The Macroeconomic Environment of Business - Essay Example

The Macroeconomic Environment of Business Part Q1. the different types of unemployment and explain what they consist of. Generally, there exist four types of unemployment namely, demand-deficient or cyclical unemployment, seasonal unemployment, frictional or search unemployment, and structural unemployment. Demand-deficient unemployment occurs when there is not enough demand to employ all those who want to work. It is also known as cyclical unemployment as it directly varies with business cycles. It can be noted that when the economy is booming, there is a strong demand for employees from various firms. This will cause a low level of demand-deficient unemployment level. However, during times of recession, demand for labor will drop thereby causing an increase in demand-deficient unemployment. Seasonal unemployment is due to the seasonality of available jobs. It often refers to certain types of jobs such as construction and migratory farm work. The third type of unemployment is known as frictional or search unemployment. This unemployment involves people being temporarily between jobs, searching for new ones; it is compatible with full employment. It is sometimes called search unemployment and is seen as largely voluntary. It arises because either employers fire workers or workers quit, usually because the individual characteristics of the workers do not fit the individual characteristics of the job including matters of the employer's personal taste or the employee's inadequate work effort. Structural unemployment involves a mismatch between the workers looking for jobs and the vacancies available. Even though the number of vacancies may be equal to the number of the unemployed, the unemployed workers lack the skills needed for the jobs - or are in the wrong part of the country or world to take the jobs offered. Structural unemployment is a result of the dynamic changes of a capitalist economy such as technological changes. Q2. What is the difference between demand side and supply side policies Explain what these policies consist of Supply-side economic policies are tools which aim to increase aggregate supply in order to attain economic growth and low inflation. The central concept of supply side economics is Says law which states that "supply creates its own demand," or the idea that one must sell before one can afford to buy. Therefore good economic policy encourages increased production, rather than attempts to stimulate demand. Basically, supply-side policies' main concern is affecting a tax rate which strongly encourages working and investment. Thus, supply side policy is essentially interested in the type of taxes levied and the specific tax rate. Supply-side economists contend that tax reductions will negate inflation and increase economic growth through the following: 1. Investment and Savings-Lower taxes will increase disposable income and increase household savings. Similarly, tax reductions on business will increase the profitability of investment. In short, lower taxes will increase both savings and investment which will result in a nation's stock of capital. 2. Work Incentives-Lower personal income tax rates increase after-tax wages and thus encourage work. As a result, any people not already in the labor force will offer their services, and those already in the labor force will want to work more hours and take fewer vacations. 3. Risk Taking-Lower taxes will encourage risk takers like entrepreneurs to invest. On the other hand, demand side policies' main goal is the promotion of economic growth by affecting the level of aggregate demand. Discretionary fiscal policy is where the government deliberately changes taxes or government expenditure in order to alter the level of aggregate demand. An example is lowering the income taxes in order for consumers to have more disposable income to spend for goods and services. The government can also use monetary policy to monitor the growth of the aggregate demand by (a) controlling the level of money supply directly, (b) controlling the demand for money regulating interest rates, or (c) rationing credit. Q3. What are the economic arguments for and against the creation of trading blocs such as the European Union and the North American Free Trade Area The world is becoming more integrated through rapid globalization. One of the recent economic trades is the creation and strengthening of trade blocs and unions like the European Union and North American Free Trade Area. A trade bloc is a group of countries having common identity, economic interests, and rules. There has also been a debate on the real economic impact of the elimination of trade barriers. The arguments for the creation of trade blocs and free trade zones which signifies the reduction or elimination of trade barriers are comparative advantage and specialization. Accordingly, the principle of comparative advantage states a country will gain from trade by specializing in the commodity which it has a comparative advantage. Thus, in order for a country to efficiently maximize its resources it should engage in trade. Aside from this, elimination of trade barriers will intensify competition between foreign and domestic firms driving down the price that consumers have to pay for commodities. This will also bring the influx of commodities which give more choices to buyers. The most common arguments against free trade is to protect the domestic firms from competition. It should be noted that when a country opens up for trade, the influx of cheaper goods will surely post a threat to domestic firms. They argue that domestic industries should be mature enough in order to compete against international firms. Part 2 Q1. What is multiplier Multiplier is the ratio of change in the equilibrium GDP to the change in investment or in any other component of aggregate expenditures or aggregate demand; the number by which a change in any component of aggregate expenditures or aggregate demand must be multiplied in order to find the resulting change in the equilibrium GDP. What is accelerator The accelerator is a causal relationship between increases in aggregate demand and national output, and the resulting increase in net investment. Net investment is a function of the change in output rather than the level of national output. The accelerator theory suggests that the level of net investment will be determined by the rate of change of national income. If national income is growing at an increasing rate then net investment will also grow, but when the rate of growth slows net investment will fall. How can the interaction of the multiplier and accelerator explain cyclical fluctuations in the national output There will then be an interaction between the multiplier and the accelerator that may cause larger fluctuations in the trade cycle. An increase in government expenditure may result to a mount in consumer income through the multiplier effect. This in turn can lead to an increase in output which may lead to higher investment through the accelerator process. This process is known to operate in a cyclical trend. Q2. Define the term liquidity ratio. Generally, liquidity ratio measures the extent to which a corporation or other entity can quickly liquidate assets and cover short-term liabilities, and therefore is of interest to short-term creditors. For a bank this is the cash held by the bank as a proportion of deposits in the bank. How will the changes in the liquidity ratio affect the process of credit creation by the banking system The proper functioning of a bank is often dependent on the cash and liquid assets that it has on hand. A bank must be liquid enough in order to cover the withdrawals which are demanded by its account holders. Also, the bank needs liquid assets like cash which can be extended to individuals who want to acquire credit. The liquidity ratio of a bank significantly affects its credit creation. As stated above, the amount of cash which is held by the bank which in turn is reflected on its liquidity ratio. It can be deduced that if the bank's liquidity ratio is low, it is also expected that the credit creation in the economy is low. This is because the bank has low cash on hand to extend to potential creditors. In contrast, the higher the bank's liquidity ratio is in general, the higher the credit creation in the economy. Q3. Why do governments experience budget deficits Budget deficit is a condition where the government's spending is higher than the level of income it generates. For a clearer discussion we should note that the government's basic expenditures are on public welfare such as the construction of facilities, subsidies, debt servicing, military spending, education and others. On the other hand, the government's main source of income is in the collection of taxes. Thus, when the government cannot pose a balance between its goals of enhancing public welfare and generating enough income, budget deficits occur. One of the main causes of budget deficit is the occurrence of business cycle. In this point, it can be noted unemployment is high. Because of this, the company cannot collect sufficient taxes. This is even aggravated by the higher expenditure for social security during recession. The government can also experience deficit due to exchange rate fluctuations, especially those which are indebted to global organizations like the International Monetary Fund and World Bank. Debt servicing is one of the priorities of indebted developing nations. However, as the value of the currencies of these developing nations fall relative to dollars, their budget for debt servicing in terms of the domestic currency rises. This leads to budget deficit. Part 3 Q1. What is fiscal policy Fiscal policy describes the actions of a government in setting the level of public expenditure and how that expenditure is funded. These consist of deliberate changes in government spending and tax collections to achieve full employment, control inflation, and encourage economic growth. The tools used by the government are tax collections and government expenditures or a combination of both. Generally, there are two types of fiscal policy-contractionary and expansionary. Contractionary fiscal policy is used to decrease aggregate output and lower inflation. In order to do this, the government decreases its purchases of goods and services, increasing net taxes, or a combination of both. On the other hand, expansionary fiscal policy aims to increase aggregate demand as well as expand national output. Expansionary policy involves increasing government purchases of goods and services, lowering net taxes, or a combination of both. What problems are associated with the implementation of fiscal policy There are common problems associated with fiscal policy: 1. Problems of Timing-The goal of fiscal policy would only be attained if the policies are implemented in the right time. Three types of time lag can occur which can dampen the effect of fiscal policy namely recognition lag, administrative lag, and operational lag. 2. Political Business Cycle-Politicians can pursue their interests and can pursue fiscal policies which can adversely affect the economy. Fiscal policy might be corrupted for political purposes which can cause economic fluctuations called political business cycles. 3. Crowding Out-This is specifically a critic of expansionary fiscal policy. An expansionary fiscal policy (deficit spending) will increase the interest rate and reduce private spending, thereby weakening or canceling the stimulus of the expansionary policy. This will render fiscal policy ineffective. 4. Fiscal policy may be rendered ineffective or inappropriate by unforeseen events occurring within the borders of international trading partners. 5. Fiscal policy may precipitate changes in exchange rates that weakens its effects. 6. Supply side economists contend that traditional fiscal policy fails to consider the effects of tax changes on aggregate supply. Q2. What improves aggregate supply within the economy The aggregate supply measures the volume of goods and services produced within the economy at a given aggregate price level. In general, there are three variables which determine the level of aggregate supply. These are: input prices, productivity, and the legal institutional environment. Improvements in the aggregate supply in the economy can be triggered by the changes in these factors. The increase in domestic resource (land, labor, capital, and entrepreneurial ability) availability can generally improve aggregate supply. Improvement in the productivity of resources as well as more relaxed business policies will have a positive impact on aggregate supply. Specific examples are: 1. increase in the size and quality of labor force available for production 2. increase in the size and capital of capital stock through investment 3. technological progress and innovation 4. increase in factor productivity of both labor and capital 5. lower wages 6. lower producer taxes 7. lower inflation expectations What causes unemployment in the economy The causes of unemployment can be split into two categories namely, demand side and supply side. Looking at the demand side, the main causes of unemployment is simply the lack of aggregate demand. In this case, unemployment is caused by the lack of employers hiring employees for their operations. Supply-side causes of unemployment are high wages, and occupational or geographic immobility. Another cause of unemployment is the change in workforce. An example of this is the baby boom which increased the number of potential employees. Unemployment rose because the market was not able to adjust to provide the number of jobs needed. Q3. What factors has prompted the globalization of business that is, increasing international trade and international investment It is irrefutable that the world is rapidly being transformed into a global village. This is even highlighted by the current increasing international trade and international investments. This phenomenon is known as globalization. The events which prompted the integration of markets can be classified into three categories-political, technological, and financial. In terms of political factors, the rise of globalization is facilitated by the emergence of trade unions, free trade zones, and free trade blocs. It should be noted that the past century saw integration of nations as they pursue economic growth. The recognition that free trade brings huge advantages to participating nations became a key in the establishment of NAFTA and European Union. Through this, trade barriers are eliminated thereby facilitating the free flow of goods and services within nation's geographical boundaries. Technological revolution also played a huge role in the integration of markets. An specific example is the creation of internet which allows suppliers and customers in different nations to interact online. Globalization also encompasses the unification of the financial market. The removal of barriers to foreign direct investments allows investors to invest their money in lucrative nations. Q4. What is the relationship between a country's balance of payments and exchange rate of its currency A country's balance of payments (BOP) reflects its transactions within the global community. Since the balance of payment involves transactions within two parties in the world, the goods and services which cross the countries' borders are often bought and sold in a currency other than theirs. For example, the widely accepted payment for goods and services is the US dollar. So, countries which want to have foreign goods may need to exchange their domestic currency to dollar. From this, we can see that the exchange rate between countries is one of the significant factors which determine the amount of the balance of payments. There are three types of exchange rate regimes which can be adopted by a nation-fixed exchange rate, managed float, and floating exchange rate. The implementation of either of these systems has a huge impact on the amount of a nation's BOP. In a fixed exchange rate regime, BOP is always equal to zero. In here, balance on current account or capital account must be of equal magnitude and opposite sign. In a managed float, if the government manages the exchange rate by driving up it value, the country will have a BOP deficit. Alternatively, driving down the domestic currency value will produce a BOP surplus. In the floating exchange rate regime, an increase the value of the dollar relative to the yen, then the US will have a BOP deficit and Japan will have a BOP surplus, regardless of which government actually does the intervention. Part 4 Q1. Explain the following terms. a. credit creation Credit creation is the process by which banks make loans. Often the amount of credit creation is subject to regulation. Lenders may have limits on the amount of loans they can make relative to the assets they have, so that they run little risk of bankruptcy. A central bank tries to keep the amount of credit creation below the level at which it would increase the money supply so much that inflation accelerates. This was never easy to get right even when most lending was by banks, but it has become much harder with the recent growth of non-bank lending, such as by credit-card companies and retailers. b. liquidity and reserve requirements A bank's liquidity is often tied with the amount of cash that it has in hand. Banks must ensure that they are "liquid" enough or have enough cash available should depositors want or need to withdraw cash. The reserve requirement (or required reserve ratio) is a bank regulation that sets the minimum reserves each bank must hold to customer deposits and notes. These reserves are designed to satisfy withdrawal demands, and would normally be in the form of fiat currency stored in a bank vault (vault cash), or with a central bank. c. economic growth Economic growth is the increase in the value of goods and services produced by an economy. It is generally considered to be an increase in the wealth, or more precisely the income, of a nation or entity. It is conventionally measured as the percent rate of increase in real gross domestic product or GDP. Growth is usually calculated in real terms, i.e. inflation-adjusted terms, in order to net out the effect of inflation on the price of the goods and services produced. In economics, "economic growth" or "economic growth theory" typically refers to growth of potential output, i.e., production at "full employment," rather than growth of aggregate demand or observed output. The ingredients of economic growth include (a) four supply factors (increases in the quantity and quality of natural resources, increases in the quantity and quality of human resources, increases in the stock of capital goods, and improvements in technology), (b) a demand factor, (c) an efficiency factor (achieving economic efficiency). d. fiscal drag Fiscal drag refers to the effect inflation has on average tax rates. If tax allowances are not increased in line with inflation, and people's incomes increase with inflation then they will be moved up into higher tax bands and so their tax bill will go up. However, they are actually worse off because inflation has cancelled out their pay rise and their tax bill is higher. The only person that is better off is the Chancellor as he is getting more tax and hasn't had to increase tax rates. Chancellors have been known to use this as a subtle means to raise more tax revenue. To maintain average tax rates, allowances should be increased by the amount of inflation each year. e. multinational corporations A multinational corporation (MNC) or multinational enterprise (MNE) or transnational corporation (TNC) or multinational organization (MNO) is a "corporation/enterprise that manages production establishments or delivers services in at least two countries." Multinational corporations (MNC) are often divided into three broad groups: (a) horizontally integrated multinational corporations which manage production establishments located in different countries to produce same or similar products; (b) vertically integrated multinational corporations which manage production establishment in certain country/countries to produce products that serve as input to its production establishments in other country/countries, and (c) diversified multinational corporations manage production establishments located in different countries that are neither horizontally nor vertically integrated. f. supply side policy Supply-side economic policies are tools which aim to increase aggregate supply in order to attain economic growth and low inflation. The central concept of supply side economics is Says law which states that "supply creates its own demand," or the idea that one must sell before one can afford to buy. Therefore good economic policy encourages increased production, rather than attempts to stimulate demand. Basically, supply-side policies' main concern is affecting a tax rate which strongly encourages working and investment. g. balance of payments The balance of payments is the sum of all the transactions that take place between a nation's residents and the residents of all foreign nations. Those transactions include exports and imports of goods, exports and imports of services, tourists expenditures, interest and dividends received or paid abroad, and purchases and sales of financial or real assets abroad. The BOP is divided within into three main categories: the current account, the capital account, and the financial account. The current account is used to mark the inflow and outflow of goods and services into a country. Earnings on investments, both public and private, are also put into the current account. The capital account is where all international capital transfers are recorded. This refers to the acquisition or disposal of non-financial assets (for example, a physical asset such as land) and non-produced assets, which are needed for production but have not been produced, like a mine used for the extraction of diamonds. In the financial account, international monetary flows related to investment in business, real estate, bonds and stocks are documented. h. floating exchange rates A floating exchange rate is a rate of exchange which is determined by the private market by the supply and demand. It should be noted that in this type of exchange rate, market forces are allowed to determine the value of a currency without any intervention from the government. A floating rate is often regarded as "self-correcting" because any differences in supply and demand will automatically be corrected in the market. An example in a simplified model is given: "if demand for a currency is low, its value will decrease, thus making imported goods more expensive and thus stimulating demand for local goods and services." This in turn will generate more jobs, and hence an auto-correction would occur in the market. It should also be noted that a floating exchange rate is constantly changing. i. aggregate demand Aggregate demand is the total demand for goods and services in the economy (Y) during a specific time period. It is often called effective demand. Put another way, it is the demand for the gross domestic product of a country when, and only when, it is in equilibrium (the total new production sold through the market). This demand consists of four major parts, which can be stated in either nominal or "real" terms: 1. personal consumption expenditures (C) or "consumption," demand by households and unattached individuals; its determination is described by the consumption function. 2. gross private domestic investment (I), demand by business firms and some individuals, for new factories, machinery, computer software, housing, other structures, and inventories. 3. gross government investment and consumption expenditures (G). 4. net exports (NX and sometimes (X-M)), i.e., net demand by the rest of the world for the country's output. j. the multiplier Multiplier is the ratio of change in the equilibrium GDP to the change in investment or in any other component of aggregate expenditures or aggregate demand; the number by which a change in any component of aggregate expenditures or aggregate demand must be multiplied in order to find the resulting change in the equilibrium GDP. The multiplier effect - or, more completely, the spending/income multiplier effect - occurs when a change in spending causes a disproportionate change in aggregate demand. It is particularly associated with Keynesian economics as some other schools of economic thought reject or downplay the importance of multiplier effects particularly in the long run k. the Euro The euro is the official currency of the European Union and single currency for over 300 million Europeans in the following twelve European Union member states: Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal and Spain; collectively also known as the eurozone. Due to bilateral agreements it is the official currency of the following non-member states: Monaco, San Marino, and Vatican City. It is the de facto currency of Andorra, Kosovo and Montenegro. The euro was introduced to world financial markets as an accounting currency in 1999 and launched as physical coins and banknotes in 2002. All EU member states are eligible to join if they comply with certain monetary requirements, and use of the euro is mandatory for all new EU members. l. Inflation Inflation refers to the continual increase in prices. The value or purchasing power of money refers to the amount of goods or services one pound can buy. Inflation means the value of money is falling because prices keep rising. Irrefutably, inflation has a huge impact in the economy. Among the advantages are the following: 1. The government finds that people earn more and so pay more income tax. 2. Firms are able to increase prices and profits before they pay out higher wages. 3. Debtors (borrowers) gain because they have use of money now, when its purchasing power is greater. However, inflation is also detrimental to the economy. 1. People on fixed incomes are unable to buy so many goods. 2. Creditors (savers) lose because the loan will have reduced purchasing power when it is repaid. 3. UK goods may become more expensive than foreign-made products so the balance of payments suffers. 4. Industrial disputes may occur if workers are unable to secure wage increases to restore their standard of living. Read More