Syllabus B. Financial Management Environment B1. The economic environment for business

Economic environment intro 1 / 6

Economic environment

The four major objectives are:

  1. Full employment

  2. Price stability

  3. A high, but sustainable, rate of economic growth

  4. Keeping the Balance of Payments in equilibrium.

Full Employment

  • Full employment was considered very important after the Second World War. 

    Unemployment in the 80s was seen as an inevitable consequence of the steps taken to make industry more efficient. 

    De-industrialisation made higher unemployment feel inevitable, and so this objective became much less important than it had been.

Growth & Low Inflation

  • Growth and low inflation have always been important. 

    Without growth peoples’ standard of living will not increase, and if inflation is too high then the value of money falls negating any increase in living standards.

    Sustainable growth means growth without inflation.

Balance of payments

The total of all the money coming into a country from abroad less all of the money going out of the country during the same period.

Policies to reduce a BOP deficit:

  1. Higher Interest Rates

    - will act to slowdown the growth of consumer demand and therefore lead to cutbacks in the demand for imports.

  2. Fiscal policy

    (i.e. increases in direct taxes) might also be used to reduce aggregate demand. 

    The risk is that a sharp fall in consumer spending might lead to a steep economic slowdown (slower growth of GDP) or an full-scale recession

Is a BOP Deficit a bad Thing?

  • Yes because….

    1. A current account deficit is financed through borrowing or foreign investment

    2. Borrowing is unsustainable in the long term and countries will be burdened with high interest payments. 

      E.g Russia was unable to pay its foreign debt back in 1998. Other developing countries have experience similar repayment problems Brazil, African c (3rd World debt)

      Foreigners have an increasing claim on home assets, which they could desire to be returned at any time. 

      E.g. a severe financial crisis in Japan may cause them to repatriate their investments

    3. Export sector may be better at creating jobs

    4. A Balance of Payments deficit may cause a loss of confidence

  • No because….

    1. Current Account deficit could be used to finance investment 

      E.g. US ran a Current account deficit for a long time as it borrowed to invest in its economy. 

      This enabled higher growth and so it was able to pay its debts back and countries had  confidence in lending the US money

    2. Japanese investment has been good for the UK economy not only did the economy benefit from increased investment but the Japanese firms also helped bring new working practices in which increased labour productivity.

    3. With a floating exchange rate a large current account deficit should cause a devaluation which will help reduce the level of the deficit

    4. It depend on the size of the budget deficit as a % of GDP, for example the US trade deficit has nearly reached 5% of GDP at this level it is concerning economists

    5. It may well be offset by foreign investment

NOTE: do not confuse objectives of macroeconomic policy with the instruments used to achieve these aims.

Low inflation is an objective, the rate of interest is an instrument used to control inflation.