UNIT 1. Chapter 7. External economic influences on business behaviour Flashcards
Def. Macro economics
The study of entire economy like economic output, inflation, interest rates, or governments policies, rather than individual markets.
What do the macro-economics objectives consider? (6)
- Economic growth (GDP)
- Inflation
- Unemployment
- Balance of payments
- Exchange rate stability
- Transfer of wealth
Def. GDP
Gross Domestic Product is the total value of goods and services produced in a country in one year - real GDP has been adjusted for inflation.
Def. Economic growth
An increase in a country’s productive potential measured by an increase in tis real GDP.
Why is economic growth important to countries? (5)
- Increased number of quality goods and services for consumers -> higher living standards
- Increased employment due to higher levels of output, higher consumer income.
- More resources for health and education
- Reduction of absolute poverty
- Higher taxes -> higher income for the government.
Def. Business investment
Expenditure by businesses on capital equipment, new technology and research and development.
What are the factors that lead to economic growth?
- Increase in output resulting from technological changes and expansion of industrial capacity
- Increase in economic resources, such as higher working population or discovery of new resources of oil and gas.
- Increase in productivity
Def. The business cycle
The regular swings in economic activity, measured by real GDP, that occur in most economies, varying from boom conditions to recession when total national output declines.
What are the four key stages of the business cycle?
- Boom
- Recession
- Slump
- Growth/ Recovery
Explain what happens during the boom period. (3)
- Boom - A period of very fast economic growth with rising incomes and profits.
- Inflation is then caused due to high demand for goods and services -> higher prices -> higher wages are demanded -> higher costs. This causes the recession.
- Governments/central banks increase interests rates to reduce inflationary pressure.
Explain what happens during the recession period. (4)
- Recession - A period of declining real GDP. Effect of failing demand and higher interests rates makes the GDP growth slow down.
- Incomes and consumer demand falls -> lower profits.
- Higher unemployment because lower demand -> less workers needed.
- Government tax revenue falls
Explain what happens during the slump period. (2)
- Slump - A prolonged recession causes a slump where real GDP falls substantially and prices fall.
- This occurs if the government fails to take corrective economic action.
Explain what happens during the recovery period. (2)
- Recovery/Growth is eventually achieved when real GDP starts to increase again.
- This may be because corrective government action takes effect, or rate of inflation falls => the country’s products become competitive and demand starts to increase.
Def. Inflation
An increase in the average price level of goods and services. It results from a fall in the value of money.
Def. Deflation
A fall in average price level of goods and services.
What causes inflation? (2)
- Cost-push causes of inflation: When business face higher costs, they raise prices to keep profits.
- Demand-pull causes of inflation: When the demand rises, producers would raise prices to increase profit margins.
The government and central bank policies to control inflation (3)
Cost push inflation:
• High exchange rate -> makes imports cheaper for the business -> less cost push inflation
Demand pull inflation:
• High interest rates -> discourage consumers from borrowing and spending.
• Higher tax rates and reduction of government spending -> Reduces consumer demand as consumers have less disposable income.
Benefits of inflation (if the rate is low) (2)
- Value of debts owed by companies will fall because the value of money is falling -> so when they are repaid, they are rapid with money of less value.
- Rising prices means that the value of land and fixed assets is higher -> increases the value of business.
Drawbacks of inflation (at high rates) (6)
- Higher wage demands
- Consumers would be more price sensitive
- Higher rates of interest
- Cash flow problems due to higher prices of raw materials etc.
- If inflation is lower in another country, it will lose competitiveness in overseas markets.
- Reluctancy to sell with extended credits periods (because when repaid the value of money is lower).
However is deflation beneficial? Effects of deflation
- Consumers delay buying because they’ll wait till the prices become even lower -> lower demand -> falling profits.
- Business are less likely to borrow to invest because the amount borrowed would be of higher value later on.
- Future of profitability of new projects would be doubtful.
Def. Unemployment
This exists when members of the working population are willing and able to work, but are unable to find a job.
Def. Working population
All those in the population of working age who are willing and able to work.
What are the 3 main factors that cause unemployment?
- Cyclical unemployment
- Structural unemployment
- Frictional unemployment
Def. Cyclical unemployment
Unemployment resulting from low demand for goods and services in the economy during a period of slow economic growth or a recession. Businesses would need less employees, therefor unemployment rates go up.
Def. Structural unemployment
Unemployment cause by the structural decline in important industries, leading to significant job losses in one sector of industry.
What are the possible causes of structural unemployment?
- Changes in consumer tastes and expenditure patterns
* Improvement in technology -> employers look for adaptable and multi skilled workers.
Def. Frictional unemployment
Unemployment resulting from workers losing or leaving jobs and taking a substantial period of time to find alternative employment.
Government policies towards cyclical unemployment (2)
- The government tries to keep inflation low in order to avoid recession
- The government would try to keep the rate of exchange competitive so that level of exports wouldn’t fall which would cause unemployment.
Government policies towards structural unemployment (1)
• Government can provide education and training programmes
Government policies towards frictional unemployment (1)
• Government can have better provision of job opportunities by establishing or supporting job centres.
What is the cost of unemployment? (5)
- Opportunity costs as the economy could be producing more goods and services.
- Costs of supporting unemployed workers and their families
- Unemployment may lead to social problems such as crime.
- Lower disposable income, so lower demands
- Lower living standards
Def. Balance of payment (current account)
This account records the value of trade in goods and services between one country and the rest of the world. A deficit means that the value of goods and services imported exceeds the value of goods and services exported.
Def. Imports
Goods and services purchased from other countries
Def. Exports
Goods and services sold to consumers and business in other countries.
Why is it bad for economy to have a large and persistent deficit? How can the government prevent it? (2 1)
It would cause:
• A fall or depreciation in the value of its currency’s exchange rate
• An unwillingness of foreign investors to put money into the economy.
The government can prevent it by: Limiting foreign exchange or putting barriers such as tariffs or quotas.
Def. Exchange rate
The price of one currency in terms of another
Def. Exchange rate depreciation
A fall in the external value of a currency as measure by its exchange rate against other currencies. E.g. if a dollar depreciated, it means that a dollar would equal less pounds.
Def. Exchange rate appreciation
A rise in the external value of a currency as measured by its exchange rate against other currencies.
What are the demand and supply of the currency? (3 3)
Demand:
• Foreign buyers of domestic goods and services
• Foreign tourists spending money in the country
• Foreign investors
Supply:
• Domestic businesses buying foreign imports
• Domestic population travelling abroad
• Domestic investors abroad
Benefits and drawbacks of appreciation of currency to domestic firms
Benefits:
• Imports of raw materials are cheaper
• Reduces the rates of inflation in the economy
Drawbacks:
• Exports of goods and services are more expensive -> less competitive
• Imported products are cheaper, so are more competitive against the domestic products.
Benefits and drawback of depreciation of currency to domestic firms
Benefits:
• Prices of exports are more competitive overseas -> higher export value -> easier to expand overseas
• Business that sell domestically will experience less competition against imported goods and services.
Drawbacks:
• Businesses that rely on imported raw materials experience higher costs
• Retailers selling imported goods would also have to raise their prices.
Def. Fiscal policy
Is concerned with decisions about government expenditure, tax rates and government borrowing. These operate largely through the government’s annual budget decisions.
Def. Government budget deficit
The value of government spending exceeds revenue from taxation.
Def. Government budget surplus
Taxation revenue exceeds the value of government spending.
Scenario 1. The economy is in recession and unemployment is rising. What would the government do?
- Increase in government expenditure plans, such as school construction to create jobs.
- Reduce taxes to increase the value of disposable income of consumers, which should encourage spending.
Scenario 2. The economy is booming and is in danger of overheating.
- Reduce government spending
- Raise tax rates
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Def. Monetary policy
is concerned with decisions about the rate of interest and the supply of money in the economy.
How would higher interest rates affect businesses?
- Increases interest costs and reduces profits for businesses that have very high debts
- Reduces consumer borrowing and this reduces demand for goods bought on credit
- Tends to lead to an appreciation of the country’s exchange rate because higher domestic interests encourage overseas capital to flow into the country.
Extra: Why does higher domestic interest rates lead to an appreciation of the country’s exchange rate?
Because with higher interest rates, more foreign investors (speculators) would want to leave their capital on deposit in domestic banks. To do so, they would have to convert into the domestic currency, hence raising the demand for it -> higher exchange rate value.
What are the 3 exchange rate policies?
- ‘Fixed’ exchange rate: set firmly by the monetary authority with respect to a foreign currency.
- ‘Floating’ exchange rate: determined in foreign exchange markets depending on demand and supply, and it generally fluctuates constantly.
- Joining a common currency e.g. euro
Drawbacks of floating rates - benefits of joining the common currency ( 3 (3) (2) )
- Frequent appreciation and depreciation of a currency against others causes problems such as:
+ Fluctuating prices of raw materials, making costing difficult.
+ Fluctuations in export prices make unstable level of demand.
+ Uncertainty over profits earned. - Hard to make plans to purchase goods from abroad because costs would fluctuate.
- Having different exchange rates adds to cost by:
+ Commission costs to banks to convert currencies
+ ‘Contracts’ to ensure the risks of dealing overseas can be expensive.
Claimed advantages of floating rates - or reasons for not joining a common currency (2)
- Replacing the currency with a common currency will lead to common tax policies -> reduces independence of each government to control its own taxes.
- By joining a common currency, there would be one rate of interest across that currency zone, but the interest rate could be too high for some economies and too low for others.
What are ‘supply side’ policies?
Government policies that aim to increase industrial competitiveness to improve the supply efficiency of the economy.
Examples of supply side policies?
• Low rates of income tax: With high taxes rates, employees or entrepreneurs would feel demotivated to work hard and gain promotion because they don’t get their full ‘award’.
• Low rate of corporation tax: Lower tax on net profit which could be reinvested into the business.
• Increase labour market flexibility and labour productivity by:
+ Subsidies for worker training programmes
+ Increased funding for higher education
+ Lower rates of income tax to encourage workers to take the risk of setting up their own businesses
Def. Market failure
When markets fail to achieve the most efficient allocation of resources and there is under or overproduction of certain goods and services.
What are the 3 market failures?
- External costs: e.g. pollution resulting from manufacturing, noise pollution.
- Labour training: Many firms do not provide sufficient training for the employees -> shortage of skilled workers.
- Monopoly producers: exploiting consumers, or preventing other business to enter the market.
Def. External costs
Costs of an economic activity that are not paid for by the product or consumer, but by the rest of society e.g. pollution from manufacturing process
What are the policies used in order to correct the external influences? (2)
- Regulatory policies: The rules established by the government (law).
- Market based policies: Policies designed to manipulate markets, prices, and incentives to correct market failures.
Def. Income elasticity of demand
Measures the responsiveness of demand for a product after a change in consumer incomes.
Income elasticity of demand = % change in demand of the product / % change in consumer incomes.
Income elasticity can be describes for which types of goods? (3)
- Normal goods: Between 0 and 1. These are essential goods, that the sales wouldn’t fluctuate a lot if the consumer incomes were to rise or drop. e.g. bread.
- Luxury goods: >1. These are expensive but preferred alternative goods, which cannot be afforded when incomes are low. Eg. Computers.
- Inferior goods: Negative ( <0) These are products that have higher demand when consumer income drops. E.g. second hand furniture.
