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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;
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