The macro-economic environment

Syllabus Guide Detailed Outcomes

Having studied this chapter you will be able to: Understand the implications of government economic decisions. Appreciate the impact of fiscal and monetary policy. Understand the relationship of economic growth to inflation and the balance of payments.

Exam Context
Macro-economic environment should not be ignored, it is high up on the agendafor FAB, the pilot paper contains 4questions on this topic.

Business Context
Macro-economic environment affect all aspects of managing organisations as the economic climate alters consumers' demand requirements as well as the price and availability of raw materials and the labour force.

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Overview
Macro-economic environment
Deficit Surplus

Balance of payments

Current account + Capital account = zero Government policy

Terminology

Business cycle

Phases Economic policy Fiscal policy Monetary policy

Taxation

Unemployment

Inflation

Functions

Direct Indirect Causes

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1
1.1

Government policies and obligations

Governments seek to manage national economy, and this may include the following aims: (a) To achieve economic growth (b) To control price inflation (c) To achieve full employment (d) To achieve a balance between exports and imports Governments spend money raised by taxation and borrowing on a variety of items. Decisions by governments on spending and taxing affects the economy in many ways. Eg if the government builds a hospital: (a) Suppliers to government building company wins the contact, they then employ more (b) Knock on effect of government spending throughout the economy the builders they employ will spend their income in shops so they will grow too (c) Taxation affects consumers' purchasing power the builders pay income tax on earnings and VAT on what they buy. Lower rates means people can afford more (d) Taxes on profits affect investment returns the building company pays tax (e) Public sector investment benefits some companies hospital equipment company (f) Public sector investment has a longer time scale and less quantifiable benefits healthy work force Government influences are outlined in the diagram below:
Market demand

1.2

1.3

G O V

Overall economic policy

O R

Cost of finance Taxation Protection vs Free Trade Grants, incentives, sponsorship

G A N I S A T I O N

E R N M E N T

Industry policy
Regulation (eg investor protection, company law) Entry barriers, capacity

Environment and infrastructure policy Social policy

Distribution Workplace regulation, employment law Labour supply, skills, education Trade promotion, export credits

Foreign policy

EU and GATT obligations Export promotion to allies, aid recipients

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2
2.1

Fiscal policy
The formal planning of fiscal policy (ie tax and spend policies) is set out annually (eg in the UK in the 'Budget') which has three components: (a) (b) (c) Expenditure planning Revenue raising Borrowing

If expenditure exceeds revenues the government will need to borrow. In the UK this is known as the 'Public Sector Net Cash Requirement' (PSNCR). 2.2 If you spend more than you earn you will be overdrawn. This is the same for a government. If a government spends more on eg building roads than it earns via eg taxation it will be running a 'budget deficit'. When the government's income exceeds its expenditure it can repaying earlier borrowings, this is known as having a 'budget surplus'. Governments can use fiscal policy to change the level of demand in the economy: Increase demand by government: (a) (b) (c) 2.4 reducing taxation, but does not change its spending then demand is stimulated. spending more, but not altering taxation. increasing taxation or reducing spending.

2.3

Reduce demand by government:

Taxation is a key: (a) (b) (c) source of revenue raising serves to discourage activities (eg tax on tobacco) redistributes income and wealth (eg income support).

2.5

A good tax system should be: (a) (b) (c) Flexible Efficient Able to attain its purpose Direct Paid directly to the Revenue authority eg income, capital gains and inheritance tax. (b) Indirect This is collected by the Revenue authority via a third party (a 'supplier') who passes the tax on to consumers. Indirect taxes can be: (i) (ii) A specific tax charged as a fiscal sum per unit sold (eg a petrol tax per litre) 'Ad valorem tax' charged as a fixed percentage of the price of the item (eg VAT and other sales taxes).
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2.6

Taxes can be either: (a)

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3
3.1 3.2

Monetary policy
Monetary policy uses money supply, interest rates, exchange rates and credit control to influence aggregate demand. Instruments of monetary policy include:

Changing interest rates higher rates leads to us saving more and so spending less and vice versa. This can be done through open market operations (issuing or buying bonds) Changing reserve requirements (the minimum balances held by banks) increased reserves held by banks means less can be lent to customers as credit and so we have less to spend. Intervention to influence the exchange rate (buying or selling currency) overseas goods become relatively more expensive for us if the is weaker and so we buy less of them.

3.3

Monetary control aims to control inflation which helps:

Provide greater economic certainty through low inflation so can plan better. Ensure business confidence and so stimulate investment through stable prices Stimulate economic growth and international competitiveness that should provide higher incomes

4
4.1

National income and economic growth key terminology

Equilibrium national income

Demand for goods and services is in balance with available supply

4.2

Inflationary gap

If a country is already at full employment then any further increase in demand will just lead to higher prices (inflation) as output is already at its maximum. (ie excess demand over supply).

4.3

Deflationary gap'

Where there is unemployment of resources price and wages should go down (then we could afford to buy more and so increase demand and so employment would improve). But people do not want their wages to go down even temporarily. This then creates the deflationary gap where prices stay fairly constant and output and demand change.

4.4

'Stagflation'

Occurs where there is a combination of high unemployment and high inflation caused by a price shock (eg crude oil price rises in the early 1970's) and inflexibility in supply.
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5
5.1

Phases in the business cycle

(a) (b) (c) (d) (e)
Output

The business cycle is the continual sequence of rapid growth in national income followed by a slowdown. An economy will naturally rise and fall without government intervention.5.3The four main p Recession (point A on the graph below) Depression (point B on the graph below) Recovery (point C on the graph below) Boom (point D on the graph below) Recession etc, etc..
Actual output

D
Trend in output

C
B

Time

5.4

In the 'Recession' phase:

Consumer demand / confidence falls Investment projects begin to look unprofitable. Orders are cut, inventory levels reduced Some companies unable to sell their inventories become insolvent

5.5 5.6

If during the recession phase there is a lack of stimulus to aggregate demand a period of 'depression' will set in. 'Recovery' is usually slow to begin due to a general lack of confidence in the economy

Governments look to boost demand (using fiscal / monetary policy) Together with confidence, output, Income and employment rise. Investment flows into the economy

5.7

Once the actual output has risen above the trend line the 'Boom' phase of the cycle is entered.

Capacity and labour become fully utilised Further rises in demand lead to price rises Business is profitable and high inward investment
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6
6.1 6.2

Inflation and its consequences

Inflation is the name given to an increase in prices. High inflation is a problem because it leads to: (a) (b) (c) (d) (e) Redistribution of income and wealth rich get richer Balance of payments effects imports get cheaper so country buys more but what country exports get more expensive so they sell less leading to country being in debt. Uncertainty of the value of money and prices less investment in projects Resource costs of changing prices higher cost of living Lack of economic growth and investment linked to (c)

6.3

The rate of inflation is measured by price indices. A 'basket' of items which represent average purchases around the country is priced regularly and this forms the basis of a price index. In the UK there are now two key price indices: (a) Retail Prices Index (RPI) This index includes prices for all goods and services (including housing costs) purchased by UK consumers. (b) Consumer Prices Index (CPI) This index, which excludes housing costs (council tax, rent), is calculated on the same basis as the rest of Europe. (c) (d) RPIX This is the underlying rate of inflation excluding mortgage interest payments. RPIY This is RPIX as adjusted for the effects of any VAT changes.

6.4

7
7.1

Unemployment
The rate of unemployment can be calculated as:

Number of unemployed 100% Total workforce 7.2 Consequences of unemployment include: (a) (b) (c) (a) (e) Loss of output which is a waste Loss of human capital (eg skills) people forget skills Increases inequalities in income distribution poor get poorer Social costs - crime goes up Increased welfare payments income support

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7.3

Unemployment can be classified into categories: (a) (b) (c) (d) (e) (f)
Real wage unemployment (labour supply exceeds demand but wage rates do not fall) ie the deflationary gap Frictional (short term delays in transferring from one job to another) Seasonal (eg tourism) Structural (closing/scaling down of entire industries eg coal mining, steel and shipbuilding in UK in 1980s ) Technological (eg robots in car plant) Cyclical or demand deficient (reflects the economic cycle)

8
8.1 8.2

Objective of economic growth

Economic growth is measured by increases in real gross national product (GNP) per head of population. Factors which contribute to growth include: (a) (b) (c) (d) (e) New investment in eg NHS Natural resources eg minerals Labour sources eg levels of education Capital availability eg from overseas Technological progress eg internet

9
9.1

The balance of payments

The balance of payments account is the UKs bank account with the rest of the world. It relates to foreign exchange movements in a country. It consists of a current account for trading activities, a capital account and a financial account. The current account is sub-divided into: (a) (b) (c) Trade in goods Trade in services Income from: (d) Residents employed in other countries Returns on capital investment in other countries Interest payments to/from bodies in other countries Non government payments to/from bodies in other countries

9.2

Transfers from:

9.3 9.4

The capital account comprises public sector flows of capital (eg government loans to other countries). The balance on the financial account comprises flows of capital to/from non government sector (eg investment in other countries).
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9.5

The sum of the balance of payments accounts must always be zero (excluding statistical errors in collecting the data known as the 'balancing item') via the financial account. When commentators speak of a balance of payments surplus or deficit they are only referring to the current account, which is also known as the balance of trade. Deficit Surplus Exporting more than importing ie country sells more than buys

9.6

Importing more than exporting ie country buys more than sells

10 Chapter summary
Section Topic Government policies and objectives Summary

Governments manage the economy through the exercise of a fiscal policy (taxation and spending), monetary policy (interest rates and credit) and supply side policies (training and industrial policy). These are designed to get a desired balance between the four main economic objectives growth, inflation, employment and balance of payments. The economy will naturally rise and fall through an economic business cycle and governments will seek to manage these changes in demand to achieve greater economic stability. Inflation is rising prices and is usually measured by an appropriate index. High inflation is damaging to an economy by creating uncertainty and making goods uncompetitive in export markets. Workers are unemployed if they are available for work but not in work. This has several costs in terms of lost output, social costs and loss in skills. There are a range of causes of unemployment and the measures used to reduce it depend on the cause (eg demand deficient unemployment requires stimulation of the economy whereas structural unemployment may require training schemes).

Business cycle

Inflation

Unemployment

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11 Overview summary
Macro-economic environment
Deficit Surplus Trade in goods Trade in services Income Transfers

Balance of payments

Current account + Capital account = zero

Terminology
Equilibrium D=S Inflationary gap Deflationary gap Stagflation

Government policy Business cycle

Phases Economic policy

Growth Inflation control Employment Balance imports/ exports

Fiscal policy
Revenue Expenditure

Monetary policy
Interest rates Credit control Exchange rates

Recession Depression Recovery Boom

Taxation

Unemployment
Real wage Frictional Seasonal Structural Technological

Inflation
RPI CPI RPIX RPIY

Functions
Revenue Redistribute Discourage

Direct Indirect

Causes
Demand pull Cost push Import cost Expectations Excessive growth in money supply

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