Book 2 íV Part 1 Economic

1. Introduction

1.1 Economic Debate

  1. Classical: Market forces are able to achieve the optimal balance between supply and demand. So, unemployment (U) was the consequence of over-priced labour, as wages fell, employment would increase.
  2. Keynesian
  1. abandoned laissez faire economic management

ii. markets are not able to adjust automatically to eliminate unemployment.

à level of employment is a function not only of wage rate but also of aggregate demand (AD)

à imperfections in the market prevent the labour market from balancing, eg. lack of mobility, inappropriate skills

iii.economic implication

à market disturbances were self íVreinforcing

à eg.1: U +à AD - à U +

à Saving +, Consumption -, Delay investment à AD íV


à eg.2: U - à AD + à U íV

à .Government intervention is justified

à Government should intervene counter-cyclically íV stimulate demand in times of recession and dampening demand in times of boom. implication

à low-income groups tend to spend a higher proportion of their income than high-income groups à intervention that favours low-income groups will have a proportionately greater impact on AD

à discretionary intervention policy is to achieve social & political objectives (Equality, Distribution of income)

à fiscal policy: taxation and public expenditure (demand side: on infra-structure, supply side: on welfare)

à encourage economic agents to ast so as to increase AD (this can be explained in terms of game theory , eg collaborative action, in improving the outcome for all players)

à there is a trade-off between unemployment and inflation.

1.2 Growth of Monetarism (1980-90, Milton Friedman)

à economic problems in 1970 à inflation

à government intervention distorts the price signals & the mechanisms of the market, leading to inefficient resource allocation & persistent inflation.

à Distortion

  1. Taxes & subsidies distort prices, leading to sub-optimal resources use.
  2. Monopoly practices of trade unions, result in uneconomically high prices for labour.
  3. GovíŽt à AD + à inflation à confuses price signals à inefficient resource use.

à Economic policy à control inflation à inherently inflationary (G+)

à The control of money supply is the key to inflation.

à GovíŽt intervention vests too much power in the hands of govíŽt à govíŽt are unable to reflect properly the public interest, this leads to sub-optimal decision making à discretionary policy should be kept to a minimum à govíŽt should operate primarily in the area of Monetary Policy.

à Welfare state à self-perpetuating expenditure

à erosion of market incentive

à Inequalities in income are a vital part of the operation of price mechanism (higher skills & experienceà higher pay)

à Differential tax rates distort market signals à lower rates of output

à Free operation of market forces à maximise the creation of wealth

à Unemployment is a direct result of artificially high wage rate + welfare benefits that act as a disincentive to work

à Policies: P.11 Book 2

  1. Monetary Policy (Money supply + interest rate policy) à inflation
  2. High level of unemployment became politically tolerated
  3. Power of trades unions was reduced
  4. GovíŽt involvement in the economy declined
  5. Individual initiative and enterprise were fostered (Tax -)
  6. Collapse of the centrally-planned economies, replaced by free-market policies

1.3 Comparison of Keynesian & Neo-Classicist Philosophies, Table 1.2 P.12 Book 2

1.4 Future Challenges

à International competition and co-operation, distributional issues and sustainability of economic growth à past policies will be inadequate

1.41.International trade and investment à

a. international trade & investment à AD +

b.íV protectionism à AD +

  1. world trade organization à AD +

d. GovíŽt policy:

i. International Trade Agreements (increase inter-dependence):

à European Union

à North American Free Trade Association (Canada, Mexico, US)

à Association of South-East Asian Nations (ASEAN)

ii.Exchange Rate management

à AD/AS ( export & import)

à exchange rate stability à currency volatility impose costs on the economy and increase risk faced by producers and traders

à introduction of European Monetary Union, a single currency à remove currency volatility

à exchange rates will be set by market forces

à role of govíŽt will be to ensure the financial & fiscal policy that will prevent speculative opportunities for arising

à Facing with future challenge à develop skills, improve education & support the financing and development of new technologies become significant

1.42 Distribution of income

à appropriate & relevant skills need to be rewarded

à pursue policies to increase labour flexibility à favourable impact on employment

à job creation à mainly on secondary employment sector, (part-time, short-term) which lacks security or benefit, offer little opportunity for acquiring new skills or for career development à in long term, these jobs will be seriously threatened by competition from lower wage economies à the growth of the underclass, increase inequality in income distribution, increase social & political pressure.

1.43 Sustainability

à Main economic theories à objectiveà continuous economic growth ( questioned on moral & environment ground)

à Consumption + may be valued less than leisure + (Consumption vs Leisure)

à Optimal outcome can only be achieved by co-operation on global scale ( non-zero sum game)

2. Macro-economic drivers: Employment & Income

2.1 Economic cycles P.23, Book 2

  1. Economic indicators ( prices, wages, trade, interest rates, íK, GNP)
  2. Four phases in the long term cycle (Schumpeter)
  3. à prosperity, recession, depression and recovery

    à upswing à downswing

    à Are these cycles predictable? (Forecasting Technique)

    à Why there might be long economic cycles?

    à Long cycles are the result of bursts of innovation & entrepreneurialism that occur at the low point in the economic cycle.

    à Inventions occur discontinuously à stimulate economic growth both directly & through the secondary or multiplier effects of the increase in employment & consumption.

    à Result of Radical changes (Freeman)

  4. Short term cycle

à Keynesian

  1. level of expenditure & investment by firm was the key cause
  2. based on the expectation of firms about the future à firm invest (if have confidence about the future)

à Monetarists

  1. Money supply and its direct impact on levels of consumption is the cause of economic cycles

2.2 Influence of cycles on management decision-making

  1. Manager should address the issue of AD and future economic growth in the following ways:
  1. by use of macroeconomic models

à Manager should compare the outcomes of different models and will also be influenced by:

  1. the relevance of the variables included
  2. the modelíŽs theoretical structure (Keynesian, monetarist..etc)
  3. the plausibility of the assumptions
  4. the appropriateness of the time horizon used
  1. by appropriate planning of capacity
  2. à Capacity may refer to availability of staff or access to raw materials as well as physical plant

  3. by considering elasticity of demand for their products

à Elasticity of demand íV the sensitivity of demand for a product to changes in its price or in purchasersíŽ incomes (Price elasticity of demand & Income elasticity of demand)

à Marketing plans and sales projections will often focus on price elasticity

à The impact of macroeconomic variables is most likely to be felt on income elasticity. Eg. if the industry is one in which income elasticity is high, and if economic activity is expected to grow, then increase in demand for the good or service will be resulted.

à 2 additional factors that may influence future levels of demand, both relate to the role of govíŽt in influencing the direction of economic growth:

  1. Distribution of income (Keynesian in favour of govíŽt intervention that the proportion of income spent on consumption is higher amongst low-income groups than amongst high-income groupsà the distributive policies of the govíŽt will affect both the level and nature of demand)
  2. Regulatory policies (regulation is introduced either to correct market imperfections or to achieve social or political objectives)
  1. by adopting appropriate competitive strategies

à an understanding of the macroeconomic environment become an element of competitive strategy

à if investing anti-cyclically (pig industry P.28-29, Book 2) à increase profitability

that is: by bringing on new production at the time that price is rising, withdrawing from production at the time the market is peaking.

(Pig cycle: free entry, price rises, supply increases, price decreases, if low elasticity of demand, price continues to fall, producer reduces capacity, output declines, price begins to rise)

à Reasons why investors do not take advantage of strategic opportunities arising from economic cycles:

  1. Cycles are easier to recognise in retrospect than at the time.
  2. Timing is all important, we are less confident about the timing of the cycle.
  3. Bounded rationality, managers lack information for making optimal decision.
  4. Entry and exit costs. High fixed costs make it impractical to adjust output levels.
  5. Groupthink. Behavioural factors often prevent optimal decisions being made.

à thus, manager is not only required to understand the external drivers of the industry but also to use this understanding to create competitive advantage or to protect against competitive threats.

2.3 Unemployment

  1. Reduction in unemployment and improved distribution of income are objectives of govíŽtsíŽ economic policies
  2. Early 80s, high interest rate and control govíŽt expenditure to reduce inflation in Western Europe à high level of unemployment in 90s.
  3. Reason for labor market distortion:
  4. à Trade unions

    à Minimum wage regulation

    à Geographical immobility

    à The structure of benefit system

    à Social contributions levied on employers (tax on employer)

  5. Improving productive efficiency:

à Privatisation (Private ownership of asset)

à Deregulation (ending of monopolies)

à Industrial Policy (by creating expectations and confidence at macroeconomic level, providing incentives and support such as tax regimes, interest rate, exchange rate, investing in infra-structure)

à Training and education (increase competitiveness)


2.4 Distribution of Income

  1. The process of industrialisation and economic growth tends to lead towards greater equality in income distribution. This reflects both the increase in the waged population and the greater participation in political process as a result of urbanisation.
  2. Welfare state policies widely adopted after the Second World War result in the increasingly inequality of income distribution.

3. Macroeconomic drivers: interest & exchange rates

3.1 Dual role of interest rates and exchange rate:

  1. they are prices, reflecting the balance between supply and demand.
  2. They are policy instruments, used by govíŽt to achieve macroeconomic policy objectives.

3.2 Concept

  1. There are different forms of money & it performs several functions, either a medium of exchange or store of wealth.
  2. Money supply can be calculated at varies level.
  3. Liquidity of an asset is defined as the speed with which it can be converted to cash without loss of value.

3.3 Objectives of money supply policy

  1. Keynesian policies are based on management of AD, such management will include reflation, to reduce unemployment by raising investment in both the public and private sectors, which raises the demand for liquidity to enable increased levels of transactions.
  2. Monetarist: tight money supply to reduce inflation.

3.4 Demand-side intervention

  1. GovíŽt influence the demand for money by level of interest rates: high interest rates will depress demand for money. Interest rates generally come under the control of the central bank, which sets the inter-bank lending rate.
  2. Demand for money may not be sensitive to changes in the rate of interest.
  3. Rise in interest rates à reduce the profitability of firm, create opportunities for speculative movement of money across currencies, which increases exchange rate volatility and may affect the international competitiveness of the economy.

3.5 Supply-side intervention

  1. Issuing new bond / buy or sell bond by the central bank à increase/decrease monetary base.

3.6 Interest Rates

  1. By raising or lowering interest rates, govíŽt can have an influence on the demand for money. This is often the only tool available to govíŽt to break the inflationary cycle.

3.61 Issues for managers on interest rates:

  1. Direct impact:
  2. à impact on profitability

    à impact on the availability of funds for short or long term borrowing

    à impact on demand, pricing & costs (work through consumer & supplier)

  3. Long term prospects for demand & investment depend on expectations of price stability and the cost of money.
  4. Price stability will result in lower inflation and reduce economic volatility, but perhaps lower overall growth rates.

3.7 Exchange Rates

a. Exchange rates are a price at which the supply and the demand of a currency are balanced.

  1. International currency movement:

à Current account movement: buying & selling of funds for normal commercial transaction, ie. Purchase foreign product.

à Capital account movement: international lending & borrowing, international sale & purchase of financial assets, long terms assets including foreign direct investment & portfolio investment.

à Speculative transactions: short term capital account movements dominated by investors who are speculating on future currency moves. They are made possible by efficient high-technology telecommunications.

3.71 International currency markets are self-adjusting in long term

à As a country loses competitiveness, its currency should depreciate until it reaches a level at which competitiveness is restored.

à If a country has rising inflation and responds with an increase in interest rates, the currency will appreciate as investors are attracted to the higher interest rates.

à The appreciating currency will reduce the cost of imports and will dampen the demand for exports íV which will have a deflationary effect.

3.72 Currency markets are not self-adjusting in short term

à This volatility imposes a high cost on economies by creating uncertainty, adding to the risk of long-term investment and obliging firms to cover themselves against currency exposure.

à Reasons for this volatility:

  1. Enormous impact of information technology, markets are not perfect à not all decisions made are optimal, results in lags in response to changed indicators íV so-called stickiness, which creates the opportunity for speculation.
  2. Governments have sought to intervene the exchange rate market, including regulation & direct trading.
  3. Stickiness & govíŽt intervention creates opportunities for speculation.

3.73 Types of exchange rate system

à fixed exchange rate system

à floating exchange rate system

Implications of exchange rates for managers

à Environmental scanning undertaken by managers must extend beyond the domestic economy.

à In face of market pressure, contingency action may be taken.

à Discontinuity in the macroeconomic environment will create competitive opportunities & threats.

à Foreign exchange movements can create substantial financial risks à hedging is important.

à Investment plans should include extensive sensitivity analysis of the impact of changed exchange rate assumptions à impact of exchange rates on financial performance, both operationally and strategically.

Current macroeconomic issues

  1. Ideas of Keynes & Friedman are no longer generally accepted.
  2. The trend to deregulation and the break-up of state monopolies seems to continue.
  3. Political control of interest & exchange rates is gaining broad acceptance
  4. Social & political consequence of market forces - the high rate of unemployment - cause increasing concern.
  5. The neo-Keynesian emphasis on intervention, is directed at supply-side management - to improve the ability of the workforce to develop appropriate skills - rather than at attempts to manage AD.
  6. Increased labor flexibility has resulted in sustained economic growth and employment, at the expense of widening inequality and the emergence of an underclass.
  7. Shifts in macroeconomic direction will affect costs of labor & borrowing à importance for managers to scan the external macroeconomic environment and understand clearly the impact of economic drivers on their own organization.