The economic environment

• Economic Environment


  All the external economic factors that influence buying habits of consumers and businesses and therefore affect the performance of a company
• Economic Systems


  Means by which societies or governments organize and distribute available resources, services, and goods across a geographic region or country
• State-Controlled Economies


  • The state (government) decides what is produced and how it is distributed
  • Also known as planned economies or command economies
  • Best-known example was the Soviet Union throughout most of the 20th century
• Market Economies


  • The forces of supply and demand determine how resources are allocated
  • Businesses produce goods and services to meet the demand from consumers
  • The interaction of demand and supply results in the market-clearing price
• Mixed Economies


  • Combines a market economy with some element of state control
  • Government provides a welfare system and runs key areas like defence, education, public transport, health and police services
  • Government raises finance through taxes and borrowing
• Open Economies


  • Few barriers to trade or controls over foreign exchange
  • The World Trade Organization (WTO) promotes free trade between economies
  • Both market and mixed economies can also be open economies
• Economic Cycle


  The overall state of the economy as it goes through four stages: expansion, peak, contraction, and trough

  
• Economic Policy


  Government actions intended to influence the economy, such as setting tax rates, interest rates, and government expenditures
• Monetary Policy


  The management of money supply and interest rate by the central bank to achieve macroeconomic objectives like inflation, consumption, growth and liquidity
• Fiscal Policy


  The policy of government spending and taxation to achieve sustainable growth
• Stages of Normal Economic Cycle

  1. Peak

  2. Contraction

  3. Trough

  4. Expansion
• Macroeconomic Policy


  • Full employment
  • Economic growth
  • Low inflation
  • Balance of payments equilibrium
• Fiscal Policy


  1. The budget

  2. Taxation

  3. Expansionary or Loose Fiscal Policy

  4. Contraction or Tight Fiscal Policy
• Implications of Fiscal Policy for Business

  • Planning
  • Cost
• Monetary Policy


  Regulation of the economy through control of the monetary system by operating on the money supply and interest rates
• The Money Supply


  The stock of money in the economy is believed to influence the volume of expenditure, which in turn influences output and prices
• Interest Rates


  Interest represents the price of money or the cost of borrowing, which is assumed to have a direct relationship with the level of spending in the economy
• Mortgage payments would rise

  Less disposable income for homeowners
• Higher cost of credit

  Deters borrowing and, hence, spending
• The Economic Environment
• The level of corporate investments would decline

  Due to higher borrowing costs
• The corporate sector may lose confidence in the economy


  Become pessimistic about future prospects
• Higher interest means greater interest income for savers
• Demands for higher wages could arise out of the need to make higher mortgage payments
• Higher interest rates attract capital inflows


  Lead to an appreciation in the exchange rate, making imports cheaper and more attractive
• Lower demand


  Could result in higher unemployment and lower tax income for the government
• Low investment


  Poor prospects for future economic growth
• Central banks


  Public bodies that operate independently of government control or political interference
• Functions and responsibilities of central banks

  • Acting as banker to the banking system
  • Acting as banker to the government
  • Managing the national debt
  • Regulating the domestic banking system
  • Acting as lender of last resort to the banking system in financial crises
  • Setting the official short-term rate of interest
  • Controlling the money supply
  • Issuing notes and coins
  • Holding the nation's gold and foreign currency reserves
  • Influencing the value of a nation's currency
  • Providing a depositors' protection scheme for bank deposits
• Federal Reserve (the Fed)


  The Federal Reserve System in the US dates back to 1913
• European Central Bank (ECB)


  Based in Frankfurt, assumed its central banking responsibilities upon the creation of the euro on 1 January 1999
• Bank of England (BOE)


  The UK's central bank, founded in 1694, gained operational independence in setting UK monetary policy in 1997
• Bank of Japan (BOJ)


  Japan's central bank, began operating in 1882, gained operational independence in 1997
• Key Economic Indicators


  • Inflation/Deflation
  • Exchange Rates
  • Level of Unemployment
  • Budget Deficits and the National Debt
  • BOP and Exchange Rates
  • GDP
• Inflation


  A persistent increase in the general level of prices
• Many governments seek to control inflation at a level of about 2-3% per annum
• Problems caused by high levels of inflation

  • Businesses have to continually update prices
  • Employees find the real value of their salaries eroded
  • Those on fixed levels of income suffer as price increases are not matched by increases in income
  • Exports may become less competitive
  • The real value of future pensions and investment income becomes difficult to assess
• Positive aspects to high levels of inflation


  • Rising house and asset prices contribute to a 'feel-good' factor
  • Borrowers benefit as the value of their debt falls in real terms
  • Inflation erodes the real value of a country's national debt
• Consumer Price Index (CPI)

  Measure of changes in the price level of a basket of consumer goods and services bought by households
• Method to calculate Inflation

  1. Collect price data on a typical 'shopping basket' of items from month to month

  2. The CPI market basket is developed from detailed expenditure information

  3. The content of the basket is fixed for a period of 12 months and different weights are attached to various items

  4. The content and the weightings are reviewed regularly

  5. To calculate changes in price, the government agency sets a base year for the total cost of the shopping basket, which is then converted into an index of 100

  6. On a monthly basis, prices are collected again and the cost of the basket is recalculated resulting in a revised index number