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1 Microeconomics, macroeconomics and economic policy

1 Microeconomics, macroeconomics and economic policy

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1.2 Economic policies and objectives
The policies pursued by a government may serve various objectives.

Control inflation


Balance of
payments stability



Economic growth
'Growth' implies an increase in national income in 'real' terms (increases caused by price inflation
are not real increases at all). It is usually interpreted as a rising standard of living.


Control price inflation
This means managing price inflation to a low, stable level. Inflation is viewed as a problem
because, if a country has a higher rate of inflation than its major trading partners, its exports will
become relatively expensive. It leads to a redistribution of income and wealth in ways which may
be undesirable. In times of high inflation, substantial labour time is spent on planning and
implementing price changes.


Full employment
Full employment does not mean that everyone who wants a job has one all the time, but it does
mean that unemployment levels are low, and involuntary unemployment is short term.


Balance of payments stability
The wealth of a country relative to others, a country's creditworthiness as a borrower, and the
goodwill between countries in international relations might all depend on the achievement of an
external trade balance over time. Deficits in external trade, with imports exceeding exports, might
also be damaging for the prospects of economic growth.




External trade

Exchange rate

Part B Financial management environment  2: The economic environment for business


To try to achieve its objectives, a government will use a number of different policy tools or policy
instruments. These include the following.

Monetary policy
Monetary policy aims to influence monetary variables such as the rate of interest and the money
supply in order to achieve targets set for employment, inflation, economic growth and the balance
of payments.


Fiscal policy
Fiscal policy involves using government spending and taxation in order to influence aggregate
demand in the economy.


Exchange rate policy
Some economists argue that economic objectives can be achieved through management of the
exchange rate by the Government. The strength or weakness of sterling's value, for example, will
influence the volume of UK imports and exports, the balance of payments and interest rates.


External trade policy
A government might have a policy for promoting economic growth by stimulating exports; for
example, by managing the exchange rate to make exports cheaper for foreign purchasers. Another
argument is that there should be import controls to provide some form of protection for domestic
manufacturing industries by making the cost of imports higher and the volume of imports lower.
Protection could encourage domestic output to rise, stimulating the domestic economy.

These policy tools are not mutually exclusive and a government might adopt a policy mix of monetary
policy, fiscal policy and exchange rate policy and external trade policy in an attempt to achieve its
intermediate and ultimate economic objectives.

1.3 Conflicts in policy objectives and instruments
Macroeconomic policy aims cannot necessarily all be sustained together for a long period of time;
attempts to achieve one objective will often have adverse effects on others, sooner or later.

There may be a conflict between steady balanced growth in the economy and full employment.
Although a growing economy should be able to provide more jobs, there is some concern that
since an economy must be modernised to grow and modern technology is labour saving, it might
be possible to achieve growth without creating many more jobs, and so keeping unemployment at
a high level.


In the UK, problems with creating more employment and steady growth in the economy have
been a lack of domestic and global demand following the global financial crisis, the balance of
payments, the foreign exchange value of sterling, inflation and the money supply. The objectives of
lower unemployment and economic growth have been difficult to achieve because of the problems
and conflicts with secondary objectives.

To create jobs and growth, there must be an increase in aggregate demand. When demand
picks up there will be a surge in imports, with foreign goods bought by UK manufacturers
(eg raw materials) and consumers.


For example, in the UK, the high rate of imports creates a deficit in the balance of
payments, which in turn will weaken sterling and raise the cost of imports, thus giving
some impetus to price rises.


To maintain the value of a country's currency, interest rates might need to be kept high,
and high interest rates appear to deter companies from investing.

In practice, achieving the best mix of economic policies also involves a number of problems, such as the


Inadequate information
Time lags between use of policy and effects being noticeable
Political pressure for short-term solutions

2: The economic environment for business  Part B Financial management environment

Unpredictable side effects of policies
The influence of other countries
Conflict between policy instruments

2 Fiscal policy

Fiscal policy seeks to influence the economy by managing the amounts which the Government spends
and the amounts it collects through taxation. Fiscal policy can be used as an instrument of demand

2.1 Fiscal policy and demand management
Key term

Fiscal policy is action by the Government to spend money, or to collect money in taxes, with the purpose
of influencing the condition of the national economy.
A government might intervene in the economy by:

Spending more money and financing this expenditure by borrowing


Collecting more in taxes without increasing public spending


Collecting more in taxes in order to increase public spending, thus diverting income from one
part of the economy to another

Government spending is an 'injection' into the economy, adding to total demand for goods and services in
the economy (known as aggregate demand) and therefore national income, whereas taxes are a
'withdrawal' from the economy. Fiscal policy can thus be used as an instrument of demand management
ie deliberate policies to stimulate and control the level of aggregate demand in an economy. Too little
demand creates unemployment, too much creates inflation.
Fiscal policy appears to offer a method of managing aggregate demand in the economy.

If the Government spends more – for example, on public works such as hospitals, roads and
sewers – without raising more money in taxation (ie by borrowing more) it will increase
expenditure in the economy, and so raise demand.


If the Government kept its own spending at the same level but reduced the levels of taxation, it
would also stimulate demand in the economy because firms and households would have more of
their own money after tax for consumption or saving/investing. This is an expansionary policy.


In the same way, a government can reduce demand in the economy by raising taxes or reducing
its expenditure. This is a contractionary policy.

2.2 Fiscal policy and business
Fiscal policy affects business enterprises in both service and manufacturing industries in various ways.
For example:

By influencing the level of aggregate demand (AD) for goods and services in the economy,
macroeconomic policy affects the environment for business. Business planning should take
account of the likely effect of changes in AD for sales growth. For example, a drop in AD might
mean lower demand from customers for a business's products and services. Business planning
will be easier if government policy is relatively stable.


Tax changes brought about by fiscal policy affect businesses. For example, labour costs will be
affected by changes in employment taxes. For example, if indirect taxes such as sales tax or excise
duty rise, either the additional cost will have to be absorbed or the rise will have to be passed on to
consumers in the form of higher prices.

Part B Financial management environment  2: The economic environment for business


3 Monetary policy

Monetary policy aims to influence monetary variables such as the rate of interest and the money supply in
order to achieve targets set, such as targets for the rate of inflation.
Money is important because:

It 'oils the wheels' of economic activity, providing an easy method for exchanging goods and
services (ie buying and selling).


The total amount of money in a national economy may have a significant influence on economic
activity and inflation.

3.1 The role and aims of monetary policy
Key term

Monetary policy is the regulation of the economy through control of the monetary system by operating on
such variables as the money supply, the level of interest rates and the conditions for availability of credit.
The effectiveness of monetary policy will depend on:

Whether the targets of monetary policy are achieved successfully


Whether the success of monetary policy leads on to the successful achievement of the
intermediate target (eg lower inflation)


Whether the successful achievement of the intermediate target (eg lower inflation) leads on to
the successful achievement of the overall objective (eg stronger economic growth)

3.2 Targets of monetary policy
Targets of monetary policy are likely to relate to the volume of national income and expenditure.

Growth in the size of the money supply

The level of interest rates

The volume of credit, or growth in the volume of credit

The volume of expenditure in the economy (ie national income or gross national product (GNP)

3.3 The money supply as a target of monetary policy
To monetarist economists, the money supply is a possible intermediate target of economic policy. This is
because they claim that an increase in the money supply will raise prices and money incomes, and this in
turn will raise the demand for money to spend.

3.4 Interest rates as a target for monetary policy
The authorities may decide that interest rates themselves should be a target of monetary policy. This
would be appropriate if it is considered that there is a direct relationship between interest rates and the
level of expenditure in the economy.
It certainly seems logical that interest rates should have a strong influence on economic activity.
However, although empirical evidence suggests there is some connection between interest rates and
investment (by companies) and consumer expenditure, the connection is not a stable and predictable one.
Some economists argue that the key element affecting investment is business confidence rather than the
level of interest rates. Interest rate changes are only likely to affect the level of expenditure after a
considerable time lag.
In 1997 the British Government gave responsibility for setting short-term interest rates to the central bank,
the Bank of England. The Bank sets rates at a level which it considers appropriate, given the inflation rate
target set by the Government. For example, if inflation is forecast to be excessive, increasing interest rates

2: The economic environment for business  Part B Financial management environment

should increase saving, reduce borrowing and reduce investment, thus reducing aggregate demand in the
economy. With lower aggregate demand, there is less pressure for suppliers to increase prices as they
struggle to hit sales targets, so inflationary pressure is reduced. The purpose of having the central bank
setting interest rates is to remove the risk of political influence over the decisions. In the European
Monetary Union (where the euro is the common currency), the interest rates that prevail are effectively set
at the European level.

3.5 Interest rate policy and business


Interest rate changes brought about by government policy affect the borrowing costs of business.
Increases in interest rates will mean that fewer investments show positive returns, deterring companies
from borrowing to finance expansion. Increases in interest rates will also exert a downward pressure on
share prices, making it more difficult for companies to raise monies from new share issues. Businesses
will also be squeezed by decreases in consumer demand that result from increases in interest rates.


Interest rate levels

Outline the effects on the economy of a policy of high interest rates to dampen demand and inflation.

An increase in interest rates is thought to reduce the money supply through demand for credit in the
economy, thereby reducing the level of effective demand. This will, in turn, decrease inflation and improve
the balance of payments (the latter by lowering the price of exports, increasing demand for them and
simultaneously increasing the relative price of imports, reducing demand for them, and freeing more
domestic output for sale abroad). Aggregate expenditure in the economy will decrease for various

A higher interest rate encourages savings at the expense of consumer expenditure.


Higher interest rates will increase mortgage payments and will thus reduce the amount of
disposable income in the hands of home buyers for discretionary spending.


The higher cost of consumer credit will deter borrowing and spending on consumer durables.


Higher prices of goods due to higher borrowing costs for industry will also reduce some
consumer expenditure in the economy.

Investment expenditure may also decline for two reasons.

Higher interest rates deter some investment due to increased borrowing costs.


Higher interest rates may make the corporate sector pessimistic about future business prospects
and the economy. This may further reduce investment in the economy.

To the extent that higher domestic interest rates lead to an appreciation of the exchange rate, this should
reduce inflation by lowering the cost of imported items. Exporters will experience pressure on their costs
as a result of the more competitive price conditions they face, and may be less willing to concede high
wage demands, thus wage inflation may be constrained. The desired outcomes of the authorities' interest
rate policy noted above may be negated by the following effects of higher interest rates.

Higher interest results in greater interest income for savers, who may increase their spending due
to this interest windfall.


Since mortgage payments are generally a significant part of domestic household expenditure, any
increase in them will be reflected immediately in reported inflation. This could lead to higher wage
demands in the economy, and may result in a wage-price spiral.


By encouraging capital inflows, higher interest rates will tend to lead to an appreciation of the
currency's exchange rate. This makes exports more expensive and imports less expensive.

Part B Financial management environment  2: The economic environment for business




A reduction in investment may decrease the pressure of demand in the economy but at the same
time will set in motion a process which in the future could reduce the economy's potential for
To the extent that higher interest rates squeeze demand in the economy, they will reduce
employment, decreasing the proceeds of taxation and increasing government expenditure on the

Case Study
US interest rates left unchanged by Federal Reserve
Analysts were divided over whether the Federal Reserve would raise interest rates or keep them as they
have been since December 2008. In fact, they left them unchanged with the aim of keeping them low until
employment levels increase. The inflation target is 2% but this has been kept down by cheaper oil and the
strong dollar. Before interest rates are raised, the Federal Reserve wants to be ‘reasonably confident’ that
inflation will increase.
Source: www.bbc.co.uk 17 September 2015

4 Exchange rates

Exchange rates are determined by supply and demand, even under fixed exchange rate systems.
Governments can intervene to influence the exchange rate by, for example, adjusting interest rates.
Government policies on exchange rates might be fixed or floating exchange rates as two extreme
policies, but 'in-between' schemes have been more common.

Key term

An exchange rate is the rate at which one country's currency can be traded in exchange for another
country's currency.
Dealers in foreign exchange make their profit by buying currency at one exchange rate, and selling it at a
different rate. This means that there is a selling rate and a buying rate for a currency.

4.1 Factors influencing the exchange rate for a currency
The exchange rate between two currencies is determined primarily by supply and demand in the foreign
exchange markets. Demand comes from individuals, firms and governments who want to buy a currency
and supply comes from those who want to sell it.
Supply and demand in turn are subject to a number of influences.

The rate of inflation, compared with the rate of inflation in other countries
Interest rates, compared with interest rates in other countries
The balance of payments
Government policy on intervention to influence the exchange rate

Other factors influence the exchange rate through their relationship with the items identified above.


Total income and expenditure (demand) in the domestic economy determines the demand for
goods. This includes imported goods and demand for goods produced in the country which would
otherwise be exported if demand for them did not exist in the home markets.

2: The economic environment for business  Part B Financial management environment


Output capacity and the level of employment in the domestic economy might influence the
balance of payments because, if the domestic economy has full employment already, it will be
unable to increase its volume of production for exports.


The growth in the money supply influences interest rates and domestic inflation.

We will look at the cause of exchange rate fluctuations in more detail in Chapter 19.

4.2 Consequences of an exchange rate policy
Reasons for a policy of controlling the exchange rate are as follows.

To rectify a balance of trade deficit, by trying to bring about a fall in the exchange rate


To prevent a balance of trade surplus from getting too large, by trying to bring about a limited rise
in the exchange rate


To stabilise the exchange rate of the currency, as exporters and importers will then face less risk
of exchange rate movements wiping out their profits; a stable currency increases confidence in the
currency and promotes international trade.

4.3 Fixed exchange rates
A government may try to keep the exchange rate at a fixed level against a major currency such as the US
dollar, or may try to keep it within a specified value range. However, if a government cannot control
inflation, the real value of its currency would not remain fixed. If one country's rate of inflation is higher
than others, its export prices will become uncompetitive in overseas markets and the country's trade
deficit will grow (or its trade surplus will diminish). Devaluation of the currency would be necessary for a
recovery. For example, a government may work to move the exchange rate from $2:£1 to $1:£1 so that
exports become less expensive.
If exchange rates are fixed, any changes in (real) interest rates in one country will create pressure for the
movement of capital into or out of the country. Capital movements would put pressure on the country's
exchange rate to change. It follows that if exchange rates are fixed and capital is allowed to move freely between
countries (ie there are no exchange controls) all countries must have consistent policies on interest rates.

4.4 Floating exchange rates
Key term

Floating exchange rates are exchange rates which are allowed to fluctuate according to demand and
supply conditions in the foreign exchange markets.
Floating exchange rates are at the opposite end of the spectrum to fixed rates. At this extreme, exchange
rates are completely left to the free play of demand and supply market forces, and there is no official
financing at all. The ruling exchange rate is, therefore, at equilibrium by definition.
In practice, many governments seek to combine the advantages of exchange rate stability with flexibility
and to avoid the disadvantages of both rigidly fixed exchange rates and free floating. Managed (or dirty)
floating refers to a system whereby exchange rates are allowed to float, but from time to time the
authorities will intervene in the foreign exchange market:

To use their official reserves of foreign currencies to buy their own domestic currency
To sell their domestic currency to buy more foreign currency for the official reserves

Buying and selling in this way would be intended to influence the exchange rate of the domestic currency.
Governments do not have official reserves large enough to dictate exchange rates to the market, and can
only try to 'influence' market rates with intervention.
Speculation in the capital markets often has a much bigger short-term impact than changes in
fundamental supply and demand.

Part B Financial management environment  2: The economic environment for business


4.5 European Economic and Monetary Union
There are three main aspects to the European Monetary Union.

A common currency (the euro)


A European Central Bank. The European Central Bank has several roles:
Issuing the common currency
Conducting monetary policy on behalf of the central government authorities
Acting as lender of last resort to all European banks
Managing the exchange rate for the common currency
A centralised monetary policy applies across all the countries in the union. This involves the
surrender of control over aspects of economic policy and therefore surrender of some political
sovereignty by the Government of each member state to the central government body of the union.


4.6 Exchange rates and business
A change in the exchange rate will affect the relative prices of domestic and foreign produced goods and
A lower exchange rate

A higher exchange rate

Domestic goods are cheaper in foreign markets so
demand for exports increases.

Domestic goods are more expensive in foreign
markets so demand for exports falls.

Foreign goods are more expensive so demand for
imports falls.

Foreign goods are cheaper so demand for imports

Imported raw materials are more expensive so
costs of production rise.

Imported raw materials are cheaper so costs of
production fall.

Fluctuating exchange rates create uncertainties for businesses involved in international trade. A service
industry is less likely to be affected because it is less likely to be involved in substantial international trade.
International trading companies can do a number of things to reduce their risk of suffering losses on
foreign exchange transactions, including the following.

Many companies buy currencies 'forward' at a fixed and known price.


Dealing in a 'hard' currency may lessen the risks attached to volatile currencies.


Operations can be managed so that the proportion of sales in one currency are matched by an
equal proportion of purchases in that currency.


Invoicing can be in the domestic currency. This means that the customer bears all the foreign
exchange risk, however, and, in industries where customers have high bargaining power, this may
be an unacceptable arrangement. Furthermore, there is the risk that sales will be adversely affected
by high prices, reducing demand.


Activities can be outsourced to the local market. Many of the Japanese car firms which have
invested in the UK in recent years have made efforts to obtain many of their inputs, subject to
quality limits, from local suppliers. Promotional activities can also be sourced locally.


Firms can aim at segments in the market which are not particularly price sensitive. For example,
many German car marques such as Mercedes have been marketed in the US on the basis of quality
and exclusivity. This is a type of strategy based on differentiation focus.

Foreign currency risk will be covered in more detail in Chapter 19.


2: The economic environment for business  Part B Financial management environment

5 Competition policy
5.1 Regulation and market failure

Key term

The Government influences markets in various ways, one of which is through direct regulation (eg the
Competition and Markets Authority in the UK).
Market failure is said to occur when the market mechanism (the interaction of supply and demand to
result in a market clearing price and quantity supplied/demanded) fails to result in economic efficiency,
and therefore the outcome is sub-optimal.
An important role of the Government is the regulation of private markets where these fail to bring about
an efficient use of resources. In response to the existence of market failure, and as an alternative to
taxation and public provision of production, the state often resorts to regulating economic activity in a
variety of ways. Of the various forms of market failure, the following are the cases where regulation of
markets can often be the most appropriate policy response.

Imperfect competition
Where one company's large share or complete domination of the market is leading to inefficiency
or excessive profits, the state may intervene, for example through controls on prices or profits, in
order to try to reduce the effects of this power.


Social costs
A possible means of dealing with the problem of social costs or externalities is via some form of
regulation. Regulations might include, for example, controls on emissions of pollutants, restrictions
on car use in urban areas, the banning of smoking in public buildings, or compulsory car insurance.


Imperfect information
Regulation is often the best form of government action whenever informational inadequacies are
undermining the efficient operation of private markets. This is particularly so when consumer
choice is being distorted.


The Government may also resort to regulation to improve social justice.

5.2 Types of regulation
Regulation can be defined as any form of state interference with the operation of the free market. This
could involve regulating demand, supply, price, profit, quantity, quality, entry, exit, information,
technology, or any other aspect of production and consumption in the market.
In many markets the participants (especially the firms) may decide to maintain a system of voluntary selfregulation, possibly in order to try to avert the imposition of government controls. Areas where selfregulation often exists include the professions (eg the Law Society, the British Medical Association and
other professional bodies).

5.3 Monopolies and mergers
Key term

In a pure monopoly, there is only one firm in the market, the sole producer of a good, which has no
closely competing substitutes.
A monopoly situation can have some advantages.

In certain industries arguably only by achieving a monopoly will a company be able to benefit from
the kinds of economies of scale (benefits of conducting operations on a large scale) that can
minimise prices.


Establishing a monopoly may be the best way for a business to maximise its profits.

Part B Financial management environment  2: The economic environment for business


However, monopolies often have several adverse consequences.

Companies can impose higher prices on consumers.


The lack of incentive of competition may mean companies have no incentive to improve their
products or offer a wider range of products.


There is no pressure on the company to improve the efficiency of its use of resources.

In practice, government policy is concerned not just with situations where one firm has a 100% market
share but also with other situations where an organisation has a significant market share.
The Competition and Markets Authority can also be asked to investigate what could be called 'oligopoly
situations' involving explicit or implicit collusion between firms, who together control the market.
The investigation is not automatic. Once the case has been referred, the Authority must decide whether or
not the monopoly is acting 'against the public interest'.
In its report, the Competition and Markets Authority will say if a monopoly situation has been found to
exist and, if so, will make recommendations to deal with it. These may involve various measures.

Price cuts
Price and profit controls
Removal of entry barriers
The breaking up of the firm (rarely)

Case Study
The healthcare giant Johnson & Johnson has become the latest foreign company to be accused of
misconduct in China.
A ruling by a Shanghai court ordered the US company to pay $85,000 (£56,000) to a local distributor for
violating anti-monopoly laws.
Two subsidiaries of the company were accused of setting a minimum price for the sale of surgical
Multinationals have faced increased scrutiny from the Chinese authorities.
Last month, two foreign milk suppliers announced price cuts after the Government launched an
investigation into possible price fixing.
Source: www.bbc.co.uk 2 August 2013
A prospective merger between two or more companies may be referred to the Competition and Markets
Authority for investigation if a larger company will gain more than 25% market share and where a merger
appears likely to lead to a substantial lessening of competition in one or more markets in the UK.
Again, referral to the Competition and Markets Authority is not automatic and, since the legislation was
first introduced, only a small proportion of all merger proposals have been referred.
If a potential merger is investigated, the Authority again has to determine whether or not the merger would
be against the public interest. As with monopolies, it will assess the relative benefits and costs in order to
arrive at a decision.



Look through newspapers or on the internet for a report on the activities of the Competition and Markets
Authority. Why is the investigation being carried out and how was it initiated?


2: The economic environment for business  Part B Financial management environment

5.4 Restrictive practices
Some countries have legislation which deals with restrictive practices that distort, restrict or prevent
competition. A notable example of a restrictive practice would be agreements with direct competitors
resulting in them colluding to the disadvantage of the consumer (eg price-fixing agreements). The
legislation may also deal with abuse of dominant position offences, such as predatory pricing (charging
low prices to unfairly destroy competition) or refusing to supply so as to restrict competition.

5.5 European Union competition policy
As a member of the European Union (EU), the UK is also now subject to EU competition policy. This is
enshrined in Articles 85 (dealing with restrictive practices) and 86 (concerned with monopoly) of the
Treaty of Rome.

5.6 Deregulation
Deregulation or 'liberalisation' is, in general, the opposite of regulation. Deregulation can be defined as the
removal or weakening of any form of statutory (or voluntary) regulation of free market activity.
Deregulation allows free market forces more scope to determine the outcome.
Deregulation, whose main aim is to introduce more competition into an industry by removing statutory or
other entry barriers, has the following potential benefits.

Improved incentives for internal/cost efficiency
Greater competition compels managers to try harder to keep down costs.
Improved allocative efficiency
Competition keeps down prices closer to marginal cost, and firms therefore produce closer to the
socially optimal output level.

In some industries it could have certain disadvantages, including the following.



Loss of economies of scale
If increased competition means that each firm produces less output on a smaller scale, unit costs
will be higher.
Lower quality or quantity of service
The need to reduce costs may lead firms to reduce quality or eliminate unprofitable but socially
valuable services.
Need to protect competition
It may be necessary to implement a regulatory regime to protect competition where inherent forces
have a tendency to eliminate it, for example if there is a dominant firm already in the industry, as in
the case of British Telecom. In this type of situation, effective 'regulation for competition' will be
required, ie regulatory measures aimed at maintaining competitive pressures, whether existing or

5.7 Privatisation

Privatisation is a policy of introducing private enterprise into industries which were previously stateowned or state-operated.
Privatisation takes three broad forms.


The deregulation of industries, to allow private firms to compete against state-owned businesses
where they were not allowed to compete before (for example, deregulation of bus and coach
services; deregulation of postal services)
Contracting out work to private firms, where the work was previously done by government
employees – for example, refuse collection or hospital laundry work
Transferring the ownership of assets from the state to private shareholders

Privatisation can improve efficiency in one of two ways.

Part B Financial management environment  2: The economic environment for business