Day 1 Slide Notes

Slides 1-6

Slide 7We first heard in the news in November 2010 about the government’s plan to survey us to determine our happiness and wellbeing!

The £2 million survey was conducted by the ONS by a Integrated Household Survey of 200,000 people aged over 16. The survey took place between April 2011 and March 2012.

It found that the most important things affecting wellbeing and happiness are health, family, relationships, work, the environment and education.

People scored their life satisfaction as 7.4 out of 10 and 7.7 for how worthwhile they found their activities.

Age groups 16-19 and 65-79 scored their levels of satisfaction as higher than other age groups.It is planned to use this measurement alongside the traditional measures such as GDP.

TUTOR EXPLAIN: You will cover the basics of economic theory but the module contains a lot of detail. After coffee, you will start working through exercises and exam type questions to understand how the theory works in practice.

Slide 8These are the four basic factors of production and the returns that can be generated from them.

LandLand is the economic resource encompassing natural resources found within an economy. This resource includes timber, land, fisheries, farms and other similar natural resources. Land is usually a limited resource for many economies. Although some natural resources, such as timber, food and animals, are renewable, the physical land is usually a fixed resource. Nations must carefully use their land resource by creating a mix of natural and industrial uses. Using land for industrial purposes allows nations to improve the production processes for turning natural resources into consumer goods.

LabourLabour represents the human capital available to transform raw or national resources into consumer goods. Human capital includes all able-bodied individuals capable of working in the economy and providing various services to other individuals or businesses. This factor of production is a flexible resource as workers can be allocated to different areas of the economy for producing consumer goods or services. Human capital can also be improved

1

through training or educating workers to complete technical functions or business tasks when working with other economic resources.

CapitalCapital has two economic definitions as a factor of production. Capital can represent the monetary resources companies use to purchase natural resources, land and other capital goods. Monetary resources flow through an economy as individuals buy and sell resources to individuals and businesses. Capital also represents the major physical assets individuals and companies use when producing goods or services. These assets include buildings, production facilities, equipment, vehicles and other similar items. Individuals may create their own capital production resources, purchase them from another individual or business or lease them for a specific amount of time from individuals or other businesses.

EntrepreneurshipEntrepreneurship is considered a factor of production because economic resources can exist in an economy and not be transformed into consumer goods. Entrepreneurs usually have an idea for creating a valuable good or service and assume the risk involved with transforming economic resources into consumer products. Entrepreneurship is also considered a factor of production since someone must complete the managerial functions of gathering, allocating and distributing economic resources or consumer products to individuals and other businesses in the economy.

Slide 9This is a very basic view of the economy – perhaps shortly after the industrial revolution.

Businesses make things for people to buy. Households work and give their labour so that businesses can do this.

This circular flow represents the foundation stones for economic theory.

Slide 10Firms pay salaries to workers in return for their labour. Households can then spend their money to purchase things that they want/need.

2

Slide 11There are things outside of the basic flow that impact on our complex economy – that this modules looks at more closely.

Injections include money from exports, government spending and investment from firms.

Leakages include imports as money from our economy leaks out into the countries where goods originate, taxation and savings.

Slide 12Opportunity Cost

• Under conditions of scarcity, economic choices involve sacrifices – deciding to do X means not being able to do Y.

• The real cost of using resources for one purpose can be measured in terms of ‘opportunities foregone’.

• The consideration of opportunity costs is one of the key differences between the concepts of economic cost and accounting cost. Assessing opportunity costs is fundamental to assessing the true cost of any course of action. When there is no explicit accounting or monetary cost (price) attached to a course of action, ignoring opportunity costs may produce the illusion that its benefits cost nothing at all.

EXAM QUESTION (June 2012) – Q1 “Explain what is meant in economics by the phrase “Marginal Concepts”.

Marginal Concepts in EconomicsIn the development of economics much use is made of measuring the marginal costs or benefit from some activity. This provides the building blocks of some of the more useful applications of economic theory to decision making in businesses and at the macro-economic level.

Marginal concepts refer to the effect of producing or consuming one more of a good, ie, at the edge, or margin, of the total produced/consumed.

Marginal cost refers to the cost of producing one more unit of some good. In general this will be lower than the average cost because the average cost includes fixed costs. This can lead to economies of scale.

Marginal benefit is the extra utility accrued from one additional unit of a good.Marginal utility is the additional utility (satisfaction or benefit) that a consumer derives from an additional unit of a commodity or service. It is assumed that marginal utility generally falls as consumption increases, so that one’s tenth doughnut in a day is less satisfying than the first or second.

Economists assume that economic agents act rationally and are motivated by a desire to maximise the benefits, at the margin, from their consumption and the rewards from supplying their labour, capital and entrepreneurial skills.

3

Slide 13We always refer to lines in supply/demand diagrams as curves although they can be straight.

Changes other than price lead to a shift of the demand line.

Price always goes on the vertical axis and quantity on the horizontal

TRAINER TO DRAW DEMAND CURVES ON FLIPCHARTA higher quantity is demanded when the price reduces.

Slide14THINK OF THE MNEMONIC – PEST (Political, economic, social, technological) – could help you remember the points below:

Political barriers – Product not available due to political regime (possible black market)

Income – increases are generally lower in a recession and we are seeing some incomes decrease. Many people have lower disposable incomes and this affects demand for some products. Changes in taxation/national insurance will also affect income

Substitutes – eg. DVD/Bluray discs and players. Potatoes/rice/pasta. Yellow pages advertising/building a website. Heating oil/burning wood. Reduction or increase in the price of a substitute may affect the price of a good. Higher heating oil costs in rural areas have led to a rise in demand for wood for burning.

Complimentary goods – Bluray player/bluray discs, reduced price of bluray players will increase demand for discs

Tastes – eg. Fashion

Demographics – eg. More older people in the area, greater demand for mobility aids. Younger area, more demand for children’s products

Advertising – can influence demand.

New technology – PS4 development will reduce demand for PS3. New iPad will reduce demand for existing iPad.

THESE CHANGES WOULD CAUSE A SHIFT OF THE DEMAND LINE RATHER THAN MOVEMENT ALONG THE LINE. TRAINER TO DEMONSTRATE ON FLIPCHART.

4

Slide 15This is the classic view of the law of supply and demand and the invisible hand works to regulate the market so that firms produce the optimum amount for the right price.

Giffen goods (named after Sir Robert Giffen ) – Poor man’s goods. The example in the book is for bread, a staple food. If the price rises, it can mean that poorer people will have less money to spend on more expensive items so they may need to buy more of it rather than less because their budget may not stretch to more expensive food.

Veblen goods (named after Thornstein Veblen, American economist) He looked at consumption in two ways, instrumental and ceremonial or wasteful. Veblen goods are ceremonial. They are for the wealthy to show off their wealth and status. Eg. luxury cars, expensive brand watches, names like Rolls Royce, Porsche, Rolex, Omega. There is always a market for these irrespective of price.

Slide 1640% reduction in demandPrice increase by 50%Answer –0.8The effect for the business is explained on the next slide.

Slide 17The negative sign in front of the number is not relevant for the purposes of analysing elasticity.

USE HANDOUT 1 FOR FURTHER EXAMPLES.

Slide 18There is no need to know how many will be supplied, we are just looking at trends.

TRAINER TO DEMONSTRATE SUPPLY CURVE ON FLIPCHART.

Slide 19Supplies are being bought at the right amount.

See example in the CISI course textbook. It is important to understand the concept – the CISI say there are no common themes to the questions. It may be that you can relate this theory to a case study question.

5

Slide 20Planned Economy: A planned economy or directed economy is an economic system in which the government or workers' councils manages the economy. Its most extensive form is referred to as a command economy, centrally planned economy, or command and control economy. In such economies, the state or government controls all major sectors of the economy and formulates all decisions about their use and about the distribution of income, much like a communist state. The planners decide what should be produced and direct enterprises to produce those goods. Planned economies are in contrast to unplanned economies, such as a market economy, where production, distribution, pricing, and investment decisions are made by the private owners of the factors of production based upon their own and their customers' interests rather than upon furthering some overarching macroeconomic plan. Less extensive forms of planned economies include those that use indicative planning, in which the state employs "influence, subsidies, grants, and taxes, but does not compel." This latter is sometimes referred to as a "planned market economy."

Free Market Economy: A market economy is a realized social system based on the division of labour in which the prices of goods and services are determined in a free price system set by supply and demand. This is often contrasted with a planned economy, in which a central government determines the price of goods and services using a fixed price system. Market economies are contrasted with mixed economy where the price system is not entirely free but under some government control that is not extensive enough to constitute a planned economy. In the real world, market economies do not exist in pure form, as societies and governments regulate them to varying degrees rather than allow self-regulation by market forces. The term free-market economy is sometimes used synonymously with market economy, but, as Ludwig Erhard once pointed out, this does not preclude an economy from having social attributes opposed to a laissez-faire system.

Mixed Economy: A mixed economy is an economic system that incorporates aspects of more than one economic system. This usually means an economy that contains both privately-owned and state-owned enterprises or that combines elements of capitalism and socialism, or a mix of market economy and planned economy characteristics.

There is not one single definition for a mixed economy, but relevant aspects include: a degree of private economic freedom (including privately owned industry) intermingled with centralized economic planning (which may include intervention for environmentalism and social welfare, or state ownership of some of the means of production).

6

Slide 21A pure monopoly exists where one supplier controls the market. In this situation, they could reduce supply to create higher demand and therefore allow the price to be forced up. This is unfair for consumers and the government want to encourage healthy competition for consumer benefit.

In reality the Competition and Markets Authority will investigate when there is potentially a market share of 25%.

An oligopoly exists when there are a small number of key players holding the majority of the market eg. Supermarkets Big Four – Tesco, Sainsburys, Morrison, Asda. Energy providers etc. They are not allowed to collude to fix prices, again as this is unfair to consumers.

Slide 22This was a radical new concept on the 1930s. Keynes believed that market systems, the invisible hand, would not solve the problems of the Great Depression. He proposed that government intervention was required to kick start the economy. He urged governments to use both fiscal and monetary measures.

Government expenditure should exceed revenues to ensure utilisation of resources. By funding capital investment, more people were in work, contributing to GDP and paying taxes, therefore more money was in the economic system.

Slide 23Keynes believed that the only way to bring about full employment was to increase demand.

Aggregate demand is the demand for the whole economy at a given price.Marginal propensity to consume was an important aspect of Keynes’ ideas. Individuals making decisions to purchase would increase demand. The main influence on purchasing decisions is income and this was still the case in the latest recession. For instance, higher income levels tend to gene rate towards greater savings. There are other factors including consumer confidence, availability of credit, interest rates and inflation. The consumption function is measured as C = a + cY.

A = amount consumed when income is zero, c is marginal propensity to consume, Y = income

Marginal propensity to save. Keynes view was that any money not used for consumption was saving. The formula MPS is (1 – MPC). People can be encouraged to save if interest rates are high, there are incentives such as ISAs and if inflation is low. Many people in the current climate feel that low interest rates discourage them to save.

7

SHOW HOW Y=E RELATES TO CONSUMPTION ON FLIP CHART

The formula for aggregate monetary demand is AMD=C+I+G+(X-M).

TUTOR TO DRAW THIS ON FLIPCHART AS A DIAGRAM

Multiplier effect (1/1-MPC) – Keynes view was that the effect of government investment into a capital project would be more than the value of the injection. The paradox of thrift – the multiplier effect is reduced where there is propensity to save.

Slide 24Monetarism is a totally different approach to Keynes’ viewpoints on government intervention.

In his book – Capitalism and Freedom, Friedman emphasised that the role of government should be restrained and kept to a minimum in a free market in order to create political and social freedom.

Friedman distinguished between nominal income and real incomes – the former are not a true reflection of purchasing power as they can be eroded by the effect of inflation Friedman, who was very proactive during the 1970s and 1980s, believed that the acute inflation experienced during that period was attributable to too much government intervention in the economy, which was inspired by Keynesian theory

Since 2009 we have had low rates of interest and large boosts to money supply.

Slide 25We have seen periods of boom and recession. Some people would say the cycle follows electoral cycles. However, the crash in 2008 had a different set of reasons to other recessions. Some government policy initiatives may be responsible. Some people believe that governments should address the problem and smooth out the boom/bust cycle.

Friedman looked at income as nominal income and real income. Nominal income is not real income as it is reduced by inflation and has limited purchasing power. He believed that the Keynesian approach of managing aggregate demand and increasing money supply led to stagflation in 1970s.The Thatcher and Reagan years moved towards a monetarist approach.

8

Slide 26ASK DELEGATES TO COMPLETE THE HANDOUT ‘MEASURES OF INFLATION’ FROM MEMORY IF POSSIBLE. YOU COULD ASK THEM TO DO THIS IN PAIRS.

Changes to interest rates take about 18 months to 2 years to show full impact on inflation.

http://www.bankofengland.co.uk/publications/Pages/inflationreport/default.aspx - This link shows the overview of the Bank of England’s report.

Slide 27See also slide 36

Operations in the domestic money marketThe main instrument of monetary policy is the short-term interest rate. Central banks have a variety of techniques for influencing interest rates but they are all designed, in one way or another, to affect the cost of money to the banking system. In general this is done by keeping the banking system short of money and then lending the banks the money they need at an interest rate which the central bank decides. In this country such influence is exercised through the Bank of England’s daily operations in the money markets.

The Bank of England is banker to the UK banking system. Transactions between commercial banks are finally settled between accounts held at the Bank of England by banks - 22 at present - which are members of the wholesale clearing systems. These settlement banks are expected to hold positive balances on their accounts at the Bank each day. The commercial banks’ total funds are altered by transactions between themselves and the Bank, and between themselves and the Government accounts at the Bank. Transactions between banks merely redistribute funds between themselves. Payments from the private sector to the government are finally settled by a transfer of funds between the settlement banks’ accounts at the Bank and the Government’s accounts. Thus, by managing the money flows the Bank can affect the size of the settlement banks’ balances with itself.

If on a particular day more funds move from the private sector to the Government’s accounts than vice versa (for example because banks’ customers are paying their taxes), then the banking system will be short of the funds needed for the settlement banks to maintain positive balances on their accounts at the Bank. If the overall movement of funds is in the other direction, then the banking system will have surplus funds. Normally the operation of the Government accounts, including money market operations, results in the settlement banks starting each day with a prospective shortage of funds.

The Bank, through its daily operations in the money market, supplies the funds which the banking system as a whole needs to achieve balance by the end of each settlement day. It is in setting the interest rate for these

9

operations that the Bank influences the general level of interest rates across the economy. Traditionally, in these operations the Bank has bought Treasury bills, and other eligible local authority and bank bills. In addition the Bank now operates in gilt repo. A gilt repo is a sale and repurchase agreement eg ‘A’ sells gilts to ‘B’, with a legally binding agreement to repurchase equivalent gilts from ‘B’ at a pre-determined price and date. In effect gilt repo is a cash loan with the gilts used as security.

The Bank’s daily operations to relieve the shortage are conducted through a group of counterparties which can include banks, building societies and securities firms. They are invited to apply for funds either by the sale of bills or by bill or gilt repo to the Bank. Depending on the size of the expected shortage, up to four rounds of operations may be held each day. If these operations are not sufficient to relieve the liquidity shortage there is a late repo facility for settlement banks.

Interest rates in the wholesale money market will generally be closely influenced by those at which the Bank conducts its operations. The decision by the MPC on the rate of interest is announced immediately after the monthly meeting and any change will normally be reflected quickly in the money market in general, and in banks’ base rates i.e. the rates they use to calculate their customers’ rates.

Operations in the foreign exchange marketIn addition to their direct effects on the domestic economy, movements in interest rates influence the value of sterling in terms of other currencies. If interest rates on sterling assets rise in relation to rates on other currencies, then (other things remaining equal) money will flow into sterling and sterling’s exchange rate will rise. The exchange rate will also reflect market expectations about economic, financial and political developments here and abroad, so that a change in interest rates may not always result in a proportionate effect on the exchange rate.

The Bank can attempt to influence the exchange rate through direct market intervention, using the country’s foreign exchange reserves. When sterling is weak the Bank can enter the market and buy sterling in an attempt to halt its decline or can sell sterling if it is perceived to be too strong. Experience shows that such intervention may be helpful in resisting shortterm fluctuations provided it is in line with the underlying trend of the market. The UK’s exchange reserves used to be held solely in the Exchange Equalisation Account owned by the Treasury. This was operated by the Bank on behalf of the Government. As part of the changes introduced by the passing of the 1998 Bank of England Act, the Bank can now manage its own pool of foreign exchange reserves, separately from those managed on behalf of the Treasury. These reserves are now available for use in operations related to monetary policy, subject to limits authorised by the Bank’s Court of Directors.

Operations in the Government securities marketThe weekly tender in Treasury bills is used to help manage the money market as well as raising cash for the Government. The Public Sector Net Cash

10

Requirement (PSNCR) is, however, funded mainly through the sale of gilt-edged securities which are long-term investments used to finance the shortfall between Government revenues and expenditure. Prior to 1 April 1998, the role of managing the Government’s debt was undertaken by the Bank of England. On this date, however, the responsibility for the management of the Government’s debt and the oversight of the gilt market passed to a new Debt Management Office (DMO) which is an executive agency of the Treasury. The DMO also provides policy advice to the Treasury on the annual gilt programme, makes decisions concerning the initiation of sales of gilts and liaises with market participants.

Slide 28Case study: John’s Gift Boxes

TUTOR TO EXPLAIN FOLLOWING:Following a business feature in a national newspaper, John decided to take a loan to move his gift box business to the next stage. He could not meet demand working from his garage at home so moved to business premises and now employs four full time staff. His website has been very successful and he sends gift boxes all over the UK.What impact would a 1.5% interest rate rise have for this business?

POSSIBLY…..Increased interest payments on loanIncreased costs for ingredients, fuel and distributionShe may need to increase her priceMay lead to fall in demand – link back to supply/demand diagramsEmployees may need higher wagesReduced demand may lead to redundanciesImpact on small businesses can be significant.What would interest rate rises mean for investment?

Slides 29-30

Slide 31WORK THROUGH EXAMPLE FROM CISI BOOK:

The consumer buys £5 of goods from a retailer and the retailer then spends this £5 on two types of products or services for herself, eg, a newspaper and a cup of coffee. The original purchase of £5 has effectively paid for a total of £10 of goods.

The expenditure has led to three separate transactions and the velocity of circulation can be simply measured as £10 ÷ £5 or 2.

The number of transactions that have taken place in this simplified model is three and if this typical pattern was extrapolated to all consumers the total

11

number of transactions, T that would take place during a week, would be 3 million.

The average value of the transactions, P, would be: £ ( 5 + 2.5 + 2.5) / 3 = £10 / 3

Putting the figures together in the quantity theory of money equation we would have the following: £5,000,000 x 2 = £10 / 3 x 3,000,000 or simply £10,000,000 = £10,000,000

As it stands, the theory does not appear to reveal too much beyond the fact that money spent in a period must equal the receipts during that same period. When the theory becomes more valuable is in an examination of the parameters to the equation.

Monetarists, like Friedman, argued that the velocity of circulation V of the equation tends to be fairly stable over time. However, that notion has become increasingly suspect as many economists believe that in the global recession of 2009 the speed of transactions and the velocity of circulation of money have experienced a notable decline. Anyway, to pursue the monetarists’ proposition, their view regarding T is that this will be subject to slow and incremental growth as the productive capacity of the economy expands gradually. So, if both V and T, from their perspective, are relatively stable the relationship between M and P must be the most critical to determining the level of prices.

Slide 32Too much legislation and restriction makes it very difficult for businesses to operate.

Laffer Curve Chapter 1 CISI Coursebook. There is an optimum tax rate and if the rate exceeds this, the incentive to work is reduced and income from taxation will actually reduce.

TRAINER DRAWS THE LAFFER CURVE ON CHART

Slide 33Ask delegates to research and explain each of the theories behind the shape of the yield curve. Draw yield curve on flip chart.

Yield curve shows the relationship between interest rate (or coupon value) and the time to maturity of government securitiesWatched by economists and traders“Normal” yield curve is upward slopingLonger dated securities have a higher yieldShape of curve indicates the market expectation of interest ratesThis can aid investment decisions

12

Refer to the expectations theory, liquidity preference theory and market segmentation theory in Chapter 1 of the CISI course textbook.

Slide 34Link to the approach being followed by the current government – In 2012/13 this was 7.3% and OBR expected this deficit to turn into a small surplus by 2018/19. Public Sector Net Borrowing for 2013/14 was £90.7 billion (£94.6 billion 2012/13).

For the fiscal year ending in March 2016:The “current budget deficit*” is estimated to be £45.7 billion.The difference between spending (including capital expenditure) and revenue is estimated to be £93 billion.The increase in UK “net debt” is estimated to be £53.5 billion.

The amount of money owed by the government to the private sector stood at £1.53 trillion at the end of March 2016, which equates to over 80% of value of all the goods and services currently produced by the UK economy in a year (or gross domestic product).

Slide 35Can you say if each tax is direct/indirect, progressive or regressive? (Chapter 1 CISI Coursebook refers)

Slide 36M0 is the Bank of England’s main narrow measure of money, known as the monetary base or high powered money. It originally covered coins and notes in circulation. M2 is a wider measure including sterling denominated retail deposits that are accepted by customers at an advertised rate for a particular product within MFIs M4 is the broadest measure of money - CISI book lists all that is included.

Sterling market operations – The Bank of England is the sole issuer of sterling central bank money. It has two main objectives:

1. To implement monetary policy so there is a flat risk free money market yield curve to the next MPC decision date and little volatility in market interest rates and maturities.2. To reduce cost of disruption to the liquidity and payment services supplied by commercial banks.

Direct Credit Controls. These have been used historically used by the Bank of England, especially in the 1970s. However, the European Central Bank have more recently used credit controls.

13

Quantitative easing. A relatively new method of increasing the quantity of money in circulation by buying securities. USE HANDOUT 3 TO ASK DELEGATES TO EXPLAIN QE, ITS RISKS AND ITS BENEFITS.

Slide 37

We now have floating exchange rates and one of the biggest concerns for the UK is sterling’s status against the Euro – our main trading partners

Floating exchange rates mean that currencies change in relative value all the time. For example, one U.S. dollar might buy one British Pound today, but it might only buy 0.95 British Pounds tomorrow. The value "floats."

The concept of floating exchange rates was not a genuine reality until the Bretton Woods agreement and the IMF were created to facilitate systems of exchange. Prior to that, the gold standard whereby the value of a piece of currency was directly linked to a specific quantity of gold was the prevalent method of currency valuation around the world. In a floating exchange rate system, when the demand for a currency is low, its value decreases just as with any other product or service. But the result of a devalued currency is that imported goods seem more expensive to the people holding that currency. What used to require $5 to buy now requires $10. Because imported goods seem more expensive, people usually start buying more domestic goods, which tends to create jobs and stimulate the economy in general.

However, the opposite is also true. When the currency becomes more valuable, imported items seem cheaper, and suddenly people want to buy fewer domestically produced items. This tends to increase unemployment and slow the economy in general.

Alternative systems:

Fixed Exchange RatesThere are two ways the price of a currency can be determined against another. A fixed or pegged rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency (usually the US dollar) but also other currencies such as the euro, yen or even a basket of currencies. In order to maintain the local exchange rate, the central bank buys and sells its own currency on the forex market in return for the currency to which it is pegged. If, for example, it is determined that the value of a single unit of local currency is equal to US$3, the central bank will have to ensure that it can supply the market with those dollars. In order to maintain the rate, the central bank must keep a high level of foreign reserves. This is a reserved amount of foreign currency held by the central bank that it can use to release (or absorb) extra funds into or out of the market. This ensures that appropriate amount of

14

money supply, appropriate fluctuations in the market and ultimately the exchange rate. The central bank can also adjust the official exchange rate when necessary.

The World Once PeggedBetween 1870 and 1914, there was a global fixed exchange rate. Currencies were linked to gold, meaning that the value of a local currency was fixed at a set exchange rate to gold ounces. This was known as the gold standard. This allowed for unrestricted capital mobility as well as global stability in currencies and trde. However, with the start of WW1, the gold standard was abandoned.

At the end of World War II, the conference at Bretton Woods an effort to generate global economic stability and increase global trade, established the basic rules and regulations governing international exchange. As such he IMF was established to promote foreign trade and to maintain the monetary stability of countries and therefore that of the global economy.

It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar, which in turn was pegged to gold at US$35 per ounce. What this meant, was that the value of a currency was directly linked with the value of the U.S. dollar. So, if you needed to buy Japanese yen, the value of the yen would be expressed in U.S. dollars, whose value in turn was determined in the value of gold. If a country needed to readjust the value of its currency, it could approach the IMF to adjust the pegged value of its currency. The peg was maintained until 1971, when the U.S. dollar could no longer hold the value of the pegged rate of US$35 per ounce of gold.

From then on, major governments adopted a floating system, and all attempts to move back to a global peg were eventually abandoned in 1985. Since then, no major economies have gone back to a peg, and the use of gold as a peg has been completely abandoned.

Why Peg?The reasons to peg a currency are linked to stability. Especially in today's developing nations, a country may decide to peg its currency to create a stable atmosphere for foreign investment. With a peg, the investor will always know what his or her investment's value is, and therefore will not have to worry about daily fluctuations. A pegged currency can also help to lower inflation rates and generate demand, which results from greater confidence in the stability of the currency.

Fixed regimes, however, can often lead to severe financial crises, since a peg is difficult to maintain in the long run. This was seen in the Mexican (1995), Asian (1997) and Russian (1997) financial crises; an attempt to maintain a high value of the local currency to the peg resulted in the currencies eventually becoming overvalued. This meant that the governments could no longer meet the demands to convert the local currency into the foreign currency at the pegged rate. With speculation and panic, investors scrambled to get their money out and convert if into foreign currency before the local

15

currency was devalued against the peg; foreign reserve supplies eventually became depleted. In Mexico’s case the gov’t was forced to devalue the peso by 30%. In Thailand the gov’t eventually had to allow the currency to float and by the end of 1997 it had lost 50% of its value as it the market re-adjusted its value.

Countries with pegs are often associated with having unsophisticated capital markets and weak regulating institutions. The peg is there to help create stability in such an environment. It takes a stronger system as well as a mature market to maintain a float. When a country is forced to devalue its currency, it is also required to proceed with some form of economic reform, like implementing greater transparency, in an effort to strengthen its financial institutions.

Some governments may choose to have a "floating," or ” crawling peg whereby the government reassesses the value of the peg periodically and then changes the peg rate accordingly. Usually, this causes devaluation but it is controlled to avoid market panic. This method is often used in the transition from a peg to a floating regime and it allows governments to save face by not being forced to devalue in an uncontrollable crisis.

The Bottom LineAlthough the peg has worked in creating global trade and monetary stability, it was used only at a time when all the major economies were a part of it. While a floating regime is not without its flaws, it has proven to be a more efficient means of determining the long-term value of a currency and creating equilibrium in the international market.

Slide 38TUTOR TO BRIEF DELEGATES:BV technologies produce electrical switches.They sell them to the British and European markets.There has been a recent interest rate rise of 0.5% and sterling has increased in value.What is the link between the interest rate and the value of sterling?

What could be the effect for this business?

Answers:The increase in interest rates may have encouraged foreign investment. This will push up the value of sterling.An increase in interest rates would affect any loans they have. It could affect price of materials/distribution. It could affect demand. The exchange rate change would make their products more expensive for the foreign market. If there are producers of similar products within the Eurozone, they could become more attractive and BV Technologies could lose business.

16

Slide 39Purchasing power parity – the rate exchange rates should move over the longer term to have the same purchasing power.

Big Mac Index – by The Economist. An informal way of measuring two currencies. Compares the price of a McDonalds Big Mac across different currencies.

International Fisher Theory states that an estimated change in the current exchange rate between any two currencies is directly proportional to the difference between the two countries’ nominal interest rates at a particular time.

According to International Fisher Theory hypothesis, the real interest rate in a particular economy is independent of monetary variables. With the assumption that real interest rates are calculated across the countries, it can also be concluded that the country with lower interest rate would also have a lower inflation rate. This will make the real value of the country’s currency rise over time. This theory is also known as the assumption of Uncovered Interest Parity.

According to the generalized International Fisher Theory, the real interest rates should be same across the borders. But the validity of generalized Fisher theory largely depends on the integration of the capital market. That is, the capital in the market needs to be free to flow across borders. Usually the capital markets of the developed countries are integrated in nature. It has been seen that in the underdeveloped countries the currency flow is restricted.

The International Fisher theory is calculated by the following formula:E = [(i1-i2)/(1+i2)] ~ (i1-i2)

Where:E represents the percentage change in exchange ratei1 represents the interest rate of country Ai2 represents the interest rate of country B

An example may help to understand the value of the theory. For example, if the interest rate of country A is 10% and that of country B is 5%, then the currency of country B should appreciate roughly 5% compared to the currency of country A.

The International Fisher Theory observation holds that a country with higher interest rate will also be inclined to have a higher inflation rate. The International Fisher Theory also estimates the future exchange rates based on the nominal interest rate relationships. The estimate of the spot exchange rate 12 months from now is calculated by multiplying the current spot exchange rate by the nominal annual U.S. interest rate and then dividing it by the nominal annual British interest rate.

17

Slide 40

Slide 41With Module 2 we need to understand some basic accounting principles before moving on to constructing a set of company accounts P&L, balance sheet and cash flow statement. We will then discuss the key accounting standards before looking at some exam style scenarios.

Dual Aspect Concept, also known as Duality Principle, is a fundamental convention of accounting that necessitates the recognition of all aspects of an accounting transaction. Dual aspect concept is the underlying basis for double entry accounting system.

In a single entry system, only one aspect of a transaction is recognized. For instance, if a sale is made to a customer, only sales revenue will be recorded. However, the other side of the transaction relating to the receipt of cash or the grant of credit to the customer is not recognized.

Single entry accounting system has been superseded by double entry accounting. You may still find limited use of single entry accounting system by individuals and small organizations that keep an informal record of receipts and payments.

Double entry accounting system is based on the duality principle and was devised to account for all aspects of a transaction. Under the system, aspects of transactions are classified under two main types:DebitCredit

Debit is the portion of transaction that accounts for the increase in assets and expenses, and the decrease in liabilities, equity and income.Credit is the portion of transaction that accounts for the increase in income, liabilities and equity and the decrease in assets and expenses. The classification of debit and credit effects is structured in such a way that for each debit there is a corresponding credit and vice versa. Hence, every transaction will have 'dual' effects (i.e. debit effects and credit effects).The application of duality principle therefore ensures that all aspects of a transaction are accounted for in the financial statements.

SEE EXAMPLE ON HANDOUT 4

18

Slide 42Money Measurement Concept in accounting, also known as Measurability Concept, means that only transactions and events that are capable of being measured in monetary terms are recognized in the financial statements.

All transactions and events recorded in the financial statements must be reduced to a unit of monetary currency. Where it is not possible to give a reliable monetary value to a transaction or event, it should not be recorded in the financial statements. However, any material transactions and events that are not recorded for failing to meet the measurability criteria, may need be disclosed in the supplementary notes of financial statements to assist the users in gaining a better understanding of the financial performance and position of the business.

Slide 43Financial accounting is based on the premise that the transactions and balances of a business entity are to be accounted for separately from its owners. The business entity is therefore considered to be distinct from its owners for the purpose of accounting.

Therefore, any personal expenses incurred by owners of a business will not appear in the income statement of the entity. Similarly, if any personal expenses of owners are paid out of assets of the entity, it would be considered to be drawings for the purpose of accounting much in the same way as cash drawings.

The business entity concept also explains why owners' equity appears on the liability side of a balance sheet (i.e. credit side). Share capital contributed by a sole trader to his business, for instance, represents a form of liability (known as equity) of the 'business' that is owed to its owner which is why it is presented on the credit side of the balance sheet.

Slide 44Going concern is one of the fundamental assumptions in accounting on the basis of which financial statements are prepared. Financial statements are prepared assuming that a business entity will continue to operate in the foreseeable future without the need or intention on the part of management to liquidate the entity or to significantly curtail its operational activities. Therefore, it is assumed that the entity will realize its assets and settle its obligations in the normal course of the business.

It is the responsibility of the management of a company to determine whether the going concern assumption is appropriate in the preparation of financial statements. If the going concern assumption is considered by the management to be invalid, the financial statements of the entity would need to be prepared on break up basis. This means that assets will be recognized at amount which is expected to be realized from its sale (net of selling costs) rather than from its continuing use in the ordinary course of the business.

19

Assets are valued for their individual worth rather than their value as a combined unit. Liabilities shall be recognized at amounts that are likely to be settled. Company auditors need to consider whether the use of the going concern is valid. Auditors who doubt the validity of such a statement are required to issue an opinion reflecting this.

What are possible indications of going concern problems?Deteriorating liquidity position of a company not backed by sufficient financing arrangements.

High financial risk arising from increased gearing level rendering the company vulnerable to delays in payment of interest and loan principle.

Significant trading losses being incurred for several years. Profitability of a company is essential for its survival in the long term.

Aggressive growth strategy not backed by sufficient finance which ultimately leads to over trading.

Increasing level of short term borrowing and overdraft not supported by increase in business.

Inability of the company to maintain liquidity ratios as defined in the loan covenants.

Serious litigations faced by a company which does not have the financial strength to pay the possible settlement.

Inability of a company to develop a new range of commercially successful products. Innovation is often said to be the key to the long-term stability of any company.

Bankruptcy of a major customer of the company.

Slide 45Financial statements are prepared under the Accruals Concept of accounting which requires that income and expense must be recognized in the accounting periods to which they relate rather than on cash basis. An exception to this general rule is the cash flow statement whose main purpose is to present the cash flow effects of transaction during an accounting period.

Under Accruals basis of accounting, income must be recorded in the accounting period in which it is earned. Therefore, accrued income must be recognized in the accounting period in which it arises rather than in the subsequent period in which it will be received. Conversely, prepaid income must be not be shown as income in the accounting period in which it is

20

received but instead it must be presented as such in the subsequent accounting periods in which the services or obligations in respect of the prepaid income have been performed.

Expenses, on the other hand, must be recorded in the accounting period in which they are incurred. Therefore, accrued expense must be recognized in the accounting period in which it occurs rather than in the following period in which it will be paid. Conversely, prepaid expense must be not be shown as expense in the accounting period in which it is paid but instead it must be presented as such in the subsequent accounting periods in which the services in respect of the prepaid expense have been performed.

Accruals basis of accounting ensures that expenses are "matched" with the revenue earned in an accounting period. Accruals concept is therefore very similar to the matching principle.

Slide 46Matching Principle requires that expenses incurred by an organization must be charged to the income statement in the accounting period in which the revenue, to which those expenses relate, is earned.

Prior to the application of the matching principle, expenses were charged to the income statement in the accounting period in which they were paid irrespective of whether they related to the revenue earned during that period. This resulted in non recognition of expenses incurred but not paid for during an accounting period (i.e. accrued expenses) and the charge to income statement of expenses paid in respect of future periods (i.e. prepaid expenses). Application of matching principle results in the deferral of prepaid expenses in order to match them with the revenue earned in future periods.

Similarly, accrued expenses are charged in the income statement in which they are incurred to match them with the current period's revenue. A major development from the application of matching principle is the use of depreciation in the accounting for non-current assets. Depreciation results in a systematic charge of the cost of a fixed asset to the income statement over several accounting periods spanning the asset's useful life during which it is expected to generate economic benefits for the entity. Depreciation ensures that the cost of fixed assets is not charged to the profit & loss at once but is 'matched' against economic benefits (revenue or cost savings) earned from the asset's use over several accounting periods. Matching principle therefore results in the presentation of a more balanced and consistent view of the financial performance of an organization than would result from the use of cash basis of accounting.

In the accounting community, the expressions 'matching principle' and 'accruals basis of accounting' are often used interchangeably. Accruals basis of accounting requires recognition of income and expenses in the accounting periods to which they relate rather than on cash basis. Accruals basis of

21

accounting is therefore similar to the matching principle in that both tend to dissolve the use of cash basis of accounting.

However, the matching principle is a further refinement of the accruals concept. For example, accruals basis of accounting requires the recognition of the estimated tax expense in the current accounting period even though the actual settlement of the provision may occur in the subsequent period.

However, matching principle would also necessitate the recognition of deferred tax in the accounting periods in which the temporary differences arise so as to 'match' the accounting profits with the tax charge recognized in the accounting period to the extent of the temporary differences.

Slide 47Preparation of financial statements requires the use of professional judgment in the adoption of accountancy policies and estimates. Prudence requires that accountants should exercise a degree of caution in the adoption of policies and significant estimates such that the assets and income of the entity are not overstated whereas liability and expenses are not under stated. The rationale behind prudence is that a company should not recognize an asset at a value that is higher than the amount which is expected to be recovered from its sale or use. Conversely, liabilities of an entity should not be presented below the amount that is likely to be paid in its respect in the future. There is an inherent risk that assets and income of an entity are more likely to be overstated than understated by the management whereas liabilities and expenses are more likely to be understated. The risk arises from the fact that companies often benefit from better reported profitability and lower gearing in the form of cheaper source of finance and higher share price. There is a risk that leverage offered in the choice of accounting policies and estimates may result in bias in the preparation of the financial statements aimed at improving profitability and financial position through the use of creative accounting techniques. Prudence concept helps to ensure that such bias is countered by requiring the exercise of caution in arriving at estimates and the adoption of accounting policies

Slide 48Financial statements of one accounting period must be comparable to another in order for the users to derive meaningful conclusions about the trends in an entity's financial performance and position over time. Comparability of financial statements over different accounting periods can be ensured by the application of similar accountancy policies over a period of time.

A change in the accounting policies of an entity may be required in order to improve the reliability and relevance of financial statements. A change in the accounting policy may also be imposed by changes in accountancy standards. In these circumstances, the nature and circumstances leading to the change must be disclosed in the financial statements.

22

Financial statements of one entity must also be consistent with other entities within the same line of business. This should aid users in analyzing the performance and position of one company relative to the industry standards. It is therefore necessary for entities to adopt accounting policies that best reflect the existing industry practice.

Slide 49

Slide 50REFER TO HANDOUT 5 SHOWING INFORMATION ABOUT COMPANY BIOMETRIC.

This material is provided in a random format and delegates job will have to:- Identify which statement the material should appear in- Construct the relevant sheets with the trainer.

The exercise should take about 1 hour in total. Note also need to explain concept of depreciation and ammortisation. The figures constructed will form the basis for ratio analysis carried out in the Module 3 session (Day 2) and also partly relate to one of the homework assignments handed out at the end of Day 2

Slide 51Owners, managers etc require financial statements to make business decisions relating to continued operations.

Employees need reports to make collective bargaining agreements with management, unions etc. They can also use the figures to help with individual decisions such as promotion, rankings, individual compensation etc.

External stakeholders such as investors need the information to assist in making decisions about investment - buy/hold/sell. Financial institutions such as banks use the statements to help with decisions about ranting fresh working capital or extension of long-term debt.

Government entities will need the information to for example, assess the correct level of taxation that should be paid by the organisation.

Media will also use financial statements for a variety of reasons ranging from company analysis to profiles on key members of staff etc.

Slides 52-S53

END

23