ch6 f1 acca bpp

Ch6 The macro-economic environment

2004 Fall ACCA Paper 1.3

Study guide Define macro-economic policyMain types of economic policyImpact of fiscal and monetary policyDeterminants of level of business activity and its influence on individuals, households and businessImpact of economic issues (inflation, unemployment, stagnation, international payments disequilibrium) on individuals, households and business


1 Government policies and objectives4 main objectives of economic policy:To achieve economic growth: increases caused by price inflation are not real increasesTo control inflationTo achieve full employment: unemployment level is low and involuntary unemployment is short-termTo achieve a balance between exports and imports*R-15:#11


Significance of gov. tax and spending to companiesGov. expenditure affects suppliers to the gov.Gov. spending has a knock-on effect on the whole economyTaxation affects consumers purchasing powerTaxation affects after-tax return on investment of companiesPublic sector investment affects public sector companies and private sector companies


Gov. role in economic planningGov. should not plan economic activity in detail, but act as enabler of private sector activity and corrector of market imperfection.Provide legal system relating to businessResponsible for macro-economic managementRaise trade barriers to protect domestic industrySubsidise and promote exportsEncourage inward investment by foreign countriesCarry out regional policy


Gov. can influence commercial decisionsOutput capacity; competition; sales demandThrough tax or grants; acts and practice; policiesGov. can influence operational decisionsHealth and care; employment; consumers; taxThrough legislation; regulations; standards; tax laws


2 Fiscal policyFiscal policy provides a method of managing aggregate demand in the economy.Aggregate demand=consumption + investment + gov. expenditure +export*Pilot paper#16Gov. must plan its spending, borrowing and taxation (how much, when, in what form) . The formal planning of fiscal policy is in the budget.ExpenditureRevenues=taxation+direct chargesBorrowing(PSNCR) =expenditure-revenues*R-14:#1; R-14:#2


Budget surplus and deficitGov. can use fiscal policy to influence demand in economy in 2 ways:Expenditure changesTax changesAggregate demand can be boosted by more government spending (directly) or by tax cuts (indirectly), financed by a higher PSNCR.Aggregate demand can be reduced by cutting government spending or by raising tax, using the savings to cut gov. borrowing.Gov. income>expenditure, budget surplus Gov. income< expenditure, budget deficit


Functions of taxationTo raise revenues for the governmentTo discourage certain activities regarded as undesirableTo cause certain products to be priced to take into account their social costsTo redistribute income and wealthTo protect industries from foreign competitionTo provide a stabilising effect on national income*R-51:#1


Types of taxRegressive tax takes a higher proportion of a poor persons income than a rich persons.Progressive tax takes a higher proportion of a rich persons income than a poor persons.Proportional tax takes the same proportion of all incomes.The gov. of a certain country decides to introduce a poll tax, which involve a flat rate levy of $200 on every adult member of population. The tax is _______ tax.


Direct and indirect taxDirect tax is paid direct by a person to the Revenue authority.Levied on income and wealthTend to be progressive or proportional taxIndirect tax is collected by the Revenue authority from a intermediary (a supplier)Levied on expenditureCan be regressiveTwo types:Specific tax: fixed sum per unit Ad valorem tax: fixed percentage of the price*R-14:#3


ActivityWhich of the following government aims might be achieved by means of fiscal policy? 1.A redistribution of income between firms and households. 2.A reduction in aggregate monetary demand 3.A change in the pattern of customer demand A Objectives 1 and 2 only B Objectives 1 and 3 only C Objectives 2 and 3 only D Objectives 1,2 and 3


3 Monetary policyMonetary policy uses interest rates, exchange rate, money supply or credit controls/expansion to influence aggregate demand. (R-15:#8; R-52:#3)Intermediary objectives can be set for monetary policy in order to achieve ultimate economic objectives:Increase in money supply will rise prices and income, leading to increasing demand for money.A rise in interest rates will raise the price of borrowing, curtail investment, postpone individual consumptions, leading to reduced demand for money.(pilot paper#24)


High interest rates will attract foreign investors into sterling investments and keep the value of sterling() higherA fall in exchange rate will decrease the cost of exports and increase the cost of imports,thus stimulate exports and reduce demand for imports, thus reduce deficits in current account, and tends to increase domestic inflation rate.(*R-14:#5; R-52:#7)Strict credit controls will reduce lending and so reduce demand in the economy3.6(P190) Monetary policy can be made to act as a subsidiary support to fiscal policy (likely), or can be given prominence over fiscal policy (might not be possible).


Economic indicators An economic indicator provides information about economic conditions and can be used as a way of judging the performance of gov.Leading indicator: gives an advance indication of what will happen to the economy in future.E.g. exchange rate changeCoincident indicator: gives an indication of changes in economic conditions at the same time when changes are occurring. E.g. money supply changeLagging indicator: is one which lags behind the economic cycle. E.g. unemployment rate


Monetary indicatorsSize of money stockInterest ratesExchange rate against US dollarSize of governments borrowingSize of governments borrowing as a percentage of GDP


National incomeEquilibrium national income is reached where aggregate demand(AD) equals aggregate supply(AS).Ideal equilibrium: AD and AS are in balance at the full employment level .Inflationary gaps: AD and AS are in balance at a level where demand exceeds the productive capabilities of the economy at full employmentDeflationary gaps: AD and AS are in balance at a level of employment which is below the full employment of national income


QuantityASADDeflationary gapsFull employmentPrice QuantityASADEquilibriumFull employmentPrice QuantityASADInflationary gapsFull employmentPrice EquilibriumEquilibrium


stagflationStagflation: a combination of unacceptably high unemployment and unacceptably high inflation.Can be caused by any long-term major increase in costs (e.g. a price shock).


The business cycle (trade cycle) Recession (dropping AD)Consumer demand falls; investment projects unprofitable; orders cut; inventory levels reduced; production and employment fall; general price level fallDepression (lowest AD)Recession will be developed into full depression in the absent of stimulus to aggregate demandRecovery (rising AD)Output, employment and income begin to rise; rising level of demand; increased production; price level rise; optimistic business expectationsBoom (highest AD)Capacity and labour become fully utilised, usually accompanied with inflation and speculation*R-51:#2


Wide fluctuations in levels of economic activity are damaging to the overall economicInflation and speculation accompanies boom periodsHigh unemployment accompanies depression periodsGov. generally seek to stabilise the economic system, tying to avoid the distortions of a widely fluctuating trade cycle.


6 Inflation Inflation is an increase in price level generally, manifesting in the decline in the purchasing power of money.High rate of inflation may be harmful:Leads to a redistribution of income and wealth in undesirable waysBalance of trade may suffer: high inflation tends to increase imports and decrease exports and decrease value of sterlingUncertainty of value of money increase, leading resource allocation less efficient and decision-making more difficultMore Time and costs spent on planningMay be harmful to a countrys economic growth and level of investment*R-15:#9; pilot paper#27


Measure of inflation rateCPI(consumer prices index) is based on a chosen basket of items which consumers purchase, excluding most housing costs.RPI(retail prices index) is average level of prices of the commodities and services, including housing costs.Adjusted RPIRPIX: exclude mortgage interest paymentsRPIY: exclude mortgage interest payments and effects of VATUKs inflation target is measured on basis of CPI.


Causes of inflationDemand pull inflationInflation arises from an excess of aggregate demand over the productive capacity of the economyCost push inflationInflation resulting from an increase in the costs of production of goods and services. E.g. from wage increasesImport cost factors: e.g. fall in the value of domestic currencyExpectations: wage-price spiralExcessive money supply growth*R-52:#4; P563#17


Unemployment Rate of unemployment=Flow of workersFlows into unemploymentFlows out of unemploymentConsequencesLoss of outputLoss of human capitalIncreasing inequality in the distribution of incomeSocial costsIncreased burden of welfare payments


Causes of unemployment*R-15:#12; R-52:#5; pilot paper#12

Real wage unemploymentReal wages do not fall for the labour market to clearShort-termFrictional unemploymentDifficulty in matching unemployed workers with available jobsSeasonal unemploymentResulting from demand for labour fluctuates in seasonal patternsLong-termStructural unemploymentArising from a long-term decline in a particular industryTechnological unemploymentOccurs when new technologies are introducedCyclical unemploymentIn the downswing of an economy in between two booms


Gov. employment policiesGov. can create new jobs or reduce unemploymentSpending more money directly on jobsEncourage growth in private sector of economyEncourage training in job skillsOffering grant assistance to employersEncouraging labour mobilityReduce real wages to market clearing levelsIt is possible to create more jobs without reducing unemployment. It is also possible to reduce the unemployment without creating new jobs. *R-14:#7


Economic growthMeasured by increases in the real GNP per head of the population.Actual growthAnnual percentage increases in national outputDetermined by the demand and supplyPotential growthThe rate at which the economy would grow if all resources were utilisedDetermined by supply sideCaused by increases in the amount of resources or increases in the productivity of resourcesSustained growthDepends on an adequate level of new investment, which is in turn dependent on business confidence in future*R-15:#10


Sources of economic growthNatural resourcesTechnological progressCapital saving: use less capital and the same amount of labour per unit of outputNeutral: use less of labour and capital in the same proportion per unit of outputLabour saving: use less labour and the same amount of capital per unit of outputTechnological progress may stimulate growth but at the same time conflict with the goal of full employmentExternal trade influence


Adv. and disadv. of economic growthAdvantagesHigher income per headHigher level of consumptionBetter standard of livingMore easy to provide welfare servicesDisadvantagesFaster use of natural resourcesCreate pollutionStructural unemploymentFinancing for more investment may come from higher savings, which leads to cut in consumption.


Balance of paymentsBalance of paymentCurrent accountTrade in goodsTrade in servicesIncome: income from employment by overseas firms and income from capital investments overseasTransfer: public sector and non-government sector payments and receipts from overseas bodiesCapital account: flows of capital into and out of the country* R-52:#6


Surplus or deficit in the current accountA surplus or deficit on the balance of payments usually means a surplus or deficit on the current account.Export > import, surplus in the current account Import > export, deficit in the current accountProblems of deficitBuild up external liabilitiesSell more and more of its assetsMeasures of gov. to rectify a deficitDepreciation of currency (devaluation)Restrict importsDomestic deflation to reduce domestic aggregate demand *R-15:#6


summaryTo increase the aggregate demand, and reduce unemployment and boost economic growth:Increase public expenditureReduce taxesReduce interest ratesIncrease money supplyReduce credit control* R-14:#4; Pilot paper#11


summaryTo reduce the aggregate demand, and reduce inflation and slow economic growth:reduce public expenditureincrease taxesincrease interest ratesreduce money supplyincrease credit control


summaryThe effects of increasing interest rates:Reduce aggregate demandIncrease unemployment, slow down economic growthIncrease value of sterling(exchange rate of )Increase importsReduce exportsIncrease the deficit in the current account or reduce the surplus in the current accountReduce inflation rateThe value of sterling is higher when interest rate in UK is higher and inflation rate in UK is lower.


ch6 f1 acca bpp

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