for them.
If there is oversupply, the price will be low and some producers will leave the market. If there is undersupply, the price will be high, attracting new producers into the market.

Question 5

Define Mixed economies

Answer 5

A mixed economy combines a market economy with some element of state control. The vast majority of established markets operate as mixed economies to a lesser or greater extent.

Question 6

How do governments raise finance for their public expenditure?

Answer 6

Collecting taxes directly from wage-earners and companies
collecting indirect taxes (eg, sales tax and taxes on petrol, cigarettes and alcohol), and
raising money through borrowing in the capital markets.

Question 7

What is an open economy?

Answer 7

Country with no restrictions on trading with other countries.

Question 8

What are the stages of the Normal Economic Cycle

Answer 8

1. Peak – GDP is at its highest point. Any growth in output stops. This is the point at which GDP is expected to decline, eg, contraction of the economy is expected.
2. Contraction – this is the period over which GDP declines as economic activity slows. When there are two consecutive quarters of declining GDP or ‘negative growth’, economists refer to this as a ‘recession’.
3. Trough – GDP is now at its lowest point. The contraction phase is over.
4. Expansion – economic activity picks up and GDP begins growing once again. Early expansion is usually characterised by a moderate increase in GDP, whereas with late expansion, the rate of increase is higher.

Question 9

What is Macroeconomic policy ?

Answer 9

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

Question 10

What are the main objectives of Macroeconomic policies:

Answer 10

1. Full employment
2. Economic growth
3. Low inflation
4. Balance of payments equilibrium

Question 11

What is Fiscal Policy ?

Answer 11

Fiscal policy is any action by the government to spend money, or to collect money in taxes, with the purpose of influencing the condition of the economy.

Question 12

What are the tools used by the government to influence the level of spending in the economy?

Answer 12

1. The Budget
2. Taxation

Question 13

What is Monetary Policy?

Answer 13

Monetary policy is the regulation of the economy through control of the monetary system by operating on such variables as the money supply, the level of interest rates and the conditions for the availability of credit. Monetary policy is generally concerned with the volume of money in circulation and the price of money or the interest rate.

Question 14

What are interests rates?

Answer 14

Interest represents the price of money or the cost of borrowing. It is, therefore, assumed that there is a direct relationship between the interest rate and the level of spending in the economy. An increase in interest rates is thought to discourage spending in the economy and thereby reduce the level of aggregate spending.

Question 15

What are Central Banks?

Answer 15

A central bank is a financial institution given privileged control over the production and distribution of money and credit for a nation or a group of nations. In modern economies, the central bank is usually responsible for the formulation of monetary policy and the regulation of member banks.

Question 16

List Central Banks’ main responsibilities:

Answer 16

1. Acting as banker to the banking system by accepting deposits from, and lending to, commercial banks
2. Acting as banker to the government
3. Managing the national debt
   regulating the domestic banking system
4. Acting as lender of last resort to the banking system in financial crises to prevent the systemic collapse of the banking system
5. Setting the official short-term rate of interest
6. Controlling the money supply
7. Issuing notes and coins
8. Holding the nation’s gold and foreign currency reserves
9. Influencing the value of a nation’s currency through activities such as intervention in the currency markets, and
10. Providing a depositors’ protection scheme for bank deposits.

Question 17

What is Inflation?

Answer 17

Inflation is a persistent increase in the general level of prices.

Question 18

Issues with high level of inflation:

Answer 18

1. Businesses have to continually update prices to keep pace with inflation.
2. Employees find the real value of their salaries eroded.
3. Those on fixed levels of income, such as pensioners, will suffer as the price increases are not matched by increases in income.
4. Exports may become less competitive.
5. The real value of future pensions and investment income becomes difficult to assess, which might act as a disincentive to save.

Question 19

Positive aspects of high inflation:

Answer 19

1. Rising house and asset prices contribute to a ‘feel-good’ factor (although this might contribute to further inflation, as asset owners become more eager to borrow and spend and lead to unsustainable rises in prices and a subsequent crash).
2. Borrowers benefit, because the value of borrowers’ debt falls in real terms – ie, after adjusting for the effect of inflation.
3. Inflation also erodes the real value of a country’s national debt and so can benefit an economy in difficult times.

Question 20

How do Central Banks control inflation?

Answer 20

Central banks use interest rates to control inflation. They set an interest rate at which they will lend to financial institutions, and this influences the rates that are available to savers and borrowers. The result is that movements in a central bank’s rate affect spending by companies and their customers and, over time, the rate of inflation.

Question 21

What is Deflation?

Answer 21

Deflation is defined as a general fall in price levels.

Question 22

What is the consumer price index (CPI)?

Answer 22

Index that measures the movement of prices faced by a typical consumer.

Question 23

Economic Growth

Answer 23

There are many sources from which economic growth can emanate, but in the long run, the rate of sustainable growth (or trend rate of growth) ultimately depends on:

1. the growth and productivity of the labour force
2. the rate at which an economy efficiently channels its domestic savings and capital attracted from overseas into new and innovative technology and replaces obsolescent capital equipment, and
3. the extent to which an economy’s infrastructure is maintained and developed to cope with growing transport, communication and energy needs.

Question 24

What is the balance of Payments BoP?

Answer 24

The balance of payments (BoP) is a summary of all the transactions between a country and the rest of the world. If the country imports more than it exports, there is a balance of payments deficit. If the country exports more than it imports, there is a balance of payments surplus.
For the balance of payments to balance, the current account must equal the capital account plus or minus a balancing item – used to rectify the many errors in compiling the balance of payments – plus or minus any change in central bank foreign currency reserves.

Question 25

What are the key differences between state-controlled and market economies?

Answer 25

In a state-controlled economy, the allocation of resources and production is centralised whilst in a market economy, this is left up to competition and the forces of demand and supply.

Question 26

Which International organisation has the role of reducing trades barriers?

Answer 26

The remit of the World Trade Organisation is to promote the growth of free trade between economies by reducing trade barriers and arbitrating when disputes arise.

Question 27

What are the main functions of a central bank?

Answer 27

A central bank can carry many functions but its main ones are to act as banker to the government and banks, issuing notes and coins, managing foreign currency reserves and acting as lender of last resort. Many central banks will also regulate the domestic banking system, supervise deposit protection schemes and undertake management of the money supply through influencing interests rates.

Question 28

What economic measure is used as an indicator of the health of the economy?

Answer 28

Gross domestic Product (GDP).

Question 29

What is the impact of high unemployment levels of economy?

Answer 29

High unemployment levels mean that individuals are out of work and have limited income to buy goods which has a knock-on effect on the sales and profitability of companies. It also affects governments as their tax receipts will fall but their expenditure on welfare payments will rise.