Chapter 2

• State-controlled economy


  The state (government) decides what is produced and how it is distributed
• Planned economy


  Production and allocation of resources is planned in advance rather than responding to market forces
• Perceived advantages of planned economies

  • Low levels of inequality and unemployment, common good replacing profit as primary incentive
• Large inequalities can arise in planned economies, as seen in countries like Russia and Venezuela</b>
• Careful planning and control in planned economies can bring about excessive bureaucracy and remove individual choice</b>
• These factors have contributed to the reform of many planned economies and the introduction of more mixed economies
• Market economy


  Forces of supply and demand determine how resources are allocated
• How a market economy works

  1. Businesses produce goods/services to meet consumer demand

  2. Interaction of demand and supply determines market-clearing price

  3. If oversupply, price is low and some producers leave

  4. If undersupply, price is high and attracts new producers
• There are markets not only for goods/services, but also for productive assets like capital, labour and money
• Characteristics of a market economy

  • People compete for jobs, companies compete for customers
  • Scarce resources have high value, inferior ones have low value
  • Competition can lead to collapse of unsuccessful companies and workers
• Mixed economy


  Combines a market economy with some element of state control
• Most economies are mixed to a greater or lesser extent
• Role of government in a mixed economy

  Provides welfare system to support the less able<|>Spends money on public services like defence, education, health, police
• How governments raise finance in a mixed economy

  1. Collecting taxes directly from wage-earners and companies

  2. Collecting indirect taxes like VAT, taxes on petrol, cigarettes, alcohol

  3. Borrowing in the capital markets
• Civil servants working for the government are one of the largest groups in the labour market
• Open economy


  Country has few barriers to trade or controls over foreign exchange
• Most western governments have policies to allow or encourage free trade, though they may impose barriers to protect against illegal goods
• Trade disputes can lead to retaliatory actions like sanctions, which is referred to as protectionism
• The World Trade Organization (WTO) exists to promote the growth of free trade between economies
• In addition to WTO rules, there are many regional and bilateral trade agreements that aim to increase trade and boost economic growth
• Macroeconomic objectives


  Full employment, economic growth, low inflation, balance of payments equilibrium
• Simultaneous achievement of all four macroeconomic objectives is extremely difficult
• Stages of the economic cycle

  1. Peak - GDP at highest point, growth stops

  2. Contraction - GDP declines, can be a recession

  3. Trough - GDP at lowest point, contraction over

  4. Expansion - Economic activity picks up, GDP grows
• Fiscal policy


  Government actions on spending and taxation to influence the economy
• Tools of fiscal policy

  1. The government budget - balanced, deficit or surplus

  2. Taxation - direct (e.g. income tax) or indirect (e.g. VAT)

  3. Changing taxation and spending to stimulate or reduce demand
• Implications of fiscal policy for businesses

  • Affects planning of output, employment, investment
  • Affects costs through taxation, especially labour costs and indirect taxes
• Monetary policy


  Regulation of the economy through control of the money supply, interest rates and credit availability
• Money supply


  Governments can target the stock of money as an economic tool, e.g. credit squeeze, reserve requirements
• Interest rates


  Represent the price of money and cost of borrowing, assumed to have direct relationship with spending
• Higher interest rates can have complex effects, not just reducing spending
• Central banks have the function of conducting monetary policy
• Higher interest rates


  Decline in consumer spending due to higher borrowing costs
• Higher interest rates


  Corporate sector may lose confidence in the economy and become pessimistic about future prospects
• It has been argued that a higher level of interest rates will not necessarily achieve the above
• Other effects of a high rate of interest need to be considered
• Higher interest rates


  Greater interest income for savers, who may increase their spending
• Higher interest rates


  Demands for higher wages could arise out of the need to make higher mortgage payments
• Higher interest rates


  Attract capital inflows, leading to an appreciation in the exchange rate, making imports cheaper and more attractive, contributing to the balance of payments deficit
• Lower demand


  Higher unemployment and lower tax income for the government, increasing unemployment benefits
• Low investment now


  Poor prospects for future economic growth