The Economic Environment for Business

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1 B. FINANCIAL MANAGEMENT ENVIRONMENT 1. The economic environment for business 2. The nature and role of financial markets and institutions The Economic Environment for Business What are the targets of macroeconomic policy? Macroeconomic policy targets are: Growth Control of inflation Full employment External balance (or Balance of payments) Why is Growth in an economy important? Growth is important to an economy because it improves the standard of living of the population. How can growth be measured? Real terms Monetary terms What is mean by Real terms? Growth in real terms is where the effects of inflation have been removed from the figures. What is meant by Monetary Terms? Growth in monetary terms is where the effects of inflation are included in the figures. Which method is a better indicator of growth and why? A better indicator of growth is growth in real terms. Real terms is a true measure of how much more real goods and services the economy produced that can be shared/consumed by the population. Growth in real terms is the measure of the increase in the standard of living of the population. What is inflation? Inflation is a rise in price of a good/service that is not caused by any change to the good/service itself. What are the advantages of inflation? Inflation has some benefits:

2 Salaries increase Producers can sell goods at a higher price Encourages consumers to buy now What are the disadvantages of inflation? It has a wage/price spiral effect (prices increase wages increase, wages increase prices increase) Harder to sell goods overseas What is meant by full employment? Full employment means that all persons willing and able to work are employed excluding those who are in between jobs. Why is full employment a desirable target? It satisfies personal desire Improves the standard of living The economy s output is at maximum Total wealth is at maximum Unemployed persons are no longer supported by the working class What is meant by Balance of Payments? Balance of payments refers to the relationship between our economy and the rest of the world. The rest of the world buys our currency from the market so that it can purchase our goods. The rest of the world sells our currency to the market so that it can purchase the goods and services of other countries. For the economy to be balance its imports and exports must be balance. If our currency is set at a rate where our economy can sell its exports and buy its imports then balance is achieve. If, however, the rest of the world does not want to purchase our goods at the going rate our imports would be greater than our exports and balance would be lost. The value of a currency is determined by the supply and demand for it. What Government policies are they to achieve the Policy Targets? Fiscal policy Monetary policy Exchange rate policies Conflicts of government policies What is Fiscal policy? Fiscal policy is the decision Government takes regarding taxation and public expenditure.

3 What Fiscal policy actions can Government take? Government can spend as much as they receive in taxation. This is called a balanced budget. Government can spend more that it receives in taxation. This is called a budget deficit. Government can spend less that it receives in taxation. This is called a budget surplus. What effect will a Budget Deficit and a Budget Surplus have on the Growth of an Economy? A budget deficit will have an expansionary effect on the economy. Government would be spending more money than it has taken out in taxation and putting additional purchasing power into the economy. Businesses will therefore sell more, employ more, and the economy will grow. A budget surplus has an opposite effect to budget deficit. Government would be spending less money than it has taken out in taxation thereby reducing purchasing power in the economy. Businesses will therefore sell less and employ less. What effect will a Budget Deficit and a Budget Surplus have on Inflation? A budget deficit will have an inflationary effect if they are no spare capacity in the economy. The additional money spent by government will push up the prices of existing goods available. However, if there is spare capacity in the economy then there will be growth without inflation also-known-as Noninflationary Continuous Expansion (NICE). NICE is an ideal condition for an economy. A budget surplus will have a deflationary effect on the economy. It will lower the prices of existing goods available. What effect will a Budget Deficit and a Budget Surplus have on Employment? A budget deficit will create additional employment if there is spare capacity in the economy. If there is no spare capacity in the economy then employers will bid higher wages to attract workers to their business. A budget surplus will lower full employment. Employers will be force to lay workers off in order to cope. What effect will a Budget Deficit and a Budget Surplus have on the Balance of Payments? A budget deficit will cause the balance of payments to worsen if there is no spare capacity. If there is spare capacity then the balance of payment will not be affected. A budget surplus will cause the balance of payments to be affected. What is Monetary Policy? Monetary policy is the decisions that the government makes regarding the rate of interest and the supply of money to the economy. What effect will lowering interest rates have on the economy?

4 Raising interest rates will have the effect of slowing down economic activity because credit is made more expensive individuals and companies are reluctant to borrow and this reduces the demand in the economy for both consumer goods and investment goods. Raising interest rates will make exports more expensive to the rest of the world and this will reduce the demand for exports. What is meant by the supply of money? The supply of money means the actual amount of money (notes, coins and bank deposits) in the economy. How can Government increase or decrease the money supply in the economy? One way that Government can increase the money supply is for the Central Bank to buy from the banks securities that the banks own. When the Central Bank buys securities from the banks it pays money to the banks in exchange for the securities. The banks can then lend this money to individuals or companies and because the banks can lend several times the amount of the new money, the money supply is increased by several times the cash injected. What relationship is there between the interest rates and the money supply? Interest rates and the money supply are very much related. High interest rates will tend to reduce the money supply and lower interest rates will tend to increase the money supply. The reason is because higher interest rates will deter people from borrowing and this lack of demand for money will cause people to both reduce the amount of new money that they borrow from the banks and pay back their earlier borrowings. Lower interest rates will encourage people to borrow and this has the effect of injecting cash into the economy. What effect will monetary policy have on economic targets? Growth: Lower interest rates and the higher money supply will encourage economic growth. Inflation: Lower interest rates and higher money supply will cause inflationary pressure if there is no spare capacity in the economy. If there is spare capacity it will have the effect of reducing inflationary pressure. Employment: Lower interest rates and higher money supply will cause demand in the economy which will increase employment if there is spare capacity but will cause inflationary pressure in the labour market if there is no spare capacity. Balance of payments:

5 Higher interest rates will cause our currency to increase in value on the foreign exchange markets and this will cause exports to be more expensive and imports to be cheaper. This will tend to reduce exports and increase imports thereby worsening the balance of payments. Exchange rate policies Conflicts of government policies How do Government policies affect companies? If Government policies increase the level of demand in the economy then it is very likely that the company s product will sell. If Government policies increase the economic growth then it is likely the company s sales will grow. If the level of inflation rises because of Government policies this would make it easier for the company to raise its prices but the costs will also increase. An economy that is near to full employment will pose a problem for companies because good workers will be hard to find and expensive to employ. Interest rates increasing make borrowing expensive thus pushing up the cost of any overdrafts and also the cost of borrowing for major investments. If the foreign currency exchange rate increasing local companies will struggle to compete overseas because their overseas prices will be high. The interaction between government regulation and the planning and decision making of companies Competition policy To ensure that there are no monopoly providers who tend to maximise profits by charging prices that are higher than a competitive market and do not respond to consumers preferences To ensure that the competitive forces operate to optimise the allocation of resources and a responsiveness to the choice of the consumer To ensure that the full social costs of productions and distribution are reflected in the price charged to consumers (for example, environmental tax) Government assistance for business General improvements to an area s infrastructure to enable that area to improve its business and employment prospects Specific assistance for a particular industry in an area where the area is dependent on that industry Specific assistance for green policies that the government want to promote Part 1 of 2 THE END

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