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Economics for business by David Begg an Damian Ward

Chapter 9 – 16

Quartile 4, 1st year IBA

Chapter 9 Introduction to the macro economy

9.1 Business problem: business cycles and economic uncertainty

Firms need to think very carefully when committing themselves to investment projects,

because the business cycle will affect the success of the investment.

There is a fluctuation all the time: after

a boom, a recession will follow.

After a recession it will get better and

then a boom will follow.

An understanding of how the

economy works and how it is likely

to develop in the short, medium

and long term is of crucial

importance.

9.2 Macroeconomic issues

Inputs � Output � Changes in variables Interest rates GDP

Government deficit Inflation

Current amount

Unemployment

9.3 The circular flow of income

Framework of macroeconomic activity:

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� Households are assumed to own the factors of production = labour and capital

� Firms will clearly provide householders with a financial reward = wages

� Households will buy products and services provided by firms

Leakages Injection

Savings by households Investments by banks (firms)

Tax payment by households Spending by government

Imported products Exported products

Total expenditure is simply all the separate sources of spending within the economy: Consumption by households + Investments by firms + Public spending by government

� Increase in expenditures = increase in economic activity = boom

� Decrease in expenditures = decrease in economic activity = recession

9.4 National income determination and business cycles

Since in macroeconomics we are examining the whole economy, we need a demand and

supply curve for the whole economy.

� Consumption

� Investment

� Government spending Aggregate demand

� Net exports

As prices increase, less is demanded = negative relationship.

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Aggregate supply

The total supply in an economy � How will aggregate supply react to a change in inflation?

� Real values: The nominal wage adjusted for the rate of inflation

� Nominal values: Wage not adjusted for the rate of inflation

When wages fully adjust to inflation, aggregate supply remains constant.

When wages do not fully adjust to price changes, a positive relationship between inflation and

aggregate supply can exist:

� Reduction in the real wage rate = increase supply = aggregate supply increases if

inflation increases.

Macroeconomic equilibrium:

Equilibrium for the entire economy occurs where aggregate demand and aggregate supply

intersect.

Increase demand (to the right) =

inflationary boom

Decrease demand (to the left) =

deflationary recession

Increase supply ( to the right) =

deflationary boom

Decrease supply (to the left) =

Inflationary recession

9.5 Business application: predicting the business cycle

An important step for firms is to predict the business cycle and this is no easy task:

� Economic insights: how much demand and supply are changing (demand falling =

recession).

� Business experience: if you know how the market works and have experience of

working in the market for a number of years, you will have seen it move through its

cycles.

9.6 Business application: profiting from recession

Even during a recession there are still many goods and services being supplied and demanded.

How to stabilize the demand and profits in a recession?

� Income elasticity: normal goods when income rises demand will be higher, inferior

goods when income rises demand will be lower.

� Pricing: having products at the right price in the market and even the ability to lower

prices to gain market share are also useful tactics in a recession; price discounts

� Managing costs: a lack of fixed costs is essential for profitable performance during a

recession.

� Diversification: having a diversified portfolio of business acitivites.

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Chapter 10 Measuring macroeconomic variables and policy issues

10.1 Business problem: what are the macroeconomic policy issues?

Managers need to be capable of understanding the key macroeconomic policy issues pursued

by governments.

10.2 GDP: measurement and policy

GDP is an estimate of the amount of economic activity in an economy.

The business cycle shows the variation between recession and boom.

Measuring economic output:

By examining the circular flow of income three potential ways of measuring output exist:

� Net value of goods and services produced by firms

� Value of households earnings

� Value of spending on goods and services

If we add up all the value added in the economy, then we have an estimate of total economic

activity: GDP.

Two more complications which need to be considered when measuring output:

� Not all factors of production are domestically owned and profits from the use of these

resources will flow to another country.

� The creation of economic output results from the use of productive capital � plant,

machinery, buildings and shops, all of which need to be maintained, repaired or

replaced as they wear out � depreciation.

GDP policy issues: Higher GDP means more goods and services are being produced.

There could come up some problems:

� Distribution of income (rich people will get richer, poor people poorer)

� Cost incurred in generating higher levels of GDP per capita (part-time jobs)

How to sustain GDP?

� Employment is growth

� Infrastructure like schools and health care is welfare

10.3 Inflation: measurement and policy

Variations over time:

� Rate of inflation is a measure of how fast prices are rising

� Inflationary recession

� Deflationary recession

� Economic boom

� Inflationary boom

Demand pull inflation Cost push inflation

When a rise in aggregate demand leads to an

increase in overall prices

When a reduction in supply leads to an

increase in overall prices

Measuring inflation:

� Price indices

� Price deflators

� Costs of inflation:

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o Inflation illusion: people suffer with this if they confuse nominal and real

changes.

o Menu costs: associated with the activity and cost of changing prices in shops,

price lists and menus

� Fiscal drag: occurs when tax-free income allowances grow at a slower rate than

earnings. This reduces the real value of tax-free allowances, leading to high real tax

receipts.

� Fear of deflation: it isn’t good when the fall in prices for goods and services also

impacts wages

10.4 Unemployment

Frictional Refers to individuals who have quit one job and are currently

searching for another job.

As such, frictional unemployment is temporary.

Cyclical Related to the business cycle and is sometimes also referred to ass

demand-deficient unemployment.

Reflects workers who have lost jobs due to the adversities of the

business cycle.

Structural Occurs when an industry moves into decline. The structurally

unemployed find it difficult to gain employment in new industries

because of what is known as a mismatch of skills.

Classical Refers to workers who have prices themselves out of a job.

How to measure?

� ILO definition: count of jobless people who want to work, are available to work and

are actively seeking employment.

� Claimant count: simply measures the number of people who are eligible and receiving

the jobseeker’s allowance.

� Philips curve: shows that lower unemployment is associated with high inflation.

10.5 Balance of payments

The balance of payments measures the flows of money for an economy (import, export,

wages, taxes, etc.).

Short-run: a one-off deficit is unlikely to be a problem � improve the country’s productivity,

type, quality, costs

Long-run: could be a problem.

10.6 Macroeconomic policies

How do governments control aggregate demand and aggregate supply and thereby manage the

economy?

� Demand side policies

� Fiscal policies

� Monetary policies

� Supply side policies

10.7 Business application: international competitiveness and the macroeconomy

Achieving higher rates of economic growth, producing more highly paid jobs and generating

additional exports are not all about increasing aggregate demand within an economy:

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� Competition

� Improving productivity

� Quality

� Investing in workers’ skills and new capital technology

10.8 Business policy: inflation targeting?

A target goal controls the rate of inflation (in the UK +/- 2 per cent).

� Stability of economy

� Price transparency = drive for competition

� Expectations

� Deflation

Chapter 11 Expenditure and fiscal policy

11.1 Business problem: who’s spending and where?

Total expenditure:

� Customer’s consumption

� Government spending

� Firm’s investment

� Export and import

It is important to understand the macroeconomic environment to understand the business

opportunities and threats: What factors will help to drive the various categories of

expenditure?

� Employment prospects

� Sales

� Stability

� Etc.

11.2 Consumption, investment expenditure and the business cycle

The equilibrium is generally defined as the situation where planned aggregate expenditure is

equal to the actual output of the firm.

Planned aggregate expenditure is the total amount of spending on goods and services within

the economy that is planned by purchasers.

� 45° line

� Closed economy = assume there is no

government sector

� PE = AD = C + I

� Consumption + investment

� Consumption is related to two factors:

o Basic need � autonomous

o Level of income � marginal propensity

to save and to consume � confidence

� C = autonomous consumption + income

� Investment is the demand for capital products

� Investment depends on future prospect

� Output > demand = increase stock

� Output < demand = decrease stock

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� Multiplier measures the change in

output following a change in

autonomous expenditure

� Multiplier = 1 / MPS = 1 / (1 – MPC)

� The higher the MPS, the faster the

initial injection leaks out of the

circular flow

11.3 Fiscal policy

For an economist, the multiplier means that small changes in autonomous expenditure can

generate big changes in national income.

If the government wishes to control the economy then it only has to change autonomous

expenditure by a small amount in order to generate a very large change in overall economic

activity:

� Fiscal policy: the government’s decisions regarding taxation and spending;

� AD = C + I + G;

� Government spending is autonomous;

� Taxation from income: AD = C + I + G � AD = 7 + 50 + 20 + 0.8(1-t)Y;

� After-tax income � MPC;

� Flatter line � when taxed are applied an increase in income has a lower impact on

consumption;

� Balanced budget multiplier states than an increase in government spending, plus an

equal increase in taxes, leads to higher equilibrium output;

� How do governments in practice use government spending and taxation to control the

equilibrium level of output?

11.4 Government’s approach to managing fiscal policy

The government’s spending and taxation decisions are reflected in the government deficit =

different between government expenditure and revenues.

� Expenditures: social security, health, education

� Revenues: taxation, insurance contributions, VAT

The continual link between the government deficit and the business cycle makes it difficult to

appraise the government’s fiscal stance.

Fiscal stance: the extent to which the government is using fiscal policy to increase or

decrease aggregate demand in the economy.

Recession: tax will be less, so greater deficit.

Better to use the level of optimal output/full employment.

Fiscal policy and implementation problems:

� Time lags: knowing when there is a boom or recession

� Uncertainty

� Offsetting changes: make more debt in order to finance its spending

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Managing inflation:

1. Manage the size of the government debt

2. Fixed exchange rate system

Crowding out (by government) exists when the public spending will reduce the private

spending.

11.5 Foreign trade and aggregate demand

International trade also has impact on the demand:

X = Export � surplus

Z = Import � deficit

AD = C + I + G + X – Z

Export = autonomous

Import = depends on income � MPZ – Marginal Propensity to Import.

Should we be troubled by a rising trade deficit? YES:

� Leakage in the circular flow of income = reduce of size of multiplier

Open economy multiplier = 1 / (MPS + MPT + MPZ)

11.6 Business application: debt funding and crowding out

Crowding out occurs when public spending stops private sector spending. Then taxation

income for the government is lower and debt will increase. The government has to borrow,

but from whom?

� Households

� Overseas

� Banks

� Etc.

11.7 Business application: taxation or government spending?

Should the form of fiscal stimulus matter to business? YES:

� Timing

� Channels of spending

Chapter 12 Money, banking and interest

12.1 Business problem: understanding how the monetary environment influences the

commercial environment

Money is a key characteristic of most economic transactions: money is commonly accepted as

payment for goods and services and is equally accepted as payment for work.

Expansion of money � provision of liquidity:

- too much expansion = too fast growth = inflation

- too less expansion = too slow growth

By mopping up excess liquidity, through higher rates of interest, the central bank limits the

ability of retail banks to expand credit for consumption and investment. Likewise, if the bank

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reduces interest rates, then money supply needs to be increased, which enables the retail

banks to expand credit to borrowers.

12.2 What is money?

Money facilitates exchange.

If there was no money, then we had to exchange goods � barter economy.

Because not everyone has the same needs and wants, there was double coincidence of wants.

Roles of money:

- medium of exchange

- unit of account (the unit in which prices are quoted)

- store of value (used to make future purchases)

- fiat money (notes and coins guaranteed by the government rather than gold)

12.3 The banking system

The banking system consists of the central bank, retail banks and wholesale banks:

Central bank Acts as a banker to the commercial bank, taking deposits and, in extreme

circumstances, making loans.

Retail bank Takes deposits and makes loans to retail customers.

Wholesale bank Takes large deposits and is involved in brokering very large loans to

companies.

The banking system is just one part of the broader financial system:

� Insurance companies;

� Building societies;

� Hedge funds;

� Pension funds;

Most financial companies are involved with intermediation:

- raising funds

- lending to or investing the cash in companies or individuals

Balance sheet:

Assets � loans to households and firms, financial securities

Liabilities � capital, deposits

Deposits:

Sight deposit � provide customers with instant access to cash

Time deposit � require the customer to give the bank notice before withdrawing cash

The central problem for most banks is that they borrow short and lend long � liquidity.

Important to a well-functioning economy is the services banks offer:

� Liquidity: Speed, price and ease of access to money

� Credit crunch: a lack of liquidity between banks.

� Government bonds: near-cash equivalent and therefore liquid; a

government pays the holder of bonds a rate of interest in return for

funding the government’s debt.

� Collateralized debt obligation: A bond; the holder of the bond is paid a

rate of interest in return for funding a debt.

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� Risk pooling: Banks have access to a large share of funds and are therefore able to

fund a larger pool of risks � risk pooling by banks enables the economy to grow.

� Risk selection and monitoring: Bank managers are trained to assess and evaluate the

merits of lending to individuals and companies; select risks more effectively

� Risk pricing: As experts in financial risk, banks are able to provide a good assessment

of risk and therefore the price for taking on such risk.

12.4 Regulation

Banks are institutions which take financial risks with depositors’ money:

- Contagion � occurs when the collapse of one bank leads to the collapse of more

banks.

- Regulation � The use of rules and laws to limit, control and monitor the activities of

banks.

History:

1960 � Bretton Woods agreement � Fixed exchange rate � Rate of conversion between

countries � control.

1971 � Abandoning fixed exchange rate systems � Lending and investing money where the

rate of return is the highest � Globalization of financial services.

Challenge � How to embrace the opportunities offered by free currency movements?

- Deregulation

� Stock broking

� Competition

These changes were followed by changes in the regulations placed on mutual deposit-taking

institutions such as building societies:

A financial organisation that is owned by its customers. This contrasts with a bank, which is

owned by shareholders.

1993 � The EU opened up competition further:

- cross-border competition

- can take a bigger risk

Types of regulation

Capital adequacy Measures the value of a bank’s capital to its risk-weighted

portfolio of assets;

Measures the extent to which assets within the bank are back by

shareholders’ funds;

Measure of bank safety;

Minimum reserve

requirements

Stipulates the ratio of deposits that must be held in reserves in

liquid or near-liquid form;

Activity-based

regulation

Enables banks and insurance companies to move into each other’s

sectors;

Risk-based regulation

and monitoring

Provides an ongoing picture of the institutions’ financial positions

and the likely risks going forward;

Based on firm risk (specific to the firm) and thematic risk (across

firms within the same sector);

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Systemic risk � Contagion � Risk which can damage the entire financial system.

If the risk is systemic, then banks have generally relied on the central bank to act as the lender

of last resort (if a bank cannot raise funds from any other lender).

Moral hazard � Occurs when a person changes their behaviour because they are partially

insulated from risk.

12.5 Credit creation and the money supply

Banks are able to boost liquidity to borrowers by recognizing that not all depositors will

withdraw their money at the same time:

- Credit creation � the process of turning existing bank deposits into credit facilities for

borrowers. The process can result in an increase in the money supply.

We clearly have to make a distinction between how much money people think exists and how

much cash actually exists.

- Money � monetary based + deposits at the bank

- Money multiplier � The ratio of the money supply to the monetary base:

� Willingness of individuals to deposit money in the bank;

� The level of reserves held by the banks;

- Technology helps to create a higher amount of cash for the banks

- Measures of money:

� M0 � a measure of the monetary base: cash in circulation outside the

banks, cash in the banks and the bank’s own accounts at the Bank of

England � narrow measure

� M4 � M0 + easy access savings accounts at banks, time deposits at

banks and deposits at building societies � broad measure

12.6 The demand for money

Economists identify three motives for holding money:

Transaction motive Recognizes that money payments and money receipts are not

perfectly synchronized;

Precautionary motive Reflects the unpredictability of transactions and the need to hold

liquid funds in order to meet these payments;

Asset motive Individuals hold money as part of a diversified asset portfolio.

Some wealth is held in equities, some in bonds, a portion in

property and some in money;

12.7 Money market equilibrium

The demand for real money balances is negatively related to the rate of interest. The supply of

money is perfectly inelastic and therefore not changing with the interest rate.

Controlling the money supply:

We know that the money supply is composed of cash in circulation plus money in deposit at

the banks:

- Regulating the credit-creation process � regulation of the minimum reserve

requirements run by banks.

o Printing more money

o Open market operations

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� When the central banks buys and sells financial assets in return for

money;

� Quantitative easing: involves the central bank buying government debt,

corporate debt and other financial securities. In return, cash is provided

to the vendors of these assets. Problems:

• Cash on reserve;

• Qualitative easing (the central bank swaps high quality assets

for poorer quality assets);

• Haircut: discount required by the buyer of a risky asset;

- Controlling the amount of notes and coins in circulation � interest rate

12.8 Monetary policy

Governments and central banks across the world attempt to use money markets and the

banking sector to influence overall levels of economic activity � setting of interest rates.

Monetary transmission: interest rates affect consumers’ willingness to consume and firms’

willingness to borrow for investment.

Transmission mechanism: How changes in the base rate feed through into changes in

economic output and inflation.

At the core of the transmission mechanism is how firms and consumers adjust their spending

decisions in the light of rate changes: Change in demand for goods and services � Change in

equilibrium GDP and inflation.

Transmission mechanism:

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- Consumption:

o Directly related to income

o Increases � MPC/Consumption increases too

o Interest rate is therefore related too � Price of money

� Fall: consumers are better off

� Fall: raise today’s value of future income

• Net present value � the discounted value of a future cash flow

• Permanent income hypothesis � States that consumption is

determined by lifetime earnings not current income

- Investment:

o A firm’s willingness to invest is determined by cost-benefit analysis

� Financial returns from investing

• Costs � investment costs, interest costs, disruption costs

� Interest rate influences investment:

• Higher rates of interest drive up the cost of borrowing and so

reduce investment

• Higher rates of interest make the value of future financial

benefits smaller in today’s terms

o Time lags: reflecting pre-committed expenditures

12.9 Business application: monetary policy and investment

Debt is a complementary good for firms seeking to invest.

- If the interest rate falls, loans become cheaper;

- Interest rates reflect the cost of investing, but what about the benefits?

o Recession � reduce of business confidence

o Uncertainty � employment prospects and inflation all damage consumer

confidence

What are the effects of low inflation on the economy and, in particular, on business?

- Stability;

- Predictions are easier to make;

But also:

- Reduce the need or desire to invest;

- Raise the final price for their products;

12.10 Business application: the importance of banking to the economy

Should banking be the engine of economic growth, or the lubricant of the economic system?

- Banking plays a facilitating role within the economy;

- Deregulation:

o Bancassurance � a conjunction of banking and insurance;

o Operating internationally;

o Technical innovations;

Banks and financial services in general have grown to be important, significant and perhaps

the largest component of growth within modern economies.

As financial services has become the engine of economic growth, it has arguably required

greater deregulation and a greater ability to take increased risk in order to achieve yet higher

rates of return.

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When there is a credit crunch and the collapse of many major banks, governments are

required to bail out the financial system:

- risk of political and social objectives

Chapter 13 Inflation, output and economic policy

13.1 Business problem: why is inflation important for wage determination and debt

repayment?

The macro-economy is nothing more than a vast collection of microeconomic decisions

bundled up in an enormous assortment of markets.

Inputs:

- Labour: wages;

- Capital: investment, debt repayments;

Inflation changes the nominal and real prices:

- These will change from each other in the future;

- Deflation will increase real values;

- Inflation will reduce real values;

- When inflation falls behind wage growth, then workers become more expensive and

firms reduce employment and output

Short-run Long-run

Unexpected changes in inflation impact the

budgeted revenues and costs of firms;

Likely to be temporary;

Prices and wages have no impact on the level

of employment, economic output and

therefore GDP;

The less resistance to price and wage changes, the swifter an economy will return to

equilibrium.

So, wage and debt adjustments are enormously important to the functioning of the economy!

13.2 Short- and long-run macro-economic equilibrium

Short-run Long-run

An economy can be shown to be in

equilibrium but the level of GDP can differ

from potential GDP � actual GDP;

Actual GDP > Potential GDP = boom;

Actual GDP < Potential GDP = recession;

Difference between both = Output gap;

The level of GDP is associated with a point

on the economy’s production possibility

frontier;

Full employment level;

Producing at its potential GDP;

Little need to correct;

13.3 Employment, inflation and output

Philips curve: Lower unemployment is associated with higher inflation. Simply, lower

unemployment has to be traded for higher inflation.

� Short-run

� Long-run

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Short-run Long-run

Trade off between unemployment and

inflation;

Unemployment is constant because real

wage is constant;

Real wage = nominal wage / inflation

Rapid adjustment in prices and wages suggests that an economy needs little active fiscal or

monetary policy, while sluggish adjustments provide the possibility for fiscal or monetary

intervention to move the economy more swiftly towards its equilibrium.

13.4 Inflation, aggregate demand and supply

Aggregate demand is total demand in the economy (sum

of consumption, investment, government spending and net

exports) � Negative relationship.

As inflation rises � interest rate increases � reduction in

consumption and investment � reduction in GDP.

A shift in the macroeconomic demand schedule results from

changes in aggregate demand.

Long-run aggregate supply:

� Vertical: inflation inelastic;

� Any change in inflation do not alter employment;

� If there are more workers, then there will be an increase in full employment level;

Long run equilibrium Long run aggregate supply

If an economy benefits from a supply shock, then long-run aggregate supply moves to the

right and the rate of inflation falls the target rate:

� Relaxing interest rates;

� Allowing demand to increase;

13.5 Short-run aggregate supply

In the short run, there is no presumption that real wages

remain constant.

It is necessary to examine the short-run equilibrium of the

economy, where real wages are not held constant. If nominal

wages are held constant and the rate of inflation rise, then real

wages fall and employment increases.

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In the long run, workers and firms have agreed nominal wage growth.

� Inflation increases = real wages fall = price of goods and service rises = more workers

= inflation and GDP rise;

� Inflation decreases = real wages rise = reduce employment and output

13.6 Short- and long-run equilibrium

A drop in consumer and business confidence =

fall of consumption and investment = fall in inflation =

raise of real wages = cutting output.

Revision expectations of inflation = lower nominal

wage growth = inflation falls further = output rises =

return to full employment.

Deflation and the credit crisis:

The credit crisis led to a fall in consumption and investment.

Why avoid deflation if adjustment to full employment can be reached in the long run?

� Time to adjust;

� Impact of deflation on consumption;

� Deflation rises the real value of debt;

Permanent shock in increase of supply � Line moves to the right.

Temporary shock in supply � potential output is unaffected.

13.7 Monetary policy rules

Targeting inflation is equivalent to targeting GDP � Having full knowledge of potential GDP

� Difficult to measure � Inflation targeting seems more appropriate.

The consequences of inflation targeting in the face of supply shocks are to provide volatility

in GDP and stability in prices.

An additional problem faced by central banks is to understand the source of the

macroeconomic shock � Demand or supply based?

Reflecting these difficulties, central banks are pragmatic in their approach to managing the

economy and tend to follow what is know as a Taylor rule:

Interest rate =

π + i* + a(π – π*) + b(GDP – GDP*)

π = rate of inflation

i = real interest rate

a and b > 0

π* = target rate of inflation

GDP* = potential GDP

A Taylor rule links interest rate changes to short-term deviations in both inflation and output

from long-term equilibrium values.

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The more the central bank is concerned about inflation deviating from the target rate, the large

a, and the more interest rate will change.

The higher the value for b, the more concerned the central bank is with variations in GDP and

the more rates will change to bring about long-run equilibrium and potential GDP.

13.8 Adjustment speed

Competing macroeconomic perspectives:

New Classical Gradual Monetarist Moderate Keynesian Extreme Keynesian Markets adjust

instantly; leading to a

clearing equilibrium;

Full employment;

No need for policy

interventions;

Focus on long-run

Markets adjust quickly but not

instantaneously;

Relatively short-time period;

Flexibility in pricing;

Open labour market;

Policies are likely to lead to an

over-correction of the

economy;

MV = PY;

Economy will eventually

return to its long-run

equilibrium but the adjustment

will not necessarily be quick;

Slow to adjust;

Extremely concerned that

prices and wages are sticky;

Enormous duty to push

spending into the economy;

Fiscal policy is better able to

do this than monetary

policy;

Core concern is output;

13.9 Business application: understanding the interest rate path

For business, it is crucial to understand the future path of interest rates:

� Borrowing to fund investment;

� Leverage their financial returns � higher returns to shareholders;

� Equity financing;

The Taylor rule enables business managers to achieve a broad understanding of where interest

rates are likely to go in the future:

� A greater divergence between actual inflation and target inflation will lead to a change

in rates;

MV = PY

Money supply * Velocity of circulation = Price level * Real GDP

Fan charts:

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13.10 Business application: understanding the formation of inflationary expectations

If growth in wages and prices is fundamental to the macroeconomic equilibrium, then it must

be important for business to understand and respond to changing inflationary expectations.

How are inflationary expectations formed?

� Inflation to the target level � future price stability;

� Variety of markets � over time tracking price changes;

� Money markets � rate of return;

Chapter 14 Supply side policies and economic growth

14.1 Business problem: assessing economic growth

The importance of growth rates becomes more apparent over time:

� Generation of individuals’ incomes;

� Potential for companies to grow;

Economic growth and the development of sales is not the only benefit for firms:

� Aid the cost structure faced by firms;

� Understanding government policies;

� Exploiting opportunities offered by economic growth;

14.2 Growth and aggregate supply

Demand side policies are only capable of moving the economy back to full employment. Real

expansion of the economy involves an increase in potential GDP. Therefore, we can only

envisage real economic growth occurring if aggregate supply increases.

If economic growth is desirable, then moving aggregate supply, or increasing the potential

productive output of the economy, is key:

More factor input As the economy gains more economic factor inputs (land, labour,

capital and enterprise), then its productive potential increases;

- Transfer of workers;

- Similar access to resource problems;

Greater productivity If it is not possible to gain more factor inputs, then economic

growth can be achieved by producing more output with the same

level of factor inputs;

Becoming more productive;

A key measure of productivity is GDP per hour worked;

The firm is only willing to supply more output at any given price if

its marginal costs decrease;

Innovation A key driver of technological change is R&D;

Any implication for economic growth?! � transfer of knowledge

and new ideas means greater impacts on long-term economic

growth;

14.3 Neoclassical growth theory

Assume we have a simple model where the economy’s output is determined by three things:

� Technical progress; � Improving;

� Capital; � Employment of more capital;

� Labour � Law of diminishing goods;

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How long can growth keep improving?

Economic growth would not increase for ever;

In the short term, providing all workers with more productive capital improves productivity

� raises economic growth � but in the long term these extra capital has to be maintained �

slowing down the output rate =

Growth rate convergence: states that poor countries grow more quickly than average, but rich

countries grow more slowly than average.

14.4 Endogenous growth theory

Neoclassical economists see even developments in technology as being exogenous, or

determined outside the model.

� Growth is determined by technological development, but technological development is

not affected by economic growth;

� Constant returns to capital;

� Governments have the potential to increase technological developments and direct

economic decision makings to investment activities with positive externalities.

Endogenous growth theory: Considers models in which the steady state growth rate can be

affected by economic behaviour and policy.

14.5 Supply side policies

Education markets Bringing a broader and larger number of individuals into

higher education widens the skill base of the workforce;

Thinking critically � core of technological improvement;

Labour markets Accommodating;

Trade unions vs. stakeholder perspectives;

R&D and innovation Government can play a role in providing incentives to

undertake research in new productive processes, or even

encourage the exploitation of existing knowledge;

Financial services With higher quality investments being undertaken, the capital

stock can become more productive and economic growth

should improve;

Tax cuts Less tax payment � more money for leisure;

Privatization Competition increases;

Effective entry barriers;

Economies of scale;

Private finance initiatives Involve the private sector in financing, building and owning

infrastructure projects in return for an annual leasing fee from

the government;

14.6 Business application: how does innovation promote business?

Creative destruction:

� Competitive advantage;

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� Generation of profits;

14.7 Business application: the BRIC economies

The BRIC economies are those of Brazil, Russia, India and China � growing fast and they

are enormous.

Factors:

� Technological expertise (C)

� Abundance of labour (C)

� Energy resources (R,B)

� Important forestry (B)

They have yet to run up against the production possibility frontier � frontier and supply are

constantly expanding:

� Rapid growth;

� Low inflation;

However, there are also notes of caution � very different stage of economic development

from other western economies:

� Product has to be right for the level of income;

Chapter 15 Exchange rates and the balance of payments

15.1 Business problem: should the UK be a member of the euro?

� Understanding of the trade-off between flexibility and stability;

� Understanding of how strong the welds are

15.2 Forex markets and exchange rate regimes

Since we are talking about a forex market, the item being traded must have a price:

‘Forex markets are where different currencies are traded.’

Who is demanding and selling currency?

� Individuals and firms buy and sell currencies whenever they undertake transactions

with other economies;

� Import � generating supply for the currency;

� Export � generating demand for the currency;

Exchange rate regimes:

Fixed exchange rate

regime

Meet this excess demand by supplying an additional AC pounds to

the market;

When the central bank was selling currencies it will have received

another currency in return � reserves � buy back your own

currency;

Devaluation: If the currency is being continually supported by the

central bank, it is probably the case that the fixed exchange rate has

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become vastly different from the long-term market for the currency

� speculative attack (massive capital outflow from an economy with

a fixed exchange rate).

Floating exchange

rate regime

As demand and supply for a currency change, the equilibrium price

adjusts accordingly;

No impact on the central bank’s foreign currency reserves as there is

no intervention in the marketplace;

Long run: purchasing power parity � requires the nominal exchange

rate to adjust in order to keep the real exchange rate constant.

Dirty float The government claims that the currency floats but in fact, through

the central bank, the currency is secretly bought and sold to achieve a

target exchange rate.

15.3 Fixed versus floating exchange rates

Fixed exchange rates Floating exchange rates

Volatility (short-term) No volatility Volatility; uncertainty

Robustness (long-term) No scope for exchange rate

adjustment

Gradual adjustment

Financial discipline Force governments to take

financial discipline seriously

Little incentive to control

inflation

15.4 The balance of payments

The balance of payments records all transactions between a country and the rest of the world.

There are 3 parts:

Current account A record of all goods and services traded with the rest of the world;

- visible

- invisible

Capital account A record among other things, net contributions made to the EU;

Financial account Record of net purchases and sales of foreign assets � captures all

investments into an economy by foreign individuals and companies:

- direct investment: foreign company which builds offices in

another country (e.g.);

- portfolio investment: purchases of shares and bonds;

- other investment: loans between banks;

Under floating exchange rate, the balance of payments must equal zero � equilibrium in the

forex market.

Under fixed exchange rate, the situation is vastly different � the balance of payment will not

necessarily be zero. In order to make the balance of payments zero, we have to incorporate the

concept of official financing (the extent of government intervention in the forex markets):

- government must buy up the excess supply of the currency;

15.5 Exchange rates and government policy

Effectiveness of fiscal and monetary policy under fixed and floating exchange rate regimes:

- real exchange:

o international competitiveness depends upon the real and not the nominal

exchange rate:

� (€/exchange rate other currency) x (price of goods / € price of goods)

- perfect capital mobility:

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o expected returns on all assets around the world will be zero;

Fixed exchange rates Floating exchange rates

Monetary policy Guarantee of profits;

Financial capital will flow to the

country with the highest interest

rate;

Loss of monetary independence;

More powerful than fiscal policy;

A reduction of interest rates will

boost internal demand �

international competitiveness;

Fiscal policy You cannot change the interest

rate;

More powerful than monetary

policy;

Demand will increase �

inflation;

Raise interest rates;

Exchange rate must also rise;

15.6 European monetary union

The monetary union is the permanent fixing of exchange rates between member countries:

- loss of monetary independence;

- international competitiveness;

Potential members do have to meet the Maastricht criteria � stability.

Optimal currency zones: a group of countries better off with a common currency than keeping

separate currencies �

- trade integration;

- similarities in industrial sectors (macroeconomic shocks);

- flexibility and mobility (safety)

Five tests:

- sustainable convergence;

- flexibility;

- investment;

- financial services;

- employment;

What if you don’t join the EU:

- lost trade;

- lower foreign investment;

- weaker financial markets;

- reduced competitiveness;

- convergence;

- euro policy and politics;

15.7 Business application: monetary sovereignty, exchange rate depreciation and export

growth

Advantages Disadvantages

Trade is less complex;

Price transparency � common pricing and

financial risks associated with currency

movements are reduced;

Recessionary impact of the credit crisis;

Abandon of monetary sovereignty;

No independent control;

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15.8 Business application: hedging

In the forex market there is ample opportunity to hedge: the transfer of a risky asset for a non-

risky asset.

Spot price � speculation � will it be more worth in the future or not?

Chapter 16 Globalization

16.1 Business problem: how do we take advantage of the global economy?

Globalization provides opportunities and threats for business:

- potential access to cheaper labour, raw materials and finance;

- willingness of customers;

- international competition;

16.2 Why is the global economy developing?

There are many potential drivers of globalisation:

Culture Convergence

Travel Promotes an acceptance of other cultures

Film and media Seeing what is consumed abroad

Technology and

communications

The ability to communicate with anyone, anywhere, any time, increases

the perception of a global village;

Integrated global financial system;

Economic

rationales

Law of comparative advantage states that economies specialize in the

good that they are comparatively better at making;

Minimizing opportunity costs;

Terms of trade P exports / P imports;

If a country’s terms of trade improve, then the price of its exports is

rising relative to the price of its imports;

Improvement means rise of command GDP;

Fundamental

importance of

comparative

advantage

Being most productive;

Factor abundance Economies appear to produce goods for which they have an abundance

of a key factor input;

Two-way trade Intra-industry trade;

Tastes for differentiated products;

Trade restrictions Protectionist measures:

- tariffs;

- subsidies;

Non-tariff barriers Quota

Reasons for

protecting trade

- Defence or national interest;

- Infant industry;

- Way of life;

International

institutions

Number of supranational institutions:

- WTO;

- United Nations;

- The world bank;

Trade blocs A region or group that have agreed to remove all trade barriers among

themselves;

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16.3 A closer look at the EU

An important feature of the EU is the limited presence of internal trade barriers:

- reduce domestic oligopolies;

- increase cross-border competition;

- realization of economies of scale;

- comparative advantage;

- emerging corporate strategy;

The EU is still growing:

- opens up more markets;

- presents an ample supply of cheap skills workers;

- opportunity to relocate;

- exploit cost savings;

16.4 To what extent are markets becoming global?

Globalization occurs at many levels:

� Global product markets � export and import of goods and services from domestic

locations to international markets;

� Global operations � multinational enterprises are usually large companies with

production and/or sales operations in more than one country:

� Investment in foreign markets: foreign direct investment (FDI)

� Why do firms become global? � variety of reasons:

� Revenue growth;

� Costs;

� Sources of international competitiveness � national, industrial or firm-specific,

sometimes also macroeconomic;

� Accessing � quality of labour, transportation costs, etc;

If a firm has a specific asset such as knowledge or branding which provides it with a

competitive advantage, the best way to exploit that asset is to retain control. Expanding the

firm’s operations into international markets enables the firm-specific competitive advantage

to be exploited. Transferring the asset to a third party is likely to increase transaction costs.

16.5 Business application: globalization – exploiting comparative advantage

A number of problems occur when opening up the trade barriers:

1. Communication and co-ordination:

a. Language;

2. Legal issues:

a. Environmental controls;

b. Contract law;

c. Employment law;

d. Import restrictions;

3. Quality of inputs:

a. Labour;

b. Machinery;

4. Image and brand: meet the tastes and preferences of a global audience;

16.6 Business application: sources of international competitiveness

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It is important to understand the crucial difference between competitive advantage and a

sustainable competitive advantage:

- long-term;

- strategy;

- difficult to copy;