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Cima C04

Fundamentals Of Business econoncs

Contents
Chapter 1 The Goals and Decisions of Organisations...............................................3
Chapter 2 Cost Behaviour and Pricing Decisions...................................................11
Chapter 3 The Market System................................................................................ 17
Chapter 4 The Competitive Process.......................................................................29
Chapter 5 - The Financial System 1..........................................................................37
Chapter 6 - The Macroeconomic Context of Business I : The Domestic Economy.....50
Chapter 7 - The Macro Economic Context Of Business II: The International Economy
................................................................................................................................. 71
Chapter 8 The Financial System 2: International Aspects.........................................81
Discounting.............................................................................................................. 89

Chapter 1 The Goals and Decisions of Organisations


Organisation
Organisations are social arrangements for the controlled performance of collective
goals.
It can refer to a group or institution arranged for efficient work.
Organisation can also refer to a process, structuring and arranging activities of the
enterprise
Organisations enable people to

Share skills and knowledge


Specialise
Pool resources

The resulting synergy allows the organisation to achieve more than the individuals
can on their own.
Classifying organisations by profit orientation
Profit Seeking main objective as maximising the wealth of their owners expanded
as

To continue in existence
To maintain growth and development
To reach an equilibrium point where profits are maximised

Not for profit Organisations


Profitability is not their primary objective, instead they are seeking to satisfy the
particular needs of their members or the sectors of society they have been setup to
benefit.
Examples of NFPs include
Government departments/agencies eg. HMRC

Schools
Hospitals
Charities
Clubs

NFPs typically operate within a backdrop of tension between financial constraints


and their mission objectives.

A special class of NFP is a Mutual. These are setup and formed for the purpose of
taking subscription from and providing common services to their members. These
include

Some building societies


Trade unions
Some social clubs

Co-operatives
A co-operative is a autonomous association of persons united voluntarily to meet
their common economic needs through a jointly owned and democratically run
enterprise. An example being a retail co-operative who joint together to increase
their buying power from retailers.
They are not owned by investors nor do they seek to return a capital gain for
investors. Co-operatives are similar to mutual organisations except that they tend to
deal in tangible goods and services such as agricultural commodities rather than
financial services.
Maximising Shareholder Wealth
This should be reflected in

Higher share prices


Higher dividend payments

Measuring and increasing shareholder wealth needs to consider these issues

Cash is preferable to profit


Cash flows have a higher correlation to shareholder wealth than profit
Exceeding the cost of capital the return on investment, however this is
measured should not only exceed the cost of borrowing but also exceed the
cost of equity (return expected by investors).
Managing both long and short term objectives investors are increasingly
looking for long term value, the stock market places a value on a companies
future potential not its current profit.

Example of comparing profit and shareholder value


EVA plc has the following structure
$100 million debt with interest rate at 6% pre tax
$200 million equity with an expected investment return of 15% to the shareholders
The company has made a profit before interest and tax of $36 million and pays tax
at 30%
Company Statement
Profit before interest and tax

$36m

Interest at 6%

($6m)

Profit before tax

$30m

Tax at 30%

($9m)

Profit after tax

$21m

Minimum profit required by shareholders $200m * 15%

$30m

The company has made a profit but has not met the return required by
shareholders, so can be said to have reduced shareholder value.

Short term measures of financial performance


It is possible that the financial performance of a business in the short run is different
from the financial performance in the long run, which means measures of both short
run and long run performance are needed.
Two standard measures of short run performance are
1. Return on capital employed
2. Earnings per share
ROCE
ROCE =

Profit Before Interest and Tax x 100%


Average capital employed

This gives an indication of how well a business uses its capital (assets) to generate
a profit. It is expressed as a percentage to make it easy to compare the ROCE of
different companies.
Another similar measure of the return on shareholder capital is

Return on net assets =

operating profit (before interest and tax) x 100 %

Total assets minus current liabilities

The higher the figure for ROCE or RONS the more profitable the company is.
Shareholders will be more interested in where that income goes ie. The profits after
interest and tax.

Earnings per Share (EPS)

This is a measure of the earnings available to ordinary shareholders, expressed as


an amount per share.

EPS =

Profit after interest, tax and preference share dividends


The number of ordinary shares issued

This is the amount that the owners of ordinary shares might receive, but the final
figure is left to the discretion of the directors.
Earnings Yield =

EPS

/ Market Share Price

as a %

P/E ratio = Market Price of Share / EPS (no. of years to recoup the price of the
shares via dividends)
Long term measures of financial performance
In addition to measuring current performance, companies also need to be able to
measure longer term performance in relation to investment. As a minimum the
business needs to ensure that the returns to shareholders are at least equal to the
cost of acquiring the capital needed to produce a long term flow of earnings.
To that end the following problems arise

Establishing the cost of capital to finance the investment project


Estimating the flow of income derived form the capital investment over the
whole life of the investment
Valuing that flow of income

To solve these problems we calculate the present value of future cash flows by a
process of discounting.
Decisions should be based on cash flows rather than profits as the former is more
correlated with shareholder value. Also, money has a value over time and cash
received in the future has less value than the same sum received today.
Example, $1 million anticipated in 5 years is not equal to the value of $1 million
received today due to
1. Inflation which erodes the purchasing power of the money
2. Risk - $1 million today is more certain than $1 million in 5 years
3. Interest - $1 million invested today could be invested to earn interest, or be
used to repay a loan thus saving interest.
The above factors are combined into a discount rate based on the cost of capital.
Discounting
The main implication for the time value of money is that cash flows at different
times can not be compared directly. Instead they have to be converted to their

present time. This is achieved by multiplying each cash flow by an appropriate


discount factor.
Present value = future value * discount factor
The net present value (NPV) of the project is the sum of the discounted future cash
flows minus the capital cost of the project.
If the NPV > 0 then the project will raise shareholder value and should be accepted,
if the NPV < 0 then the project should be rejected.

Stakeholders
Defined as those persons having and interest in the strategy of the organisation.
The organisation needs to understand the needs of these diverse groups of
stakeholders as well as their interests and how they may wish to influence
objectives and strategy.
Stakeholder groupings
Internal part of the fabric of the of the organisation and have a strong influence
on the organisations objectives and how it is run. Internal stakeholders include
employees, managers and directors.
Connected these stakeholders have a contractual relationship with the
organisation and include customers, suppliers, shareholders and finance providers.
External these include the government, community and local authority. They
typically have diverse objectives and varying ability to endure that the organisation
meets its objectives.

The needs of the different stakeholder groups will not always be aligned. Examples
of these conflicts are

Wage levels vs cost efficiency


Product/service quality vs profits/dividends
Effect on environment vs profit
Growth vs independence

Solving or managing such conflicts will involve compromise and prioritisation.


Management objectives
One of the more common and important examples of stakeholder conflict is
between shareholders and the managers.
The principal agent problem
Any organisation no just those listed on the stock market is composed of
Principals the legal owners of the company, typically a large number of
shareholders
Agents those appointed by the shareholders to act on their behalf, such as the
board of directors and senior managers
In the case of public sector organisations, the principal is the legal owner which is
the state represented by the government and the agents are the managers put in
charge of the industries.
An example for an individual is where the individual (principal) wants to buy a house
so they appoint a lawyer (agent) to handle the legal aspects of the transactions.
The problem presented by agency theory is that how can the principal ensure that
the agent behaves in such a way as to achieve the aims and objectives of the
principal. The conflict arises where the agent acts to prioritises their own personal
objectives and goals over those of the
Corporate governance
This is defined as the system by with companies and other organisations are
directed and controlled. It sets out to improve the way companies are run and
address the principal agent problem.
The main objectives are

To control the managers/directors by increasing the amount of reporting and


disclosure.
To increase the level of confidence and transparency in company activities for
investors.
To increase disclosure to all stakeholders
To ensure that the company is run in a legal and ethical manner
To building control at the top that will cascade down the organisation

Principles

The board of directors should meet on a regular basis and the responsibilities
should be spread evenly across the board with a clear separation between
the chairman and chief executive.
Directors should have fixed term contracts and director remuneration should
be publicly disclosed.
There should be 3 sub-committees, audit committee, nominations committee
and a remunerations committee.
Non executive directors should be appointed who have no direct financial
interest in the company to provide a level of independence in decision
making.
The annual accounts should contain a statement approved by the auditors
that the business is financially sound and a going concern.

Chapter 2 Cost Behaviour and Pricing Decisions


Business Strategy
Defining a business strategy involves considering the following
Which markets should they operate in
What should be the basis of their competitive advantage
To what extent should they perform all activities in house, be part of a joint venture
or outsource.
Should products be manufactures in the domestic country or should they be made
offshore.
What should their portfolio of products be and how should they be marketed
Competitive strategy
A key decision when trying to obtain a sustainable advantage is the choice between
cost leadership and differentiation.
Cost Leadership the company competes by achieving lower costs than its rivals for
equivalent products and services. This can be through under cutting competitors
prices or by charging the same prices with superior margins.

Differentiation the company tries to differentiate itself by offering a better product


or service than the competition. The customer is persuaded to pay a premium for
the added perceived value in the product. The better in this context could be
brand prestige, performance or technical features which are designed to be sold at
higher prices with higher margins than the undifferentiated product.
This forms the basis for understanding the decision making regarding costs.

All firms will look for opportunities to reduce costs (off-shoring).


However there is a trade-off particularly for differentiators between cost and
quality.
In many mature industries it has become increasingly difficult to gain an
advantage through differentiation as rivals are very quick to copy product
developments.

The theory of costs


Factors of production these are the economic resources of production and are
categorised as

Land natural resources, limited in supply but can be improved through technology.
The reward accruing o land in the production process is rent.
Labour a specific category of human resource, the quality of which can be raised
through education and training. The application of capita through machinery will
improve labour productivity. The reward of labour is wages.
Enterprise this is another category of human resource but refers to the role played
by the organiser of production. In return for risk-taking, organising and decision
taking the entrepreneur receives profit.
Capital this is a man-made resource, which may be fixed eg a factory, or more
fluid as in working capital eg raw materials and work in progress. The reward
accruing to capital in the production process is termed interest.

Cost Behaviour
Fixed costs these do not change with a given production range, eg rent of
premises, depreciation of a machine, directors salary.

However the average fixed cost per unit will fall as output increases. This is because
the same (fixed) cost is spread out over a greater volume of output.

Variable costs are costs which do change with the level of output. These variable
costs arise from the use of production inputs such as labour and raw materials.
The average variable cost per unit can vary with output as follows.
Short run
The short run in economics is defined as the period of time in which at least one
factor of production is fixed (not measured in days or months). This fixed factor
definition means that the level of production in the short run can only be increased
by adding more of the variable factors to the fixed factor. For example, we cannot
increase the size of the factory in the short run but can make the workers do
overtime.
Long run
In the long run all factors are considered variable so that in the long run all factors
of production can be added to in order to increase the production output.
Efficiency in the short run
This can be considered by using the average total cost (ATC) per unit of production.
The total cost is the sum of fixed and variable costs which is then divided by the
number of units produced.

This U shaped shows the optimal level of output in terms of costs.


Technical efficiency means producing the level of output at which average cost is
lowest (ie producing at the lowest point on the average cost curve).
A graph showing ATC, AVC and AFC would look like this.

The U shape can be explained by the law of diminishing returns, which is a short
run phenomenon.
This law states that as equal quantities of one variable factor input are added to the
fixed factor, output efficiency increases This is due to the fixed costs being spread
over greater levels of output. However a point will be reached beyond which adding
more of the variable factor will decrease efficiency due to increasing average costs.

Cost behaviour in the long run


In the long run all factors of production can be varied. It follows that if all factors can
be varied then the law of diminishing returns cannot apply. This means that the firm
can move to a different short run cost curve. In this way the long run cost curve is a
combination of different short run average cost curves.

The long run average cost curve is not flat as economies and diseconomies of scale
occur.
Economies of scale also known as increasing returns to scale, are defined as
reductions in average unit costs caused by increasing the scale of production in the
long run. An example is larger firms negotiating greater discounts when purchasing
raw materials. Constant returns to scale occur when total costs and output rise at
the same rate, thus keeping average costs constant.
Diseconomies of scale or diminishing returns to scale are defines as increasing
average unit costs due to inefficiencies creeping in to the production process.
Diseconomies effect the long run average cost curve and occur when firms grow
very large, reflecting the difficulties of communicating and management control
within a very large organisation.
Implications for businesses
The existence of significant economies of scale can be expected to lead to

Costs and prices to the consumer falling as firms increase their scale of
output
Barriers to entry to smaller firms being raised
Industries being dominated by a small number of larger firms

The car manufacturing industry is dominated by global firms due to significant


economies of scale such as

Purchasing discounts on raw materials eg, steel


Use of large automated production lines
Marketing economies
Ability to have a global supply chain benefiting form lower costs in certain
countries

In some circumstances economies of scale do not present an advantage, eg estate


agents, where house buyers regard local expertise and a local presence as more
important.
Internal economies of scale include
Technical economies arise out of more efficient working as the firm becomes bigger.
Financial larger firms with household names can morrow more easily.
Trading - purchasing power greater for larger firms.
External economies of scale include
Examples include availability of skilled labour, eg IT skills in Silicon Valley and
localisation of industries in one area eg. raw material suppliers, and production
facilities located together.

Diseconomies of scale
Technical the optimal technical size of factory required to produce the lowest
production cost may create large administrative overheads raising the ATC.
Trading with very large scale production the products may become standardised at
the expense of individualism making it difficult to adapt mass produced goods to
changing market trends.
Opportunity costs
Opportunity cost is the value of the benefit sacrificed when one course of action is
chosen in preference to an alternative. In most cases the opportunity cost of a
particular course of action is the next best alternative foregone.
Opportunity costs should be considered in decision making along with the net future
incremental cash flows involved.
Pricing considerations
When setting their prices firms should consider the 4Cs

Costs in the long run the selling price needs to at least cover the average
total cost per unit.
Competitors the pricing decision needs to be aligned with the competitive
strategy chosen, a cost lead would pitch at slightly lower than the
competition and a differentiator would price at a premium.
Customers the price needs to reflect what customers are willing to pay,
keeping in mind the downward sloping demand curve, a balance needs to be
found between price and quantity sold.
Corporate objectives normally the price chosen would be the one that
maximises profit. However in reality other factors come into play eg.
grabbing market share, maximising revenue or setting a high price to reflect
image.

Maximising profit
Profit maximisation occurs where there is the biggest difference between total
revenue and total cost, illustrated in the following graph.

The key points on the are graph are


A.
B.
C.
D.

The first breakeven point where profit = 0, average cost = average revenue
Maximum profit optimum output, marginal revenue = marginal cost
Maximum revenue
A second breakeven point

Maximum efficiency is where average cost is at its minimum.

Chapter 3 The Market System


Market Economy Interaction between supply and demand determines what is
made and in what quantities. Economic activity is determined by the sum of
collective decisions made by producers and consumers.

Command Economy production decisions controlled by government.

Mixed Economy a mix of free market and government intervention.

Market Forces

Downward sloping demand curve, effect of price on demand assuming all other
factors are constant.
P= Equilibrium Price
Q= Equilibrium Quantity

Generally, the lower the price the higher the demand due to 1. Substitution Effect the consumer buys more of one product than another
due to a relative price change.

2. Income effect the change in price of a good effects the purchasing power of
the consumers' income. Normally weak unless the expenditure is on the
goods is a large proportion of income.

Increase in demand due to price change = Expansion


Decrease in demand due to price change = Contraction
Conditions of demand assuming that price is held constant

A shift in demand to the right = increase in demand


A shift in demand to the left = decrease in demand
Conditions of Demand
Income for normal (discretionary) goods increasing income leads to a increase in
demand for these goods.
For inferior goods, a rise in income reduces demand, eg. Demand for public
transport substituted for private cars.
Tastes fashions may make demand for certain goods volatile, can be manipulated
by advertising where producers "create" markets.
Price of other goods goods may be complements or substitutes of each other
eg. The price of a car falls there may be a corresponding increase in demand for
tyres. Complementary goods experience joint demand and as such experience an
inverse relationship between price and quantity demanded.
Population Increase in population immigration increases the demand for most
goods shifting demand outwards.

Price change - will result in a movement along the demand curve resulting in
either an expansion or contraction in demand.
Conditions of demand change there will be a shift in the demand curve
resulting in an inrease or decrease in demand.

Income inequality
In a market economy resources are allocated between competing uses via a market
mechanism which is the interaction of supply and demand. The economic behaviour
of both producers and consumers is influenced by price. One main weakness of the
market mechanism is that it leads to income inequality as only those with
marketable resources may produce and earn income.

Price Elasticity of Demand (PED)

PED = % Change in Quantity Demanded


% Change in Price

PED and Gradient Elasticity and gradient are not he same thing. The PED will
depend on where you are on the demand curve.

a = -4 (1 / )
b = -3/2 (1 / 1/3)
c = -2/3 (1/3 / )
As the calculation of the PED moves down a linear curve from top left to bottom
right, elasticity falls in value, ie the curve becomes relatively more inelastic.
If The PED is -1, then a 10% fall in price will lead to a 10% rise in demand.

Factors that effect PED


Proportion of income spent on the good if the good is a very small proportion
of income, price movements are unlikely to change demand, eg. Milk inelastic,
clothing elastic.c,
Substitutes and the availability of close alternatives will make demand more
elastic, as consumers will switch to competing brands. However a specialised
unique product will be relatively inelastic.
Necessities demand for essential products such as sugar, milk and bread tends
to be inelastic, however luxury items such as foreign holidays tends to be highly
elastic.
Habit addictive products tobacco, alcohol, drugs - inelastic
Time inelasticity may lessen in the long term as consumers discover alternatives.
Definition of the market widely defined food, few alternatives inelastic.
Specified more narrowly orange juice will create elasticity in the demand for
these brands.

Link Between PED and Total Revenue If Total revenue increases following a price cut, then demand is price elastic.
If Total revenue increases following a price rise then demand is price inelastic.
If total revenue remains unchanged following a price movement then demand is of
unitary elasticity.
Supply
Upward Shift
Supply curve, shows how much producers are willing to offer for sale at a given
price. Normally upward sloping to reflect the desire to profit form selling more
expensive goods.

As with the demand curve changes in price cause an expansion or contraction in


supply (up or down in the curve rather than a change in the curve itself).
Upward shift in supply caused by the cost of supply increasing. At existing prices
less will be supplied.

At price P the quantity supply shifts from Q to Q1, hence the supply curve shifts
from S2 to S1.
This could be caused by
Higher production costs or indirect taxes.
Supply
Downward Shift
This is an increase in supply at a given price curve shifts from S1 to S2, showing
that the cost of production has fallen. Lower unit costs may be caused by Technology innovations, more efficient use of factors of productivity, lower input
process, reduction of indirect taxes or additional subsidies.
Elasticity of Supply (PES)

A normal supply curve will slope upwards indicating that producers will supply more
at higher prices.
Increase in price = expansion
Decrease in price = contraction
The price elasticity of supply (PES) is positive
PES > 1 - price elastic supply

PES < 1 - price inelastic supply


PES = 1 unit elasticity
Factors that influence elasticity of supply.
Time Supply tends to be more elastic in the long term.

If the supply curve is horizontal it shows that supply is perfectly price elastic
If the supply curve is vertical it shows that supply is perfectly price inelastic
Perfectly Price Elastic

Perfectly Price Inelastic

Factors of production the availability of trained labour, raw materials and spare
capacity will make supply more elastic.
Stock levels high stock levels of finished goods will make supply elastic.
Number of firms in the industry supply is more elastic the more firms there are in
the industry.

The Price Mechanism


This graph shows the intended demand and planned supply.

Point P shows where the consumer demand and supply plans of producers
correspond, the equilibrium point. P is the equilibrium price and Q the equilibrium
quantity. At prices and outputs other than (P,Q) either demand or supply aspirations
can be met not both at the same time.
For example
P1 consumers only want Q1, but producers are making Q2 available, leaving an
excess supply of Q1Q2 output. Eventually a reduction in price will lead to a
contraction in supply and an expansion in demand until equilibrium price P is
reached.
P2 conversely, at price P2, the quantity demanded Q2 will exceed the quantity
supplied Q3, leaving a shortage (Q2-Q3) representing excess demand. This demand
will show as back orders, empty shelves and high second hand values. The excess
demand will lead to a rise in the market price until equilibrium point P is reached.

Shifts in Supply and Demand


The more inelastic the supply or demand the more the price volatility following
shifts in either supply or demand. The longer term effects of these changes in the
market depend somewhat on the reactions of the consumers. The longer the
production period, the more inelastic the supply and the more volatile the price will
tend to be.
Price acts as a signal to sellers on what to produce
Price rises, with all other factors constant, will stimulate extra supply.

Equilibrium price is where the plans of both buyers and sellers are aligned.
Increase in demand due to consumer tastes changing.

D1 is the new consumer demand curve reflecting increased consumer appetite.


Supply in initially Q and fixed in the short term, causing the price to be bid up to P1.
Producers respond to this price stimulus by expanding the quantity supplied,
bringing the price down to P2, the new equilibrium price (above the old equilibrium
P).
If a reduction in the price of 10% resulted in a fall in total revenue of 10%, then the
quantity sold must have stayed the same. This suggest that demand is perfectly
price inelastic.

Interference with market prices


Minimum Price
If a government seeks to ensure that a minimum price above the equilibrium price,
is set for a particular goods or service, this will create an excess of supply.
Eg. Setting a minimum wage can lead to unemployment, minimum commodity
prices can lead to excess storage of these commodities or the need to pay
producers not to grow the product.
This sort of price regulation by government intervention will mean that they may be
shortages or surpluses due to an imbalance of supply and demand that resources
are not allocated by price. However profits for producers are protected.

This sort of price interference is only effective if the minimum price is set above the
current equilibrium price. The example above shows a contraction in demand, an
excess of supply and no change in the equilibrium price.
Maximum Price
Where the governmentt seeks to protect the low paid or to control inflation. This
maximum price must be set below the equilibrium price and will have the effect of
creating a shortage of supply. This shortage is Q1Q2

The problem arises maximum prices can lead to a misallocation of resources,


shortages of supply and arbitrary ways of allocating resources.
A consequence of this shortage can be the emergence of black markets, where the
sellers agree on an illegal price that is higher than the government sanctioned
maximum price.

The Common Agricultural Policy (CAP)


This is a buffer stock system with an external tariff which protects European
producers from foreign competition. The EU sets target prices for foodstuffs and
buys stocks at intervention prices if target prices are not achieved. The EU stores
surplus quantities of food and EU consumers pay a price above the market price.

Agricultural Prices and Cobweb theorem


Agricultural commodities are often regulated because of the inherent instability in
prices which is linked to supply issues. In the short run supply is inelastic, in that
increasing output takes time, ie. Plant seed, grow crop, harvest, produce finished
product.
Price fluctuations may be due to rapid changes in demand linked to consumer
tastes, exchange rates and cost of storage.
This combination of rapid changes in demand coupled with inelastic supply can
cause volatility in prices and income for producers. To prevent such price
fluctuations buffer stock systems have been developed by the worlds main
suppliers. They form cartels to regulate prices which are only allowed to fluctuate
within narrow ranges. They buy surpluses if excess supply threatens to push prices
through the floor. Alternatively they sell from stock if shortages threaten to push
prices through the ceiling. Thus providing fairly constant prices, the policy also
maintains stable income for producers.
Market Failure
In theory market forces should result in an equilibrium that provides the optimal
benefits for consumers. Market Failure is the failure of the market to allocate
resources in a way that maximises utility. Sources of market failure include external
costs, external benefits and monopolies. Unequal income distribution on the other
hand is an outcome of market failure not a cause.
Public Goods These are the goods that would not be provided at all by a market
economy eg street lighting.
These have the following characteristics Non-excludability - Provision of the good/service for one member of society
automatically benefits the rest of society.
Non-rivalry consumption of the good by on person does not reduce the amount
available to others.
These 2 characteristics mean that a market for this type of goods can not exist.
Externalities
These are social costs or benefits that are not automatically included in the supply
or demand curves for the product or service. For example, take smoking and
drinking, the consumer pays part of the cost at the point of purchase. However the
social costs are met by society as a whole, eg. Burden on the health care system,
emergency treatment for drunk drivers. These are described as negative
externalities. The role of the government is to ensure that the management of these
externalities is factored in to the decision making eg. the polluter pays policy, the
larger the tax the more significant the impact. In short, externalities are the

differences between private and social costs as they impact otherwise uninvolved
parties.

Imposing a tax on to the supplier or indirect tax on the good, would shift the supply
curve to the left, resulting in an equilibrium with a higher price and lower quantity.

For pricing policies to maximise net social benefits they would need to consider
such externalities by
Calculate Social Costs
Use indirect taxes/subsidies
Extend private property rights
Regulations
Tradable permits
Merit Goods
These are defined by their positive externalities positive social benefits in
consumption. Also, merit goods are seen as ones that should be available to al
irrespective of ability to pay. Government often provide these merit goods even
though these can be provided by the market.The private sector provides
alternatives to consumers with the means and willingness to pay for them.
Demerit Goods
Goods or services that are seen as unhealthy or undesirable. The concern is that a
free market results in an excess consumption of the goods, eg. Smoking, drinking,

drugs and gambling. The focus on demerit goods is the negative impact on the
consumer rather than externalities.

Re-take Online Unit test Supply and Price Determination

Chapter 4 The Competitive Process


Competition Rivalry
Different Levels

Competition for market share between roughly equal sized firms.


New markets growth can be shared, mature markets, growth comes at the
expense of someone else.
Competition around differentiation making price a key factor.

Market Failure and Government Regulation


Left unchecked, market forces may result in large companies who can abuse their
market power and hold their customers to ransom with excessively high prices.
This creates the need for government intervention to protect consumers from this
abuse.

Market Structures
Defined by buyers and sellers of goods/services willingly participating trading these
goods/services transacted in an underlying currency. The participants in these
trades require information on the prices of the goods/services being traded. This
price acts as a signal as well as an incentive.

Extreme forms of market defined by the number of suppliers in the market

Perfect Competition
Imperfect Competition oligopoly and duopoly
Monopoly

Market structures are defined according to the following criteria -

Structure number of firms, seller concentration, type of product, barriers to


entry.
Conduct: pricing behaviour, how much freedom do sellers have to set prices.
Efficiency Technical (production at the lowest cost), Allocative(use of
resources optimal to consumers), X- Inefficiency (high barriers to entry)
Profit

Markets can be segmented as follows Geography international, national, regional or local


Time demand and supply conditions can change depending on day of week or
season
Customer Type preferential discounts may be offered to regular customers

Market concentration this describes the phenomenon whereby the growth of firms
leads to a few large firms dominating an industry's output, sales and employment.
For example the five firm concentration ratio is over 85 % in the car, cement
tobacco and steel industries.
Aggregate concentration ratio this measures the share of the total production or
employment contributed by the top 100 firms in an industry. This growth in firm size
and rise in concentration ratios have occurred more by takeovers and mergers than
by internal growth.
The Growth of Firms

Internal Expansion or Integration (horizontal, vertical and diversification)


Horizontal larger retailers enjoy greater economies of scale, buying power etc. An
example being a larger retailer taking over a smaller retailer or technology sharing
Renault Nissan. Less common now due to anti-monopoly legislation.
Vertical one form moves into another stage of production through acquisition in
the same industry eg. Ross Foods purchasing a fleet of trawlers to control the supply
chain (backwards vertical integration). This gives the following advantages
elimination of transaction costs, increasing barriers to entry, securing supplies
improving distribution network, gaining economies of scale, making better use of
existing technologies.

Diversification a firm expanding into a business with which is was previously


unconnected. Examples being Virgin Records, EasyJet, Hitachi resulting in
conglomerates.
Other than short term profits, the goals for diversification can be Minimise risk from market fluctuations
Transfer of expertise
Economies of scale particularly in administration.
Vertical disintegration the hiving off of service or product centres in order to
reduce costs and concentrate on its core business.

Perfect Competition many buyers and sellers, behaving rationally with perfect
information about unbranded homogenous products. No barriers to entry exist to
the market and normal profits as abnormal profits/losses are removed by
competitive forces. These rarely exist in real life, the closest would be the stock
exchange or the local farmers markets. An implication is that since suppliers can sell
all their stock at a given price, there is no incentive to offer discounts. Conversely
profits are constrained as any attempts to raise prices will shift customers to the
competition.
This level of rivalry forces firms to operate at minimum costs implying technical
efficiency and the lowest prices suggest allocative efficiency.
Although and extreme, this model demonstrates that high levels of competition are
good for the consumer (low prices) and good for the economy (low costs).
The down sides being - lack of choice for consumer and limited profits which
constrain growth and innovation.
Monopoly

Conditions where a market has a single dominant producer and no substitutes or


competition. This can arise though high barriers to entry caused by
Legal barriers, patents oo state control
Cost structure of industry- high start up costs
Integration to the extent that the monopolists control the full end to end business
process, making it hard for a new entrant to become established.
Rather than market forces determining the equilibrium price the monopolist can
choose whether to

They fix the price and let demand determine the amount supplied or
Fix supply and let demand determine the price

Price discrimination
Examples
Time Gym fees cheaper during off peak hours
Customer- non members at a golf club pay more
Income pensioners pay less
Place house calls cost more than surgery visits
These pricing strategies can be successful if several conditions are met At least two distinct markets with no seepage between them. If there was seepage
then enterprising consumers could buy the product in the lower priced market and
sell in the higher priced market, hence undercutting the monopolist.
Differing demand elasticities a higher price could be set in the more inelastic
market.

Imperfect Competition
Between perfect competition and monopoly several forms of market exist which
share characteristics of these two extremes.
Monopolistic Competition
Large numbers of producers supplying similar but not homogenous products.
Competition on price to gain market share at the expense of rivals.
Consumers lack perfect knowledge but have a choice.
Low barriers to entry, firms can enter and leave at little cost.
Prices higher than at perfect competition but consumers benefit from more choice.
Example the market for greeting cards.

Oligopoly
A few large firms with a high concentration ratio.
Behaviour of firms dependent on actions of rivals, with an interdependence on
decision making.
Consumers lack detailed product information and are susceptible to the strategies
of suppliers.
Very high barriers to entry due to entrenched market dominance involvement of
economies of scale. Advances in technology and global corporations can still
provide a challenge to established oligopolies.
Typical strategies for an oligopolistic firm Cooperate with other large firms within the constraints of competition legislation.
Make their own decision and ignore rivals - try to set higher price and behave like a
monopolist or risk a price war if a price cut is copied by rivals.
Become a price follower by awaiting the action of a price leader (firm behaves like a
price taker).
Avoid price based competition. Price stability is often associated with oligopolistic
behaviour as they cannot predict how rivals will behave. Instead there is substantial
non price competition eg. Advertising campaigns. Firms often produce multiple non
branded goods in the same market at different price points (not homogenous).
In the absence of collusion and price fixing does not occur, consumers may benefit
from an oligopoly through access to a wide range of branded goods, price stability
and after sales support.
A duopoly in once such example of the above.

Regulation
3 aspects which require government regulation
1. Mergers and Acquisitions monitored to see if the resulting organisation has
excessive power that may not be in the public interest. In the UK the
Competition and Markets Authority sets this threshold at 25%.
2. Restrictive Trade Practices collusion by suppliers over price fixing
undermines consumer power, in the UK the OFT investigates such anti
competitive behaviour.
3. State Created Regional Monopolies the process of privatisation of state
owned utility companies has created regional monopolies. Regulators such as
OFWAT have been setup to regulate pricing and minimum investment and set
an appropriate return for investments eg maximum ROCE.
The European Commission
The Treaty of Rome allows the European Commission to control behaviour of
monopolists and to increase the level of competition across Europe. An example is
the prevention of dual pricing. For example distillers sold whisky at higher prices in
France and tried to prevent British buyers from buying more cheaply in England and
selling at lower prices in France. The European court ruled against the distillers dual
pricing.

Public vs Private provision of goods and services


Public Sector includes public corporations (state post offices), government
departments (MOD) with a government minister exercising overall control, local
authorities, QUANGOS quasi autonomous non governmental organisations (health
authorities).
Arguments for nationalisation
Low costs potential economies of scale
Capital from government support
Provides uneconomic services for consumers and allows for these to be distributed
more fairly.
Allows strategic control of key resources.
Protects employment and minimises social costs keeping open uneconomic pits to
protect jobs and communities.
Gives a fairer distribution of wealth surpluses can be re-invested for the benefit of
society instead for profits for capitalist investors.
Privatisation 3 broad approaches

The transfer of ownership of a business, public service or property from the


public sector to businesses or to non profit organisations, includes
government out-sourcing. Can be achieved by either selling state owned
assets or the introduction of competition between an existing monopoly of
existing suppliers (deregulation and competitive tendering).
Deregulation to allow private firms to compete
Contracting out work to private firms

Arguments for privatisation


Improve efficiency in state owned industries
Wider share ownership employees are more invested, work harder and strike less
Improved quality privatised companies have to compete to survive and have to be
more efficient and responsive to customers. The necessary condition that leads to
profits through efficiency is competition as a firm can be profitable but inefficient in
the absence of competition.
Greater economic freedom market forces are more influential than political forces.
Will provide funds for the treasury.
Arguments against privatisation
Fewer services and higher prices
Private monopolies are created
Quality of service diminished example G4S and London Olympics
Assets sales under priced
Only the profitable parts of the public sectors are sold off
Impact on the balance of payments dividends payments go abroad
Executive bonuses and high salaries stand in contrast with wage restraint.
Competition is not enhanced - due to the creation of local monopolies that require
the creation of regulatory control to manage investment and pricing decisions.
The poor suffer, water privatisation in developing countries, the poorest 20% of the
population spend 10% on water.
Pricing as many privatised companies are now private monopolies they are
expected to follow profit maximisation principles. This on its own does not lead to
technical or allocative efficiency as this would require perfect competition. The
government therefore is obliged to create such competition.
Public Private Partnerships (private finance initiatives)

Private sector financing of public services, transfer of council housing to housing


association using private loans or the contracting out of refuse collection to a
private firm.
Perceived advantages are finances public projects without the need for
government borrowing or more taxes.
Risk transferred to the private firm, who will be paid less if they miss performance
targets.
Introduces private sector efficiencies such innovation and raises the quality of the
provision.
Critics of PFI point out
This method of finance is more expensive as the government has access to the
cheapest of funds.
How much risk is really transferred to the private companies as the government has
a record of bailing out private firms managing troubled public services.
Efficiency savings are made at the expense of quality of service eg. hospital
cleaning.
Public and Merit Goods revisited
Public goods are those for which no market exists, characterised by consumption by
one individual does not prevent someone else from benefiting. This allows freeriders benefit from the service even though they would not be prepared to pay for
it. Hence defence is provided at zero price but tax payers fund the service. As the
government can provide the services in bulk technical efficiencies could be
achieved through economies of scale. Technical efficiency means producing the
level of output at which average cost is lowest (ie producing at the lowest point on
the average cost curve).
Merit goods, which the government provides for the benefit of society and it's
general wellbeing have alternatives from the private sector eg private health,
private education, private security. In the case of merit goods provided by the
government, technical efficiency can be sought (state education is one third the
cost of private on a per pupil basis). This technical efficiency cannot be maximised
as in practice it has proven difficult to close local schools and hospitals. Free
marketeers would point out that zero pricing goes against allocative efficiency.

Chapter 5 - The Financial System 1


The Financial system is composed of 3 parts
Financial Markets Stock and bonds, Money, Commodity, Derivatives, Insurance and
Foreign exchange markets
Financial Institutions
Financial Assets and Liabilities

Financial Intermediaries their job is to match entities with trading surpluses who
seek to invest and make an economic return with parties who wish to borrow to
improve their liquidity position.
These two groups of end user can choose to interact in 3 way
1. Contact each other directly
2. Lenders and borrowers use an organised financial market
3. Lenders and borrowers use intermediaries.
Financial Intermediaries have a number of important roles.
Risk Reduction lending to a wide range of individuals mitigates the risk of a single
default causing a significant wipe out of assets.
Aggregation by pooling a large number of small deposits, intermediaries can make
larger advances than would otherwise be possible.
Maturity Transformation typically borrowers want to borrow for the long term and
savers do not want their money tied up for a long time. Financial intermediaries with
their floating pool of resources are able to satisfy both sets of conflicting
requirements.
Financial Intermediation the process by which financial intermediaries bring
together lenders and borrowers.
Liquidity Surpluses and Deficits
Financial intermediaries help with the lack of synchronisation between payments
and receipts which effects businesses, individuals and government. These impacts
operate in the short, medium and long term and the approach to management need
to be tailored according to these timeframes.
Individuals the flow of income may be regular but not continuous.

Payments
Short
term

Essential expenditure irregular


and continuous

Medium
term

Infrequent but essential purchase


of expensive items eg, domestic
appliances, cars, holidays, medical
bills.

Long
term

Housing, savings for pensions

Managing Lack of
Synchronisation
Current account savings to cover day
to day expenditure
Credit cards
Save during periods where receipts
exceed payments to cover the period
where the reverse is true
To save over a period of time prior to
purchase.
Borrow and pay back over a period of
time.
Financial instruments needed bank
deposit accounts, bank loans and
consumer credit.
Specialist Mortgage and Pension
products

Business
The mismatch between payments and receipts for a business is referred to as the
cash flow problem.
Payments typically flow from sales which will follow a pattern dependent on the type
of business, seasonal, the frequency of invoicing, payment or credit terms and the
credit risk profile of the customers.

Payments
Short
term

Day to day business costs


Wages, salaries, rent, utility
bills. This creates the need for
working capital.

Medium
term

Sales revenue may be received


long after initial investment
expenditure
Contracts specify part

Managing Lack of
Synchronisation
Maintaining a stock of cash to
managing periods of low or
delayed income.
Access to trade credit
Access to overdraft facilities

Business need medium term


finance, eg 2-3 years to manage
medium term financial problems

Long
term

payments long before delivery


Reorganisation costs are
incurred long before the
benefits of the savings are
realised.
Long term financing problems
arise out of investment
activities such as
Investment in capital
Investment in long term R&D
Takeovers and mergers of
existing businesses.

The long term nature of the


payback from these activities
requires long term finance such as
Internally generated funds
Equity capital through share issues
Debt capital from mortgages, bank
borrowing and bonds

Government
Some government income may come from profitable state industries but the bulk
comes from taxation.
The main sources of tax revenue are indirect taxes (sales) VAT, excise duties on
tobacco, petrol and alcohol.
Direct taxes on individuals PAYE and NI
Direct taxes on businesses corporation tax

Payments
Short
term

In the short term the


government will need to pay for
Wages for government
employees
Payments to unemployed and
retired
Payments to suppliers of goods
and services related to
government activities

Medium
term

These from the need for


investment in the public sector
New hospitals and schools
Infrastructure projects, roads,
railways
Loans to private sector to
finance risky venture eg.
technology and aerospace

Managing Lack of
Synchronisation
As these are spread evenly of the
financial year, it is difficult to
match tax revenue for these items.
Hence the need for short term
financial facilities, typically met by
the central bank.

These are not likely to be spread


evenly over time. Government may
try to time these investments to
coincide with a fiscal policy in line
with the trade cycle. In this case
the government may run up a
budget deficit by raising spending
during a recession when receipts

Long
term

Government take responsibility


for financing very long term
investment projects such as
nuclear power,
telecommunications, defence
programmes

from taxation is low.


It is more likely that governments
will be net borrowers hence the
need for financial intermediaries
over the long term.
Governments can continue to
borrow over the long term so long
as there is sufficient taxation to
cover the subsequent debt.

For larger companies there are a range of financial products available to them to
meet the short, medium and long term needs, especially those firms that are listed
on the stock market. A common complaint is that smaller firms are not so well
catered for in terms of both debt and equity finance. In response governments have
designed a number of initiatives designed specifically to meet the needs of finance
for smaller firms. Mezzanine Finance for example combines aspects of both debt
and equity finance. Although the loan is issues initially as debt finance, the lender
reserves the right to convert this into an equity interest if the loan is not paid back
on time.
The main considerations for weighing up the relative merits of the various financial
products available Yield/cost - investing in certificates of deposits gives a lower yield than investing in
equities.
Risk the main determinant of yield is risk, if the company wishes to raise funds
from the sale of bonds, the yield offered must reflect the perceived risk associated
with the bond.
The amounts involved eg the minimum amount for a certificate of deposit is
50,000
The time period the funds are available for
Liquidity how easy it is to exchange the asset in to cash to release funds early if
required.
Transaction costs
Capital and Money Markets, distinguished by
Capital Markets maturity > 1 year, equity, bonds and mortgages
Money Markets maturity < 1 year, certificates of deposit and bills of exchange
Ordinary Shares (equity)
Ownership of companies is through ordinary shares, the holders of which have
voting rights.

Characteristics
Return- Potentially high if company is profitable, in the form of dividends or increase
in prices.
Risk Considered high risk, low or zero dividends, with the extreme risk of company
being liquidated, with the shareholders being paid after all other claims are settled.
Timescales the company usually has no desire to buy back the shares, so the
equity is considered long term
Liquidity - for unquoted companies, difficult to sell shares, for companies quoted on
the stock exchange, the investors can cash in at any time so the shares are highly
liquid.
Bonds
In the same was as ownership of a company can be broken down into shares, loans
may be broken down in to smaller units, eg.one bond may have a nominal par value
of 1000 and coupon rate of 5% and redemption terms (redeem at par in 2015).
Characteristics
Return typically low returns as risk is low, taking the form of interest payments
and possible gain on redemption generally lower risk than equity, the bonds may be
secured and the interest rate fixed. High risk bonds do exist junk bonds
Timescales The maturity period is defined in the bond, can be short term Treasury Bills to long term - 25 year corporate bonds. Both Treasury Bonds and Bills
(Gilts) are issued by the central bank on behalf of the government. However only
Bonds have a fixed rate of interest called a coupon rate.
Liquidity For unquoted bonds the investor must wait for redemption, however if
quoted they will be easy to liquidate on the bond (capital) market eg. Government
bonds.
Certificate of Deposits CD
A fixed amount deposited with the bank for a fixed period, usually has a minimum
amount eg 50000.
Return low returns due to low risk
Risk very safe
Timescales 3 6 month maturity common
Liquidity Can be readily sold on money markets
Credit Agreements
Examples are credit and store cards, hire purchase contracts. The agreement being
between one party who takes possession of something in exchange for a payment
at a later date.

Return high interest rates eg credit cards 25-30%


Risk card company carries risk of default if the card holder fails to pay back the
amount borrowed, as such cards are unsecured loans.
Timescales designed to be short term but individuals get trapped into financial
difficulties where they are unable to pay back having run up large debts on credit
cards.
Liquidity the lender cannot sell on the debt but the borrower can repay early if
funds permit.
Mortgages
A loan specifically for the purpose of buying property, usually with a specified
repayment period and interest rate.
Return - interest usually low as the property itself acts as security for the loan.
Risk - considered low risk, however a fall in house prices can lead to negative
equity.
Timescales long term between 10 and 35 years
Liquidity The traditional position was always that lenders could not sell on the
mortgage and had to wait for the borrower to repay early or at the end of the
mortgage term. However a factor that contributed to the financial crisis of 2008 was
that lenders sold on their mortgage books onto other institutions using
collateralised debt obligations trading on the captial markets.

Bills of Exchange
A bill of exchange is a promise to pay a certain sum to another party at a fixed
future date, the same as a post dated cheque. When a financial intermediary
accepts a bill of exchange it is effectively loaning money to a private trader upon
promise of a refund by another trader.
Return usually no interest paid
Risk levels of risk varies, some bills may be guaranteed by banks
Timescales short term 3-6 months are common
Liquidity = can be re-sold on money markets

Calculating yields on financial products


Equity the total return to the shareholder is made up of dividends and growth in
share price.
Dividend Yield = dividend per ordinary share / market price of share * 100%
For example a company paying 30c / share with a share value of $7.50 the dividend
yield is
0.30/7.50 *100 = 4%
Bonds
The 3 ways of calculating the yield on bonds 1. The bill rate
2. The running rate or interest yield
3. The gross redemption yield
For example a bond with the following characteristics
Nominal value $100
Coupon rate 8%
Redemption terms = to be redeemed at par in 5 years
Current market value $108.40
1. Bill rate - same as coupon rate = 8%
2. The running yield or interest yield = (annual interest/market value) *100%
($8/$108.4) *100 = 7.38%

In other words if you bought the bond for $108.04 and received $8 interest
per year your return would be 7.38%. This takes into account the market
value of the yield but not the capital gain/loss on redemption.

3 The gross redemption yield


This gives the overall annualised return to the investor and incorporates both
interest and capital gains/losses. The calculation is out of scope.
Another example
A bond has a face value of $100. It has a coupon rate of interest of 3%. The current
market price of the bond is $90. The yield on the bond is calculated as 3% of $100
as a percentage of the market price of the bond.
3 100 = 3.3%
90
Yield Curve As the bond approached its maturity date it will move closer to its
face value and the yield will fall.
A major factor in determining the yield on bonds is the rate of interest. Rising
interest rates would decrease the price of bonds due to the fact that in order for the
yield to match the higher rate of interest the price of the bond must decrease.

The role of risk


The main determinant of the investors desired yield is their risk which in turn drives
the market price for the bond or share.
If a company is paying a dividend of 20c/share on a share price of 1$, this gives a
new dividend yield of 20%. Assuming environmental factors increase risk and the
investors demand a yield of 25%, the only way the yield can rise to 25% is if the
share price falls.
The yield on equities is known as the dividend yield, calculated as Net dividend yield = (annual dividend/market value) * 100%
0.25 = (0.20/market value) *100
Market value = $0.80
Pricing in the new risk gives a revised market value of $.80/share
The sequence of events is important, risk drives desired return which drives the
market price.
The term structure of interest rates and yield curves

The annual interest rate on a loan varies on the duration of the loan even across
loans of the same risk class. Lenders typically demand higher interest rates as the
length of the loan increases known as a term structure of the interest rate.

The shape is typically upward sloping to reflect the higher rates of interest
associated with longer term lending. As the stock nears maturity the yield falls as
the market price gets closer to its nominal price.
The shape of the yield curve would suggest that rather than take out a single 10
year loan, it would be cheaper to take out two 5 year loans. However most firms do
not do this for two reasons
1. A 10 year loan has a fixed rate for its duration. If two 5 year loans are used,
the rate for the second 5 year loan would be driven by the prevailing rate at
the time which introduces risk.
2. Arrangement fees.

Credit Rating Agencies


Credit rating agencies provide information on the creditworthiness of firms which
give an indication of whether these firms are likely to default on the debt.
The consumers of this information are Potential investors
Regulators of investing bodies
The firm itself
The following characteristics of a firm have been showed to correlate with the
likelihood of whether they will default on their obligations.
Size and strength of cashflows
Size of debt relative to asset value of the firm
The volatility of the firm's asset value
The length of time the debt has to run

Credit spreads
As investors have no way to tell which firm will default on their debts, lenders are
compensated for this risk by the firms adding a premium (spread) onto the risk free
rate of interest.
Required Yield on a Corporate Bond = Yield on Equivalent Treasury Bond + credit
spread
Credit rating agencies publish a table to credit spreads for the different risks and
maturities.

Central Rate of Interest


A central bank may decide on a base rate of 0.5% but the rates that the banks lend
to businesses is usually much higher.
Nominal vs real interest rates Assuming inflation is running at 3% and you place
$100 in a deposit account at 4%, after on year you will have $104. However you are
not 4% better off as 3% of the increase merely covers inflation. The real rate of
interest is closer to 1%.
The real rate would be
1 + r = (1 + m)/(1+i) where r = real rate, m = money rate and i = inflation rate
1 + r = (1 + 0.04)/(1 + 0.03)
Real interest rate = 0.97%

Determining Interest Rates


Can be viewed as the price of money determined by supply and demand
Demand
The demand for money can be thought of as the preference for holding assets in the
fully liquid form rather than in an illiquid form such as bonds and shares. Can be due
to
Transactions motive the need to buy goods and services
Precautionary motive kept to meet unforeseen personal and financial
contingencies
Speculative motive held to speculative with
Supply

The supply of money is partly determined by the creation activities of the banks
(and central bank) and a change in policy and interest rates may influence the
degree of liquidity in the financial system.
Credit Multiplier
Banks are able to create credit because not all of the money deposited will be
withdrawn regularly. In addition to this when the bank lends money to a borrower
some of that money may be deposited back into the bank to some one who is also a
bank customer. (B pays C below) which provides more cash reserves. In practice
banks need only provision for 10% to be withdrawn (known as the cash ratio),
leaving the remainder to be available for lending or investment.

The term deposit multiplier or credit multiplier describes the amount by which total
deposits can increase as a result of the bank acquiring additional cash.
Change in deposits = 1/cash ratio * initial cash deposit
Hence a cash ratio of 10% gives a balance sheet multiplier of 10 ie. The total
increase in money supply is ten times the initial deposit.
The credit multiplier is the balance sheet multiplier 1.
The amount of credit the bank can generate depends on 2 factors

The amount of cash and near cash liquid assets they hold
The size of the credit multiplier
Credit Multiplier = 1/reserve asset ratio
Eg. reserve asset ratio = 10%, credit multiplier = 10

Financial Markets
Financial institutions operate in 3 main markets
1. Money markets. Here the banks, companies, local authorities and the
government operate through discount houses in buying and selling short
term debt. The discount houses are described as buyers and sellers in bills
because hey will buy/sell treasury or commercial bills to allow holders to
convert assets into liquidity or vice versa. These discount houses are obliged
to buy the full issue of treasury bills each week. The price the discount
houses pay depends on the market rate of interest, ie high price reflects low

interest rate. Discount houses profit by being able to borrow at very low rates
of interest from the government and by charging slightly higher rates of
interest.
2. The stock market. This encompasses several markets - Equities/Securities,
AIM (for smaller companies), Government bonds/gilts. The term 'capital
instrument' refers to the means by which organisations raise finance (shares,
bonds, gilts). The stock market is known as a perfect market, high numbers of
buyers and sellers with a good knowledge and rapid prices reactions which
reflect supply/demand changes.
3. The Government Bond market These bonds are few in number but higher in
value eg 250,000 per transaction for long dates stock. These are traded by
tender rather than a fixed price, but the Bank of England sets the minimum
price. These bonds are sold in 100 units at a fixed interest rate. The main
buyers of these are pension funds and life assurance companies attracted by
the fixed income. The market price varies with the interest rate, called the
coupon. For example if the rate if interest is 5%, a bond with a 10 coupon
will trade at around 200.
Ie. 10/price= %5. If the interest rate rises to 6%, the bond price will fall to
166
The supply of bonds is connected to the national debt. Public sector
borrowing which is founded on debt sales will increase the supply of bonds.

The 2008 Banking Crisis and Credit Crunch


The started out as a global banking crisis which led to a credit crunch and for some
countries a recession.
US sub prime mortgage lending
The move by the federal reserve to cut interest rate to 1%, a historical low, was
designed to stimulate the economy following 9/11 and the post dot com bubble
bursting. This boom in credit had the effect of stimulating the housing market and
was fuelled by the US government pressure on lenders to lend to people who would
normally have been considered a high risk of default. These were to become known
as the sub-prime mortgages, which were typically adjustable rate and affordable for
the first 2 years.
By 2005 on in 5 mortgages in the US were subprime but the lenders felt protected
as house prices were continuing to rise and the banks felt that following a default
they would be able to recover their loan.
With interest rates rising to 4% in 2006, due to inflationary pressure defaults and
foreclosures increased significantly. This was made worse by the house construction
boom as the flood of new homes on to the market meant that the banks were only
able to recover a fraction of the debts.
Collateralised debt obligations CDO's

Normally the risk of loss sits with the lending bank which obliges them to enforce
strict creditworthiness checks. However in the US mortgage lenders were able to
sell on the mortgage debt in the form of CDOs to other banks and institutions. A tier
structure of CDO debt was created and reflecting the levels of risks and returns.
Debt rating organisations
The CDO bonds were credit rates for risk. As these were purchased by 'responsible'
banks or because of a lack on understanding of CDOs, risk agencies significantly
underestimated the true amount of risk involved. This encouraged the widespread
purchase of sub prime debt across global markets.
Banks financial structures
Unlike commercial organisations, banks are highly geared with less than 10% of
their asset value covered by equity. A fall in asset value can quickly wipe out a
bank's equity forcing it to selling asset backed securities. These toxic assets found
few buyers leaving some banks in a position of negative equity.

Assets of a typical Commercial Bank include

Cash
Market loans
Bills of Exchange
Investments
Advances

Liabilities include

Deposits
Shareholder Capital

Credit Default swaps


These were a form of insurance against sub prime debt. Sold heavily by AIG and
Lehman Brothers. These were the first banks that started to suffer as the levels of
defaults began to increase.
Implications and Consequences
The collapse of major financial institutions Lehman Brothers marked the start of
the liquidity crisis, the bailout of AIG and nationalisation of Northern Rock.
The credit crunch banks lost trust in everyone else's credit worthiness resulting in
a reluctance to lend inter bank and shortage of liquidity for normal businesses who
were unable to re-finance short term debt.
Government intervention One form of intervention was to bail out or directly
invest in troubled financial institutions. Another form of intervention was to

stimulate the economy by directly injecting funds in to it. Slashing interest rate
could only go so far, central banks were then forced to buying assets such as
government or corporate bonds using money that has been "printed" - quantitative
easing.
The result was that governments ended up with huge levels of debt, with high levels
of interest and the need to repay the debt itself.
Recession and austerity measures The preceding events resulted in recessions in
many countries. The normal response would have been for the government to
increase spending to stimulate the economy. However having already over
extended in terms of debt many governments made major cuts in public spending
to control their debt levels and preserve the country's credit rating. Fears that a
country may default on its debt would result in the rating agency downgrading it
and thus pushing up the cost of future borrowing.
Problems of Re-financing government debt Spain was successful in 2010 in raising
3 billion Euros from the ECB in exchange for cutting spending such as cuts in public
sector salaries, public investment, social spending, tax hikes and a pensions freeze.
For other countries their credit rating was downgraded which compounded the
problem.
The Eurozone and fears over contagion the problem of countries trying to boost
their economies and at the same time trying to control national debt (less than 60%
GDP) has had implications for the membership and stability of the Eurozone.

Chapter 6 - The Macroeconomic Context of Business I :


The Domestic Economy

Policy Goals includes

Growing the economy, how can productive capacity be increased. Should


result in better standard of living in a country and higher profitability for
businesses. However growth must be greater than inflation to be "real", can
increase disparity between rich and poor and may disproportionately favour
imports creating a balance of trade problem.
Reducing inflation, ensuring that general prices levels do not increase. The
reasons for controlling inflation are to reduce uncertainty which stifles
business investment, not all incomes follow inflation eg. Fixed income and the
poor. Inflation distorts the working price mechanism and is a market
imperfection. Inflation reduces the purchasing power of savings so
encourages people to spend rather than save.
Creating jobs everyone who wants a jobs has one. Mass unemployment
creates problems such as the government having to pay more benefits
creating the need to raise taxes, borrow and cut back on services.
Unemployment has been linked to a rise in crime, poor health and a
breakdown in family relationships. Unemployment is a waste of human
resources and can restrict economic growth.
Managing trade with other countries and balance of payments. To run a
persistent trade surplus or deficit has negative macroeconomic effects such
as a long term deficit has to be financed and the servicing of this finance is
a drag on the economy. A long term surplus can cause inflation and a lack of
international competitiveness.

The economic diamond

Models and Framework


How to measure the size of the economy, the starting point is to use the
concept of national income which is the total value of all the goods and services
produced by a countries over a year. This involves considering, national output
(finished goods and services), national income and national expenditure (total spent
purchasing the national product). All 3 measures should give the same figure. When
goods and services are produced people receive incomes therefore the addition of
all the prices of these goods and services should equal the income of the
population. Similarly these figures should equate to the sum of the spending by the
population on goods and services.
The measure of the productivity of an economy is its national income or Gross
Domestic Product. This is defined as the value of all output for a country and
excludes income from assets held overseas. An increase in GDP is considered
growth.
The standard of living in an economy is measured by Gross National Product (proxy
for standard of living), this refers to the total of all output produced and income
earned by the countries residents in one year domestically or abroad. This excludes
income from foreigners remitted to their home country.
In a closed economy with no international trade, the GDP would equal GNP, however
in reality they differ. The black market trade which by its nature is excluded will
distort these national income calculations.

Both GDP and GNP are considered "Gross" as no deduction is made to reflect
depreciation (capital consumption).
The relationship between GDP, GNP and national income is therefore this.
GDP plus Net property income from abroad equals GNP minus Capital consumption
equals Net national income or net national product.
National income is GNP minus an allowance for depreciation of the nation's capital.
National income data is used by businesses when making strategic decisions such
as predicting sales growth in certain markets and making location decisions.
For governments accurate national income data is essential to policy making. In
addition to this it is important to know the factors and processes that determine the
level and growth of national income.

The circular flow of funds and money Y- national income


C- consumption
S- savings
I- investment
T- taxation
G- government expenditure
X- exports
M- imports

Equilibrium can be described as (injections = withdrawals)


I+G+X=S+T+M

Injections are additions to expenditure form outside the circular flow itself, these
include exports, government and private investment.
Withdrawals (leakages) reduce the circular flow, examples being savings, imports
and taxation.
Equilibrium an economy making full use of its resources will be moving to a state
of rest or equilibrium.
An equilibrium in national income is where injections = withdrawals
However, if injections are greater than withdrawals the level of national income will
rise.
Equally, if withdrawals are greater than injections then the level of national income
will fall.
Consumption this is the spending by people or households and its single biggest
determinant is income. The extent to which consumption changes with income is
called the marginal propensity to consume MPC.

Household consumption is influenced by the following objectives influences income, wealth, government policy, the cost and availability of credit and price
expectations. Cultural norms subjectively influence spending Japan vs South
America, rural vs urban.
Savings - defined as the amount of income not spent and is influenced by the
same factors as consumption but their effect is the mirror image.
Linkages between the different elements in the circular flow
There are two important elements
The accelerator for growth to occur the economy needs to increase output of
goods which requires there to be excess capacity or additional investment in capital
goods. Failure to increase output in a time of rising demand would increase inflation.

When an economy starts to grow this in turn can fuel further growth due to the
pressures of more investment. The reverse is also true as a reduction in the size of
an economy will result in a cut in investment accelerating the decline further. The
accelerator principle views investment as a dependent on changes in national
income. Increased wages depress this accelerator and creates more demand which
is met by firms investing in capital goods to meet this demand.
Accelerator theory assumes that:

Organisations will try to maintain a stable relationship between the amount of


productive capital stock (e.g. machinery) and the expected volume of
output/sales, this is known as the capital/output ratio.

Organisations will replace worn out capital each year, this is known as
replacement investment.

Total investment will be replacement investment plus additional investment


to meet expected increases in demand/sales.

The multiplier changes in injections government expenditure, exports and


investment may cause a more than proportionate increase in national income. This
describes a cascade effect following the injection into the circular flow, leads to the
use of more factors of production adding to the income of others who themselves
spend more.

The multiplier is calculated using the marginal propensity to consume. The greater
the MPC the greater the multiplier effect.

In a simplified economy where the withdrawal is saving, assuming a MPC of 0.8, the
multiplier would have a value of 5 and an increase injections of $10m would
increase the total national income by 50m.
Explaining the trade cycle combining the accelerator and multiplier effects
Something happens to boost investment (innovation or war)
The increased investment triggers the multiplier effect leading to rising incomes
Rising incomes increases increase consumption and therefore demand

Higher than expected demand triggers the accelerator effect as firms invest further
to meet demand.
The extra investment then triggers the multiplier again leading to rising incomes.
In this was once the economy starts growing it will continue to grow leading to a
strong upward swing in the trade cycle. However this will not continue indefinitely
as the economy will eventually reach full capacity. At this point investment will tail
off and incomes start to fall triggering a reverse multiplier. As incomes start to fall
so does consumption and demand resulting in a downward part of the trade cycle.
Aggregate Supply and Demand
Much of government policy is designed to prevent the two common economic
problems of inflation and unemployment. The starting point for understanding how
these two undesirable outcomes may arise in a market economy is the aggregate
demand and aggregate supply model. The total demand for goods and services can
be described as
AD = C + I + G + (X-M)
However aggregate demand does not on its own explain how an economy functions
or why problems occur. We also need to consider aggregate supply.
Aggregate Demand
In the circular flow model, AD was related to the level of national income and
expenditure. In the aggregate demand model it is related to national income and
the price level. AD is inversely related to price since a price fall would raise
everyone's real wealth through increased purchasing power. The AD curve slopes
down from left to right but may shift eg the levels of investment or exports changes
through the multiplier effect.
The components of aggregate demand are

Consumer Expenditure
Business Investment
Exports
Government Expenditure

The AD curve slopes down from left to right but may shift.

Aggregate Supply
AS in an economy refers to the willingness and ability of producers in an economy
(the business sector) to produce and offer for sale goods and services. This is the
collective result of millions of business producers large and small, to produce and
sell goods and services.

It is positively related to price as an increase in price will lead to greater profits and
encourage businesses to expand output. It is limited to the availability of resources
(labour,capital) so that at full employment output cannot be expanded any further.
AS can only shift in the long run as the result of a change in the costs of production
or in the availability of factors of production.
The AS curve slopes upward from left to right and does not shift in the short run.
Equilibrium
National equilibrium is where the AD curve intersects the AS curve. Here the total
demand for goods and services in the economy equals the supply. The utility of this
model is that it demonstrates the effect of either aggregate demand or aggregate
supply both on the level of national income (proxy for unemployment) and at the
price level (proxy for inflation).

Changes in Aggregate Demand

Scenario 1
Assuming a starting point where the economy is in equilibrium of Y1, an increase in
aggregate demand from AD1 to AD2 would have the following effect

a new equilibrium point would be reached at national income level Y2


unemployment would fall
The price level will rise from P1 to P2

In this case the significant impact of an increase in AD would be felt through an


increase in national income and a reduction in unemployment with only a small
inflationary impact. From the Y1 starting point, if the government wanted to reduce
unemployment, increasing AD by reducing taxes or increasing government
expenditure would be an effective policy.
Scenario 2
Assuming this time a starting at equilibrium point Y3 and an increase in aggregate
demand AD3 to AD4 would have the following effects

The new equilibrium point for national income would move to Y4


Unemployment would fall, but less than the previous scenario
The price level would rise from P3 to P4.

In this example most of the effect of increasing AD is felt through the rising price
level (inflation) with only a marginal increase in national income (employment).
From this starting point, a governments attempt to further reduce unemployment
through increasing AD would only have a small effect and come at the expense of
significant inflationary pressure. At this point the AS curve becomes very steep as
the economy nears full employment. A better policy would be for the government to
restrain demand by raising taxes and reducing government expenditure thereby
reducing aggregate demand from AD4 to AD3.

Shifts in the AD curve may happen for reasons other than government policy. A
recession (falling output and employment with reduced inflationary pressure) will
result in a leftward movement in the AD curve. This can be caused by

A fall in investment if business confidence is damaged


A fall in consumer spending if consumers loose confidence or if they run out
of credit
A fall in exports due to recessions in one or more trading partners

A rightward shift in the AD curve may be caused by

An investment boom if business is confident and profitable


A rapid rise in consumer spending if they are confident and have access to
affordable credit.
A rapid rise in exports or competitiveness (depreciation of currency) or an
economic boom in trading partners.

Changes in Aggregate Supply


It is possible that in the long run aggregate supply may change which shows as
shifts in the AS curve.

Scenario 1
The economy may suffer supply side shocks which reduce the willingness for
productive businesses to produce and sell goods and services, resulting in a shift to
the left for the AS curve. The result would be a rise in price level and a fall in
output/employment (stagflation). Supply side shocks may arise from

A major increase in energy or raw material prices.


A major increase in wages and labour costs due to legislation (EU).

A major fall in productivity due to technology problems eg. Emissions


regulations.

A negative supply shock would shift the aggregate supply curve to the left and
cause the rate of inflation to increase. However the level of national output would
fall. An expansionary fiscal policy would shift the aggregate demand curve to the
right leading to a rise in both the level of national output and the rate of inflation.

Scenario 2
The economy may experience a rightward shift in the supply curve, AS1 to AS3. This
would produce a beneficial increase in national output and falling prices, the
opposite of inflation. Rightward shifts in the supply curve may be the result of

Falling energy or raw material costs or big productivity improvements due to


technological change.
Deliberate government supply side interventions designed to shift the AS
curve to the right such as business tax reductions or labour market reforms.

Demand and supply side policies


At least 3 different theories exist on how to manage the national economy that
integrates fully with the global economy.
Classical view the economy if left alone would eventually move to equilibrium with
full employment. For instance in the event of a depression price factors of
production would fall and demand would eventually increase for them leading to
renewed economic growth. This theory was challenged by the events of the great
depression in the 1920s and 1930s in which the economy did not respond by
growing.
The Keynesian view (demand side consumer spending focussed)
Keynes believed that an economy could get stuck and it was the governments role
to intervene and move the economy to a better position with one closer to full
employment.
This intervention involves injecting borrowed money into the economy to stimulate
growth and recovering this at a later date through increased taxes. Conversely if the
economy was growing too quickly it could increase taxation.
Effectively Keynes argued for active management of aggregate demand (demand
side economics).
The Monetarist View (supply side productive capacity focussed)

Monetarists believe that the markets will automatically gravitate to an optimal


equilibrium point if unhindered by market imperfections. For example, in the short
run an increase in the money supply will increase real output, but in the long run it
will only increase process. In this way it is the role of the government to remove
these imperfections and once removed the governments role should be minimal.
Market imperfections include the following

Inflation
Government spending and taxation
Price fixing
Minimum wage agreements
Regulation of markets
Abuses of monopoly power

Monetarist solution to solving problems is known as supply side interventions as


they focus on the supply side factors of production.
Further information on Supply side policies
In terms of aggregate demand and supply models, these are aimed to shift the AD
curve to the right when the problem is unemployment and to the left when the
problem is inflation. However concern over the effectiveness of this approach has
led to a shift in emphasis to supply side policies.
The objective of supply side policy is to shift the aggregate supply curve to the
right. In terms of the aggregate demand and supply model this would have the
effect of raising national income and lowering unemployment at the same time as
reducing inflationary pressure on the economy.
Supply side policies include the following

Shifting taxation away from direct to indirect thus reducing marginal rates of
taxation to encourage work and enterprise.
Reducing corporation tax
Reducing and tailoring social security payments to encourage employment
An emphasis on vocational training to improve work skills in the labour force.
Reducing the power of trade unions to limit entry into professions and raise
minimum wages.
Deregulation and privatisation to encourage enterprise and risk-taking.

In the long run these policies appear to have been successful, particularly in the US
and UK where they have been most widely adopted. However supply side policies
have had some undesirable consequences.

Unfair taxation in the UK the poorest 20% pay more tax than the wealthiest
20% of the population.
A more unequal distribution of income
A greater degree of uncertainty fir the work force and less employment
protection.

A fall in the relative standard of living for many who are dependent on social
security.

Trade Cycles
Stage of trade
cycle
Recession

Features

Causes

Policy Response

Falling
output/income
Rising
unemployment
Reduced
inflationary
pressure
Improving trade
balance as imports
fall
Poor public
Finances due to
reduced taxation
and increased
social security
payments.

Falling domestic
AD sure to lower
levels of consumer
spending,
investments,
exports and
government
expenditure.
World recession

Raise AD by
reducing taxation,
raising public
expenditure and
lowering interest
rates

Stagflation (type
of recession)

Falling output,
income and
employment
Rising inflation

Supply side policy


to raise aggregate
supply
Prices and income
policy

Recovery

Output and
income begin to
rise
Unemployment
begins to fall
Only moderate
inflationary
pressure
Improving public
finances
High output and
employment
Rising inflationary
pressure
Worsening trade
balance as trade

Supply side shocks


reducing
aggregate supply
Could have a
recession due to
low AD combined
with imported cost
push inflation
Returning business
and consumer
confidence
Effect of
government
spending policy
undertaken in
recession

High and rising AD


from higher
consumer
spending,
investments,
exports and

Reduce AD by
raising taxes,
reducing public
expenditure and
raising interest
rates.

Boom

Increase
government
borrowing to fund
the above

Reduction in
expansion policy
to prevent too
strong a boom

imports rise
Higher net income
for government
allows repayment
of debt

government
spending

The ideal situation is a period of steady economic growth with all the features of an
economic boom but without inflationary pressure. The abilities of some countries
(USA and UK) to maintain this situation may be due to the supply side reforms in
these countries in the 1980s.
Implications for businesses
The main implication for business of trade cycles is the impact on the demand for
the firms products. The firms could mitigate the effect of trade cycles by diversifying
its range of products. Economic downturn may provide the firms with more
bargaining power with employees in terms of pay.
Fiscal and Monetary Policy Options

Fiscal policy options relate to the governments approach to taxation and spending
plans (demand focused). In contrast with monetary policy which involves changing
the interest rate and influencing the money supply.
In the medium to long term the government should aim to have a balanced budget
whereby the amount it spends is matched by government income.
Budget deficit = government expenditure > income
Budget surplus = government income > expenditure
A Balanced Budget is when government income = expenditure, not to be confused
with a balance of payments which is relates to the flow of funds into and out of a
country.
Running a budget deficit
A budget deficit is financed by public sector net borrowing which is the actual
borrowing requirement over a fiscal year. The national debt on the other hand is the

total accumulated debt going back to the 17th century and the formation of the
Bank of England.
Running a budget deficit has been frequently used to promote economic growth and
reduce unemployment by closing a 'deflationary gap'. This gap exists where the
level of aggregate demand in the economy is less that that required to allow full
employment due to the level of national income being too low to satisfy everyone
seeking work.
By running a budget deficit the government is injecting more money in to the
economy to boost aggregate demand and reduce unemployment. An increase in the
money supply will cause interest rates to fall, as interest rates are a proxy for the
price of money. This is known as an expansionary policy which itself is criticised due
to the potential for crowding out private sector investment through higher interest
rates.
Running a budget surplus
If aggregate demand is above the level necessary to support full employment this
can lead to inflation also described as an 'inflationary gap', too much money
chasing too little goods.
The fiscal policy change to deal with an inflationary gap is to take money out of the
economy by running a budget surplus. This is known as contractionary policy.
Monetary Policy Options
This is the management of the money supply to the economy, aggregate supply
focused.
Monetary policy can involve setting interest rates directly or indirectly and by
setting reserve requirements for banks.
Like fiscal policy, monetary policy can be described as expansionary or
contractionary whether the policy is to increase or decrease the total money
supplied respectively. Expansionary policy is used to reduce unemployment in a
recession by lowering interest rates, while contractionary policy has the goal of
controlling inflation through raising interest rates.
Money Supply
This refers to the total amount on money in the economy, measured as follows M0 notes and coins in circulation and balance at the country's central bank
M4 notes and coins in all private sector bank accounts
Reserve requirements
Banks operate a fractional reserve system, whereby only a proportion of their
deposits are actually held in cash as they do not expect to all their customers to
want to withdraw their money at the same time.

This proportion of deposits that the banks are required to retain as cash is known as
the asset reserve ratio or liquidity ratio.
Open market operations
By buying and selling its own bonds on the open market the government is able to
exert some control over the money supply. For example by buying back its own
bonds will release more cash into circulation.
Interest rates
Higher interest rates suppress the demand for money due to an increased cost of
borrowing. This would have a significant impact on consumer spending on durable
goods as these tend to be purchased on credit.
The problem of government borrowing
Two elements exists t budget deficits
Cyclical element - the deficit arises as part of a downswing in the trade cycle and
will decrease or possibly turn in to a surplus during the upswing in the trade cycle.
Structural element the deficit is the result of a permanent imbalance between
expenditure and taxation and will not be effected by the trade cycle. This implies a
continuous pattern of borrowing by the government in response to pressures, thus
increasing the total debt owed over the longer term, hence the appearance of
structural budget deficits. These pressures include

An aging population increasing spending on healthcare and pensions.


Inflation in the prices of public sector goods and services.
Spending commitments on merit goods such as social welfare, education and
health which are difficult to decrease in the face of voter opposition.
Tax changes and difficulty in raising them.

Interest Rate Management


Monetary policy is concerned with controlling the monetary environment in order to
influence the decision of the economic agents such as consumers, investors and
businesses. It can do this by controlling the availability of credit or the price of
credit.
Increasing interest rates has the following effects

Fall in consumer spending due to more expensive credit. Higher interest


payments on mortgages and credit cards will leave less money to spend on
consumer goods and services.
Fall in investment Asset Values fall eg. Bond prices fall due to the inverse relationship with
interest rates.

The net effect of these changes is to shift the demand curve to the left. This will
reduce inflationary pressure but also slow the economy and increase
unemployment.
External effects of higher interest rates

Foreign funds are attracted to the country


Exchange rates rise due to increased demand for the currency, in the long
term hurting exports.

The impact on businesses


Costs the costs of credit and the cost of holding stock are related to the rate of
interest that businesses have to pay.
Investment decisions - the rate of interest is the cost of acquiring external
investment funds or the opportunity cost of using internal funds. A change in
interest rates effects the profitability of investment projects.
Sales Revenue The volumes of sales will fall if interest rates rise. Partly due to the
deflationary impact of the rate rise and partly due to some of the sales being
financed by credit.
Taxation
As well as a mechanism for generating revenue taxation can be used to

Change markets potentially harmful goods such as alcohol and tobacco are
heavily taxed to defer consumption.
Control aggregate demand AD can be reduced by increasing taxation and
raised by decreasing taxation.
Finance the provision of public and merit goods the provision of certain
services like defence and street lighting paid for by taxation can be provided
for everyone. Similarly the of merit goods such as education provides access
to everyone.
Distribution of wealth progressive taxation falls most heavily on upper
income groups, regressive taxation ha a bigger impact on lower income
groups. Changing the taxation policy can alter income distribution.

The 3 main categories of taxation are


Income Income tax, corporation tax and national insurance
Expenditure VAT, excise duties, customs duties
Capital inheritance tax, capital
In addition to this there is taxation on housing, car tax, TV use, company payroll, oil
royalties.
Taxes are mostly levied by central government.

Taxes are split into direct and indirect taxes. Most taxes on income are direct in that
they are paid directly to the authorities. Expenditure taxes on the other hand are
typically indirect in that they are firstly paid to the vendor through a higher sticker
price who then remits this on to the tax authorities.
With a progressive form of taxation, the proportion of tax paid increases with a rise
in income (PAYE). Whereas for a regressive tax (VAT) the proportion of tax paid is
less with rising incomes. The average rate of taxation is constant with a proportional
tax. The marginal rate of taxation is higher with a progressive tax than with a
regressive tax as income rises.
Principles of taxation
1.
2.
3.
4.
5.
6.

Certainty
Convenience
Equitable
Economy
Efficiency
Flexibility

The Tax Yield

Laffer analysis suggests that there is an optimum rate of tax for maximising tax
revenue. Above a certain rate of taxation revenues will fall which presents a case
for reducing taxes.
Higher marginal tax rates are a disincentive to work resulting in a black market or if
the leisure substitution effect is greater than the income effect.
A reduction in tax liability would also reduce inflationary pressure on salaries by
increasing workers net disposable income.
The effect of taxation on goods and services depends on consumer needs, demand
elasticities and time. When a good has a price inelastic demand (alcohol) sales and
consumption will not fall by much due to higher taxation. However if a good has a
high price elasticity of demand then higher taxation can kill off sales and associated
tax revenue. This prevents retailors from passing on all of the indirect tax onto
consumers for highly price elastic goods..
For this reason the heaviest indirect taxation is levied on goods with very low price
elasticities of demand, eg cigarettes, alcohol and petrol.

Policy Objectives
Recovering from a recession

Cutting interest Rates can be viewed as either a demand side approach


(Keynesian) boosting aggregate demand or supply side (Monetarist) boosting
the money supply in to the economy.
Running a budget deficit a classic Keynesian response to a recession. A
monetarist would view this as a limited response as the additional financing
needed would need higher taxes hence its' limited effectiveness.

Enabling Long Term Growth


Supply side policies attempt to improve the total quantity of factors of production
especially capacity as well as levels of productivity.

Increase quantity and availability of skilled labour, through training, tax


incentives for parents to re-enter the job market, tax incentives for working
harder and longer hours.
Modernisation of transport infrastructure to improve distribution networks.
Assistance for smaller firms and start-ups.
Deregulation of markets
Protectionist measures to limit imports.
Creating a stable economy to boost confidence (low inflation)

Factors influencing economic growth


The growth potential for an economy is dependent on 2 things

The amount of economic resources land, labour, enterprise and capital


The productivity of these factors of production

Productivity is the amount of output produced per unit of input. For example higher
rates of productivity would lower the per unit costs of production and improve the
firms competitiveness.
This could lead to lower costs, greater market share in both domestic and
international markets. This expansion could lead to greater investment for the firm
leading to still higher productivity and a virtuous circle of economic growth.
Capital is also an important ingredient, the greater and higher the quality of capital
the greater will be the growth in technology eg. Investment in R&D and
modernisation of machines.
The quantity and quality of labour also influences economic growth. This is
impacted by demographic factors as well as the participation rate. Education and
training in vocational skills is likely to make a workforce more adaptable and
enterprising.
Unemployment
Unemployment may have different causes, each of which would require different
control measures.
Cyclical unemployment referred to as demand driven, persistent or Keynesian
unemployment. Caused by aggregate demand in an economy being insufficient to
provide opportunities for all of those willing to work.

Keynesian economists would regard this as a deflationary gap and seek to remove it
by boosting aggregate demand. Monetarists on the other hand would try to resolve
this by appropriate supply side measures as they would argue that cyclical
unemployment does not really exist.
Frictional Unemployment the short term unemployed who are in between jobs.
Not seen as a problem and dealt with by better access to vacancy information and
other supply side measures.
Structural and Technological unemployment caused by structural changes in
the economy caused by the types of skills required changing and the location of
where the economic activity.
Demand side policies such as boosting aggregate demand is unlikely to help with
structural unemployment. Supply side policies are more likely to help, such as

Funded retraining schemes


Tax breaks for the re-development of old industrial sites.
Grant aid to relocate industries
Business start-up aid
Improved information on job vacancies

Seasonal Unemployment farm workers


Real wage unemployment wages are kept artificially high due the threat of strike
action causing the number of people employed in the industry to be reduced.
Monetarists would cite this as a prime example of a market imperfection and
address it by removing union powers and abolishing the minimum wage.
Keynesian vs Monetarist views on unemployment
The Keynesian view is that unemployment is due to a demand deficiency since
equilibrium national income is too low. The solution is for government to boost
aggregate demand to move the equilibrium to a point that supports full
employment. This can be achieved by increasing government spending during a
recession. Keynesian economics does not allow for the co-existence of
unemployment and inflation. This is because they see lack of demand as the root
cause of unemployment and that inflation is caused by excess demand.
Monetarists take a different approach. They would ask for interest rate cuts to
encourage business investment. They would also seek to remove market
imperfections such as government subsidies, the influence of trade unions and
unemployment benefits. Their view is that the natural rate of unemployment has a
structural cause and it is the role of government to reduce the imperfections in the
labour market. Their view on directly manipulating demand is that it would lead to
stagflation.
Inflation - Causes and solutions
Demand-pull inflation- this is where demand for goods and services in the economy
is growing faster than the ability of the economy to supply these goods and

services, ie. Too much money chasing too few goods. Demand side policies would
increase interest rates, cuts in government spending and higher taxes. One type of
demand pull inflation is caused by an excessive growth in the money supply.
Monetarists argue that inflation is a result of an expansion in the money supply
which increases the purchasing power of the economy beyond the rate at which the
goods can be supplied.
Cost Push Inflation if the underlying cost factors of production increases, this is
likely to result in an increase in output prices as firms look to pass on these extra
costs to customers. These increased costs can be due to higher commodity prices,
rising import prices, a weaker national currency and higher indirect taxes.
Expectations effect although not the root cause of inflation, expectations of
inflation can contribute significantly to the inflationary spiral. This can be managed
by a prices and incomes policy where manufacturers agree to limit prices in
response to unions agreeing to wage limits.
Governments excessive financing the redevelopment through a rapid growth in the
money supply has been the main contributory factor leading to double and triple
digit inflation.
The quantity theory of money
Demand pull and cost push inflation were mainly Keynesian reasons for inflation.
Monetarists reject the idea of cost push inflation, believing instead that inflation is
caused by excess money supply leading to excess demand for goods and services.
In their view the money supply effect prices but not output and employment except
in the very short term.
Monetarism is based on the quantity theory of money.
MV = PT
M = money supply
V = velocity of circulation, speed with which money is spent
P= average price of a transaction
T = volume of transactions
They believe that
In a given period V is constant
T is limited to the amount of goods and services in the economy and as the
economy grows, so does T
If the money supply M grows more quickly than the economy (ie the growth of T),
for the equation to remain in balance P has to increase. In other words inflation
occurs as the average price of a transaction increases.

The Phillips Curve

It is generally believed that inflation and unemployment are linked. As wage costs
are 70% of the total cost, it was assumed that cost plus pricing was in effect.

This shows that

The lower the rate of unemployment the higher the rate of inflation
The higher the rate of unemployment the lower the rate of inflation
There was a trade off between inflation and price stability
Governments could not achieve price stability and full employment together

As the Philips curve had become established in the 70s, the inverse relationship
between inflation and unemployment began to break down. Monetarists were not
surprised as they regarded the trade off as temporary. However by the 80s the
trade off re-appeared by was shifted to the right.

Cost push pressures shifted PC to PC1.

Chapter 7 - The Macro Economic Context Of Business II:


The International Economy
The Benefits of International Trade
Trade between nations allows specialisation enabling different countries with
different skills and resources to gain rewards form the division of labour. This allows
nations to specialise in the production of goods and services in which they have a
natural advantage.

The economies of scale that can be achieved depend on the size of the
market and international trade opens up a much wider market.
Competition should be fostered by international trade forcing complacent
domestic firms to raise their game.
Lower prices and greater choice will benefit the consumer.

Comparative advantage example


The law of comparative advantage states that two countries can gain from trade
where each specialises in the industries in which it has the lowest opportunity cost.
For example, two countries produce two products and at present all needs are met
by domestic production. Each country has the same resources available and
production is split equally between the two products.
Country A
Country B
Total Daily Production

Units of X per day


1200
960
2160

Units of Y per day


720
240
960

Country A has an absolute advantage in the production of both A and B. Given this
what are the benefits of A trading with B ?
If country A were to focus entirely on making product X, the opportunity cost would
be 720 units of Y. For each unit of x it loses 720/1200 = 0.6 units of Y
If country B were to focus on making X only, the opportunity cost would be 240
units of Y. In this case for each unit of X it loses 240/960 = 0.25 units of Y.
It follows that country B should make X and country A should make Y.

Specialisation based on lowest opportunity cost


Units of X per day
Country A
Country B
Total Daily Production

1920
1920

Units of Y per day


1440
1440

Summary
Comparative cost is based on opportunity cost.
Every country has a comparative or competitive advantage in some goods or
services.
This will reflect their natural endowment of factors of production
Trade enables countries to specialise where they have a comparative advantage
thus raising world output and benefitting all countries in the process.
Inter-industry trade occurs when a country's imports and exports are different
goods and services and intra-industry trade occurs when a country's imports and
exports are the same sorts of goods and services.
Limitations on specialisation
Factor immobility factors tend to be fairly immobile in the short run, however
technology has lowered factor costs and facilitated more international trading.
Distribution costs Domestic suppliers have an advantage for bulky intermediate
goods.
The size of the market specialisation and the resulting economies of scale are only
possible if the production can be sold. Certain types of production can be supported
by domestic demand alone. For example pan European production facilities were
established to build the Airbus A380.
Government Policies barriers may be established between countries for political,
economic and social reasons.
Protectionism

The protect domestic producers their profit margins from foreign competition. This
of course comes at the expense of domestic consumers.
Protecting the balance of payments many western countries have a high marginal
propensity to import, meaning imports grow proportionately more as their
economies grow. The resulting frequent payment deficits have caused deflationary
domestic policies. This rise in imports will reduce the market share of domestic firms
and make them less competitive and less viable.
Methods of protection
Tariffs a tax may be added as valorem, which is a given percentage of the import
price or a set amount per item. It makes sense to place import tariffs where there is
an elastic demand if the objective is to reduce imports. If on the other hand the
objective is to raise revenue then goods with an inelastic demand should be chosen.
Quotas this a restriction on the quantity of imports. This is discouraged by the
WTO except for countries with severe balance of payment problems. A more
acceptable variant of import quotas is the Voluntary Export Restraint Agreement
(VERA) - an example be the VERA between the EU and the Japanese car and the
Japanese car industry which was supposed to limit the sales of Japanese cars in
Europe to 16%.
Hidden restrictions Admin procedures, special testing certification and other subtle
measures to make importing certain goods difficult. Public procurement can also be
used to favour domestic firms even though they may no be the best choice on the
market.
Subsidies As well as restricting imports by economic support of key domestic
exporters eg. Government sponsored trade events, export credits and promotions.
Trade Agreements

Trade agreements are the result of collaboration between groups of countries in


different parts of the world designed to encourage free trade. However the WTO is
against such trading blocs and customs unions as they often have high barriers for
non members but give opportunities to firms within the area specified. Examples
are Bi-lateral and multi-lateral trade agreements agreements between two or more
countries to eliminate tariffs and quotas between them eg. Australia and New
Zealand
Free Trade areas Variation on the multi-lateral model where all members are in the
same region (NAFTA and AFTA).
Customs Unions This is a free trade area with a common external tariff eg.
Mercosur in South America.
Single Market this is a customs union with a common policy on product regulation
and together with free movement of goods and services as well as capital and
labour eg. ECOWAS.
Economic Unions single market with a common currency - the Eurozone

The balance of payments


The balance of payments is an account which shows the economic transactions of
one nation with the rest of the world over a period of time. This is made up of 3
parts

current account (goods and services)


Capital account (buildings)
Financial account (cash flows)

The nature of the accounting system for the balance of payments is similar to
double entry book keeping and ensures that the accounts as a whole balance to
zero. However there may be deficits or surpluses on any of the accounts that make
up the balance of payments.
The convention used is that exports are a credit entry and imports are a debit.

Expenditure-reducing policies are designed to reduce the level of aggregate


demand in the economy thus also reducing the demand for imports. This deflation
might be achieved by the following instruments:

Fiscal policy

Monetary policy

A rise in the general level of taxation would reduce aggregate demand and lead to a
decrease in the demand for imports.
Terms of trade
The terms of trade show the relationship between the prices of imports and the
prices of exports, not between the quantity of imports and exports. If export prices
fall relative to import price this is a deterioration in the terms of trade, if export
prices rise relative to import prices, this is an improvement in the terms of trade.
For example a rising exchange rate raises export prices and therefor improves the
terms of trade.
The current account
This is made up 2 parts
Visible trade trade in goods, a negative balance on this account indicates that
there are more imports than exports.
Invisible trade - trade in services, the income earned from the sale of British
services abroad is know as an invisible export (eg. Dividend from an overseas
share). This account contains interest, profit and dividends (IPD), Services and
international transfers.
The current account of the balance of payments contains payments made for trade
in goods (visible account) and services (invisible account). Exports of manufactured
goods would be an item in the visible balance. Interest payments on overseas debts
and expenditure by tourists would be items in the invisible balance. An inflow of
capital investment by a multinational organisation would be an item in the financial
account.
The current account balance is the combination of the visible and invisible trade. A
surplus indicates a healthy and growing economy. A deficit on the current account
will be balanced by a surplus or net outflow on the combined capital and financial
account. This outflow means a decrease in spending power and is deflationary.
The capital and financial accounts
These accounts show transactions in Britain's external assets and liabilities. It shows
capital movement by firms, individuals and government. It also records a balancing
item, which can be positive (unrecorded net exports) or negative (unrecorded net
imports).

Examples of transactions recorded on this account at Foreign direct investment of a UK firm in another country or vice versa
Portfolio investment abroad
Financial derivatives
Reserve assets eg. gold held by the Bank of England
If the flow of money is outwards it will appear as a debit, if inwards it will appear as
a credit.
Equilibrium and disequilibrium
The balances of payments accounts always balance for technical reasons:
Current account + capital account + financial account + balancing items = 0
However persistent imbalances in the visible trade account and the current account
indicate a fundamental disequilibrium.
Countries which have persistent deficits on their current accounts include UK, USA
and France.
Countries which have persistent surpluses on their accounts are China, Japan and
Germany.
A longer term solution to a balance of payments problem is policy change designed
to achieve economic growth via lower interest rates. A structural deficit in the
balance of payments is usually due to a high demand for imported goods together
with a weak performance in exporting manufacturing products (import penetration
and export performance).

Balance of trade = visible exports visible imports


Invisible Balance of trade = invisible exports invisible imports
Current Account Balance = trade plus invisible balances combined
Financial Account Balance difference between inflows and outflows
Balancing Item ensures that the overall accounts sum to zero

Policies
Options for restoring the balance of payments equilibrium are
Do Nothing The main advantage in a floating exchange rate is that it is supposed
to lead to an automatic correction in the balance of payments disequilibrium. For
example,
If imports exceed exports a balance of payments deficit exists ie. More sterling is
being sold to buy imports than bought to sell UK exports. Outside the UK this excess
of supply o f sterling will weaken sterling over other currencies. This will make
imports in to the UK more expensive and exports from the UK cheaper. As a result
the trade equilibrium should re-balance reducing the balance of payments deficit.

Deliberate depreciation of exchange rate The objective behind depreciation


(floating exchange rate) and deliberate devaluation (of a fixed exchange rate) has
been to encourage expenditure switching by consumers. This is designed to have
the dual effect of consumers buying cheaper domestic goods over more expensive
imports and for foreign consumers to buy cheaper UK exports.
With this "dirty floating" exchange rate mechanism, the intervention is driven
through central bank buying and selling of currency on the open market.
Deflation domestic deflation is designed to induce expenditure reduction by
consumers. This is introduced by government restricting the money supply at home
to curb demand. This improves the balance of payments deficit through the lower

demand for imported goods. Domestic suppliers, facing a static home market switch
resources to focus on export markets. In this way the balance of payments deficit is
improved. The downside to this approach is that the tightening of fiscal policy
through tax increases or cutting the money supply can lead to unemployment
because of the reduction in demand and then supply.
Import Controls These have the impact of expenditure switching rather than
expenditure reduction. Quotas prevent the purchase of imports beyond a set limit.
Tariffs raise import prices and assuming elastic demand, will reduce imported
volumes. The advantage gained by import controls is likely to be temporary as the
basic weakness of price un-competitiveness as not been addressed.
Supply side policies these are polices directed at improving the supply base of the
economy. The intention is to transform attitudes and behaviour so that
competitiveness re-emerges.
A deficit on the current account must be financed by a surplus on the capital and
financial accounts. This can be achieved by selling overseas assets, borrowing from
abroad or by running down reserves of foreign exchange. A tax on imports would
reduce the flow of imports; this would help to correct the current account deficit, not
to finance it.

Globalisation
The IMF definition is - "the growing interdependence of countries worldwide through
increasing volume and variety of cross border transactions in goods and services,
free international capital flows and more rapid and widespread diffusion of
technology".
Key features

The erosion of trade barriers


The homogenising of consumer tastes across geographies
Firms selling the same product across every world market rather than
tailoring to local preferences.
Greater harmonisation of laws across different countries
The dilution of traditional cultures and values in certain 3 rd world countries as
they are replaced by western value systems

This is distinct from internationalisation which refers to the increasing spread of


economic activities across geographical boundaries eg. Firms using the internet to
sell overseas and firms setting up factories overseas.
The factors driving globalisation
Improved communications advances in ICT which has allowed developing
countries to leapfrog traditional steps in the development of their infrastructure.

Political realignments in the former Soviet Union and China have opened up
markets that were previously closed to western firms.
Growth in global firms MacDonalds and Coca Cola who can influence governments
to open up trade and forge stronger political between countries.
The liberalisation of capital controls has allowed developing countries greater
access to capital through a combination of aid and loans.
Industrial relocation off-shoring involves firms relocating their manufacturing base
to countries with lower labour costs.
This access to more markets and enhanced competition puts greater pressure on
cost bases and increases calls for protectionism.
The opponents to globalisation are concerned that it is creating greater gaps
between the rich and the poor. Many poor countries are being pressured to organise
their economies towards producing exports to pay for foreign debt rather than
improve public services such as health and education.
Multinational corporations MNCs

A multinational corporation is one which owns or controls production facilities


in more than on geography and this extends to the control of foreign assets.
MNCs can be ranked by either the amount of foreign assets they control or by
a trans nationality index.
Advantages of a corporation establishing itself as an MNC are
Costs these can be reduced is cheaper production facilities can be
established in other countries, especially where labour costs are a factor.
Expand Sales by establishing overseas production facilities the MNC can
avoid transportation costs, tariffs and quotas.
Secure Supply vertical integration backwards eg oil companies Shell and
BP can gain access to the resources they need.
An organisational structure the MNC can create a divisional structure based
on product or geographical characteristics which help with the management
of complex global corporations.
Advances in new technologies have made it easier to conduct business
internationally.

Impact of MNCs
The impact of MNCs on national economies can be profound. To what extent
national economies benefit from their relationships with MNCs is uncertain. The
growth of globalisation seems unstoppable and with it their power to influence
international trade.
The World Trade Organisation (WTO) and the General Agreements on
Tariffs and Trade (GATT)

The WTO replace GATT in 1995 and it has a number of roles

To ensure compliance of member countries with previous GATT agreements


To negotiate future trade liberalisation agreements
To resolve trading disputes between nations

The European Union


The EU is an example of a single market and within the Euro zone area, an
economic union. It has its origins in the treaty of Rome which were
The elimination of customs duties and quotas between member
states
An agreement on the common customs tariffs between the EU
and non member states
Removal of barriers between member states
Establishment of common policies on transport and
agriculture The prohibition of business practices that restrict or
distort competition
The association of overseas countries in order to increase trade
and development
Q14 Q&A
Harmonisation and convergence
Trade barriers were removed in 1968 and there was a greater acceptance of
monetary union with the launch of the single currency in 2002. The danger of
removing trade barriers was that domestic firms felt that there was unfair
competition as the labour laws in other member states were less strict. For
the EU single market to operate as a level playing field there is a need for
harmonisation between member states on employment legislation.
Countries who wished to join the Euro needed to satisfy the following criteria
Inflation no higher than 1.5 points above the best performing 3
member states
Government Finance annual government deficit no more than
3% of GDP and gross government debt of no more than 60% of
GDP
Exchange rates countries should have been part of the ERM for
2 years and must not have devalued their currency during the
period
Long term interest rates their central bank interest rate should
be no more than 2 % points above the 3 best performing
member states.

Future challenges
Managing the current economic crises and save the euro, specifically
Portugal, Ireland, Greece and Spain.
Enlargement The EU voted in 2002 to enlarge from 10 to 25 increasing the
number of members to 500 million. This has brought concerns over cheaper
labour rates in countries such as Poland.
Reform of the Common Agricultural Policy (CAP) - this provides prices
guarantees to farmers and a direct subsidy for crops planted. This provides
some level of economic certainty to EU farmers and the production of a
certain quantity of agricultural goods. This policy has the downside in that it
increases third world poverty by creating an oversupply of goods which are
sold to them and prevents these same countries exporting to the EU.
The G8
Canada, France Germany, Italy, Japan, Russia, US and the UK which represent
65% of the world economy. Their remit is to align policy on controversial
issues such as global warming, poverty in Africa, fair trade and AIDS.
The G8 does not have any formal resources or power as is the case with the
WTO. G8 summits give direction on complex international issues and
provides a forum to develop the personal relations that help the member
states respond in a collective fashion to sudden crises or shocks.

Chapter 8 The Financial System 2: International Aspects


International Money Markets are made up of international capital
markets and foreign exchange markets.
International Capital Markets
These have expanded as a result of the abolition of exchange controls that
used to limit the flow of capital into and out of an economy. Also the growth
of MNCs who are free to shop around and avoid domestic restrictions on
credit that may exist.
The funds available on the international capital markets fall into 3 categories
1.
Short term capital (Eurocurrency) borrowed mainly for the purpose of
working capital.
2.
Medium term capital (Eurocredit) borrowed for working capital and
investment purposes
3.
Long term capital (Eurobonds) borrowed for investment purposes and
for financing mergers and acquisitions. These bonds are issued by very large
companies, banks and supranational institutions such as the European
Commission to raise long term finance.
As well as for business borrowers, the International capital markets are also
used by government borrowers (UK local authorities) and provides a market
for lending funds for businesses with surplus cash.
Foreign Exchange Markets
These markets exist for the purchase and sale of foreign exchange, primarily
for 4 reasons
1.
The finance of international trade
2.
The companies holding a portfolio of foreign exchange as part of their
financial asset management function
3.
Financial institutions dealing in foreign exchange to and on behalf of
their customers and to benefit on changes in exchange rates.
4.
To manage risks associated with exchange rate movements
Foreign exchange trading may be spot (at the prevailing rate for the
transaction date) or forward (futures price to protect anticipated flows of
foreign currency from rate volatility).
Foreign exchange risks
Economic risk - a strengthening currency will weaken an exporters
competitive advantage as their products will be more expensive to overseas
customers. One way of managing this is to setup production facilities in the
overseas country itself.
Transaction risk in the time period between the order being placed and the
payment being received the exchanges rate may have moved resulting in a

transaction amount more or less than expected. This can be hedged by buying or
selling forward.
Translation risk if a company has foreign assets denominated in a foreign
currency, the value of this will depend on the exchange rate at the time. If the
domestic currency strengthens the value of these foreign assets will fall at the time
of sale.

Exchange Rate Systems floating exchange rates


These are exchange rates that are free to fluctuate in response to changes in
supply and demand. Such exchange rates are examples of a near perfect
market.
Demand for a currency eg sterling, comes from a number of sources.

Required to pay for UK exports, eg a French supermarket buying British


food will need to pay its suppliers in sterling.
Overseas investors making investments in the UK will need to pay in
sterling.
Speculators may buy sterling if they feel it is about to increase relative
to other currencies.
The government (the central bank) may wish to buy sterling to
manipulate the exchange rate.
For some currencies there may be a demand for it to be held as
international medium of exchange (US dollar).

Supply of sterling is also derived form a number of sources.

UK residents wishing to buy imports will be required to buy foreign


currency.
UK residents wishing to make foreign investments.
Speculators may sell sterling if they feel its value is about to
depreciate.
The UK government may sell sterling on the international markets to
weaken the currency to improve export performance.

Currently the sale and purchase of currencies is dwarfed by the lending and
borrowing of funds.
Factors that impact the exchange rate
High inflation will weaken a currency as it will make goods more expensive,
dampening exports and reducing the demand for currency.

An increase in interest rates has a two fold effect. In the short term hot
money will be attracted to UK deposits increasing the demand for currency
with a corresponding rise in interest rates.
In the long run, high interest rates will erode the competitiveness of UK
goods reducing the supply and demand of UK goods. This will reduce the
demand for sterling and the exchange rate. A trade deficit will cause the
demand for sterling to be less that the supply of sterling to pay for imported
goods.
Speculation can push the rate up or down but this is a short term factor.

The diagram shows the effect of a factor change which reduces the demand
for British goods due to lower competitiveness on world markets.
This will result in a fall in demand for British exports and a shift in the
demand curve to D1.
This shift causes a fall in the exchange rate to P1 assuming that the demand
for British imports remains unchanged.
P1Q1 would be a new equilibrium position at which point the demand for
sterling and the supply of sterling are equal.

The exchange rate will rise if there is an increase in any element of demand for it,
such as exports and inflows of direct foreign investment or a fall in any element of
supply, such as capital outflows. A rise in outflows such as portfolio investment
would increase the supply of the currency and lead to a fall in the exchange rate.

Exchange rate systems Dirty Floating


Governments often interfere with exchange rate markets either by creating
demand or supply as required to achieve a particular exchange rate target.
The purpose of this is normally to make a countrys export more competitive
by lowering the exchange rate or to control inflation.
The central bank can

Buy or sell the currency to raise or lower the exchange rate


Alter interest rates to encourage the buying or selling of the exchange
rates

Arguments for floating rates


Balance of Payments
In theory a floating rate automatically adjusts a balance of payments
disequilibrium.

Suppose a country has a balance of payments deficit due to imports


being greater than exports.
This will result in the supply of currency (to buy imported foreign
goods) to exceed the demand for currency (to pay for exports), which
will result in the fall in the value of the currency.
The fall in the currency will make exports seem cheaper to foreign
buyers, but imported goods will appear more expensive.
The net result is that the balance of payments deficit will be reduced
until it is eliminated, this is the key advantage of a floating rate over a
fixed one.

This self-correcting mechanism means that policies such as deflation, to


rectify a balance of payments deficit need not be implemented.
The counter argument to this is that demand and supply inelasticities , the
activities of speculators and the behaviour of government prevent this
natural rebalancing from taking place in the real world.
Speculation is reduced less speculations will occur because a currency can
appreciate or depreciate, whereas under a fixed rate regime, currency
movements were nearly always devaluations. This allowed speculators who
sold a currency which becomes devalued could never lose.
Holding 1000 at GBPUSD of 1.8, moving into USD, gives $1800. A
devaluation of GBP moving the rate to 1.4, means that the dollar holding is

now worth 1280. If Sterling is not devalued then a switch back is still worth
1000.
On fixed rate system, with enough speculators selling sterling forwards, even
though they do not currently have any sterling, the additional supply created
could give considerable downward pressure on sterling. This would make it
even harder for the government to maintain the currency within its specified
band. Some countries such as China have banned forward contracts to
prevent such speculation.

Resource Allocation A more efficient allocation of resources is secured if


exchange rates can move to reflect economic conditions. If floating exchange
rates reflect changes in demand and supply this may enable the theory of
comparative advantage to operate.
Fluctuations in exchange rates can cause uncertainty which may deter trade.
This can be mitigated to some extent by buying the currency in the forward
market.
Reserves A large supply of reserves is unnecessary in a floating rate
system because the automatic adjustment of the balance of payments deficit
(surplus) is achieved by a currency depreciation (appreciation).

Purchasing Power Parity (PPP)


Suppose we have a product that costs the same in the UK and the US

UK 200
US $280
GBPUSD 1.40

Also the inflation rates in each country is


UK 5% making the price in 1 year 210
US 8% making the price in 1 year $302.40
PPP would suggest that the exchange rate should move to reflect the
difference in inflation rates ie. 210 = $302.40, GBPUSD = 1.44
The higher inflation rate in the US implies a weaker economy and a
weakening exchange rate.
In the short to medium run, it is clearly the operation of the foreign exchange
market that determines changes in exchange rate for a country's currency. In

the very long run, some more fundamental factors may operate. These are
reflected in a theory of the long run exchange rate: the purchasing power
parity (PPP) theory.
This theory states that in the long run, exchange rates will settle at a point
where the purchasing power of two currencies is equalized.

Interest Rate Parity (IRP)


Suppose we have 100,000 to invest in one year and are faced with the
following information

UK interest rates 3%
US interest rates 4%
GBPUSD 1.40

Given that interest rates are higher in the US we may be tempted to convert
our sterling to $140,000 and invest in the US.
If we invest in the UK we will end up with 100,000 * 1.03 = 103,000
If we invest in the US we will end up with $140,000 * 1.04 = $145,600
It may appear that you have gained more by investing in the US, however
IRP suggests that the exchange rate will move to compensate for the
difference in interest rates.
103,000 = $145,600 - GBPUSD = 1.414
The higher interest rate in the US implies a weaker economy hence a
weakening currency.

Single Currency Zones


Countries sharing a currency can avoid exchange rate risks. The best know
example of this is the Economic and Monetary Union whose remit is to
establish economic and monetary authority across the European Union. The
2 main parts of this integration are

A single European Currency the Euro


The European Central Bank

The Euro
The Euro was launched in 1999 and replaced currencies of 11 of the 15
member states by 2002.
The ECB
The ECB based in Frankfurt is the central bank for the Euro currency. Its
main objective based on the Maastrict treaty is price stability which gives it
the authority to set short term interest rates. Like the Bank of England MPC,
the ECB pursues a policy of using interest rates as a lever to influence
inflation.
Should the UK have adopted the Euro ?
Greater economic stability within Euro, but the UK would lose control over
interest rates and monetary policy and may be subject to interest rate
changes that are out of step with the domestic economy.
Foreign exchange costs for trading within the Euro zone these would be
removed if the UK joined the Euro
Exchange rate risk adopting the Euro would remove the risk of exchange
rate fluctuations impacting profitability of trades within the Euro zone.
Increased volumes of trades a single currency removes a significant barrier
to trade as the need to deal in foreign currencies presents a disincentive for
small companies to trade internationally.
The role of major institutions in fostering international development
and stability
The following institutions are involved in international financing

World Bank
The International Bank for Reconstruction and Development (IBRD) is also
known as the World Bank. Its original purpose was to help finance the
reconstruction of countries damaged by the second world war. It has shifted
its focus to countries of the developing world.
The bank now comprises of 3 elements
1. The IBRD proper which lends long term funds for capital projects in
developing countries at a commercial rate of interest. The source of
these funds is borrowing by the IBRD itself.
2. The international Development Association (IDA) provides soft loans
to the poorest of developing countries. This is financed by the

generosity of the 20 donor countries and provides concessionary loans


over 50 years.
3. The International Finance Corporation, which promotes the private
sector in developing countries by lending.

International Monetary Fund


Founded in 1944 the so called Bretton Woods System that the IMF was to
supervise was to have 2 main characteristics stable exchange rates and a
multilateral system of international payments and credits.
The IMF became responsible for

Promoting international financial cooperation, stable exchange rates


and freely convertible currencies
Providing a source of credit for members with a balance of payments
deficits
Managing the growth of international liquidity

European Bank for Reconstruction and Development


This was established in 1992 during the fall of communism in central and
eastern Europe when these countries needed support to create a new private
sector and democratic environment.

Discounting