FINANCIAL MANAGEMENT Principles and Applications Volume I 2015 Edition MA. ELENITA BALATBAT CABRERA BBA MBA CPA CMA PRESENTLY: Academic and Business Consultant President and CEO, CLA Consultancy and Training Center, Inc. FORMERLY: Vice Chairman, Professional Regulatory Board of Accountancy World Bank Consultant Dean, College of Business Administration, Lyceum University of the Philippines CPA Review Director & Reviewer, Professional Review and Training Center, Inc. Professor of Accounting & Finance, University of the East, Far Eastern University, De La Salle University, Centro Escolar University, St. Scholastica’s College Audit Staff, SGV and Co., CPAsContents in Brief Preface _ ——ENTALS OF ee [PARTI FUNDAMENTALS OF FINANCIAL MANAGEMENT 7 unit | Introduction to Financial Management 1 Chapter | NATURE, PURPOSE AND SCOPE OF FINANCIAL MANAGEMENT 2. RELATIONSHIP OF FINANCIAL OBJECTIVES TO ORGANIZATIONAL STRATEGY AND OTHER v ORGANIZATIONAL OBJECTIVES 12 3. FUNCTIONS OF FINANCIAL MANAGEMENT 25 4 FORMS OF BUSINESS ORGANIZATION 34 unit The Framework of Financial Management : 4B Chapter 5 APPLICATIONS OF MICROECONOMICS THEORY AS A BASIS FOR UNDERSTANDING THE KEY ECONOMIC VARIABLES AFFECTING THE BUSINESS 44 6 APPLICATIONS OF MACROECONOMICS THEORY AS A BASIS FOR UNDERSTANDING THE Key ECONOMIC VARIABLES AFFECTING THE BUSINESS 74 7 COMPETITION AND POLICIES TOWARDS MONOPOLIES AND OLIGOPOLIES, PRIVATIZATION AND DEREGULATION 109 Unit I Effects of the Economic Environment on Business Strategy : 129 Chapter 8 UNDERSTANDING THE ROLE OF THE FINANCIAL 2 MARKETS AND INSTITUTIONS 130 9 INTERNATIONAL TRADE 146 10 THE TIME VALUE OF MONEY 169 Unit V Evaluating Operating and Financial Performance tot Chapter 11 UNDERSTANDING FINANCIAL STATEMENTS ei 12. ANALYSIS OF FINANCIAL STATEMENTS ea 13. CASH FLOW ANALYSIS . 300 - 14 OPERATING AND FINANCIAL LEVERAGEUnit V Financial Forecasting, Planning and Control 15 16 FINANCIAL FORECASTING FOR STRATEGIC GROWTH FORECASTING SHORT-TERM (OPERATING) FINANCIAL REQUIREMENTS Unit VI Working Capital Management Chapter 17 18 19 20 Appendix Table 1 2 3 4 5 6 List of References ADDRESSING THE WORKING CAPITAL POLICIES AND MANAGEMENT OF SHORT-TERM ASSETS AND LIABILITIES (CASH AND MARKETABLE SECURITIES MANAGEMENT ACCOUNTS RECEIVABLE AND INVENTORY MANAGEMENT SHORT-TERM SOURCES FOR FINANCING CURRENT, ASSETS ‘ FUTURE VALUE OF P1 PRESENT VALUE OF P1 FUTURE VALUE OF AN ORDINARY ANNUITY.OF P1 PRESENT VALUE OF AN ORDINARY ANNUITY OF P1 FUTURE VALUE OF AN ANNUITY DUE OF P1 PRESENT VALUE OF AN ANNUITY DUE OF P1 364 395 421 453 479 dit 394 A-L A-3 A-S A-7 A-llContents Preface i [PARTI FUNDAMENTALS OF FINANCIAL MANAGEMENT aa unitt Introduction to Financial Management Chapter 1 NATURE, PURPOSE AND SCOPE OF FINANCIAL, MANAGEMENT Learning Objectives Nature of Financial Management The Goal of Financial Management Scope of Financial Management Types of Financial Decisions Significance of Financial Management Relationship Between Financial Management and Accounting Financial Management and Economics WURWWN 20 Review Questions and Problems 10 Chapter 2 RELATIONSHIP OF FINANCIAL OBJECTIVES TO ORGANIZATIONAL STRATEGY AND OTHER . ORGANIZATIONAL OBJECTIVES 12 Learning Objectives Introduction Strategic Financial Management 14 Financial Objectives of a Business Organization 15 Responsibilities to Achieve the Financial Objectives \7 Investing 7 Financing 18 Operating . 19 Environmental (“Green”) Policies and Their Implications for the Management of the Economy and Firm 20 Review Questions and Problems a2Chapter 3) FUNCTIONS OF FINANCIAL MANAGEMENT Learning Objectives Role of Finance Manager The Finance Organization Relationship with Other Key Functional Managers in the Organization Corporate Governance Ethical Behavior Review Questions and Problems ' Chapter 4 FORMS OF BUSINESS ORGANIZATION Learning Objectives The Organization of the Business Firm Legal Forms of Business Organization Proprietorship Nature Advantages Disadvantages Partnership Nature Advantages Disadvantages Corporation Nature Advantages Disadvantages Review Questions and Problems Unit It The Framework of Financial Management 5 APPLICATIONS OF MICROECONOMICS THEORY AS A BASIS FOR UNDERSTANDING THE KEY ECONOMIC VARIABLES AFFECTING THE BUSINESS Chapter Learning Objectives ‘| Introduction to Microeconomics mu Demand Nature Demand Curve Shift 25 26 27 28 30 31 25 34 4Chapter 6 Factors Affecting the Demand of a Product Other than its Price The Elasticity of Demand Supply Nature Eee sn urve eae Affecting the Demand of a Product Other than its Price Elasticity of Supply Market Equilibrium and Pricing Impact on Equilibrium of Shifts in the Supply and Demand Schedule Short-run Total Costs Long-run Total Costs Profits Production Marginal Product Money and Interest Rates The Role of Money in the Economy The Supply and Demand for Money Money Supply The Demand for Money The Impact of Money The Quantity Theory of Money Interest Rates How Interest Rates are Determined Money Market Equilibrium The Nominal or Money Rate Versus the Real Rate of Interest Interest Rates and Risk Effect of Change in Interest Rates Review Questions and Problems APPLICATIONS OF MACROECONOMICS THeory Asa BASIS FOR UNDERSTANDING THE KEY ‘CONOMIC VARIABLES AFFECTIN BUsINEss i se Learning Objectives Introduction to Macroeconomics ? e Flow of Goods and Services nificance of. Macroeconomics ‘aleulation oj of Gross Dor ic Aserégaie Denenda eee Product 74vii Production 81 Inputs in the Production Pr Capital, Land, Intermediate Labor, Inputs, and Business Know-How 81 Short-term Profit Maximization and Long-term Decision 82 Business Cycles 82 Peak 82 Recession 82 Trough 83 Expansion 83 The Impact of Recession on Busine: 83 Fiscal Policies: Their Nature and E Economy 84 Impacts of Fiscal Policy 86 Monetary Polic' Their Nature and Effect on Economy 86 Goals of Monetary Policies 87 Controlling Inflation 87 Smoothing Out the Business Cycle 89 Ensuring Financial Stability 90 Monetary Policy versus Fiscal Policy 90 Long-term Effects of Monetary Policy ol Monetary Policy Tools 92 Control over Short-term Interest Rates 92 The Discount Window 93 The Reserve Requirement and Other Regulations 94 Nature of Supply-Side Policies 95 Review Questions and Problems 97 Chapter 7 COMPETITION AND POLICIES TOWARDS MONOPOLIES AND OLIGOPOLIES, PRIVATIZATION AND DEREGULATION 109 Learning Objectives 109 Competition 110 Price Takers 110 Price Searchers Ww Significance of Competition MW Income Inequality and Poverty 2 Market Entry Barriers 114 Economies of Scale 4 Control over an Essential Resource 114 Government Licensingvill Patents Monopoly Model Oligopoly Market Price and Output under Oligopoly Financial Management in Public Sector Ineffectiveness, Inefficiency and Corruption in PSEs Ways to Reform PSEs Objectives of Disinvestment/Privatization Arguments for/against Disinvestment/Privatization Process Review Questions and Problems Unit Ht Effects of the Economic Environment on Business Strategy Chapter 8 UNDERSTANDING THE ROLE OF THE FINANCIAL MARKETS AND INSTITUTIONS Learning Objectives Introduction : Structure and Function of the Financial Markets Types of Markets Financial Institutions Categories of Financial Institutions The Stock Markets Kinds of Stock Market Reasons for Transactions in Stock Market Meaning of Stock Exchange Listing of Securities on Stock Exchange Top Five Publicly Listed Companies Classified according to Industries as of September 30, 2011 Review Questions Chapter 9 INTERNATIONAL TRADE Learning Objectives Historical Perspective of International Free Trade Gains from International Trade Obstacles to Free Trade Foreign Exchange Rates Factors Influencing Exchange Rates 1s 116 V7 lig 119 120 120 121 124 130 131 132 132 133 133, 134 135 135 136 137 138 142 146 147 147 149 150 150 130 146ix Interaction in Foreign Currency Markets 151 Exchange Rate Determination 151 Fixed Exchange Rate 151 Managed Float 152 Spot Rates and Forward Rates 152 Cross Rates 154 Managing Fi ‘oreign Exchange Risk 154 Avoidance of Exchange Rate Risk in Foreign Currency Markets 455 Foreign Investment Decisions 1ST Analysis of Foreign Investments 157 Funding of Foreign Transactions 158 Balance of Payments . 158 Current Account 158 Capital Account 159 Official Reserves Account 159 International Institutions and Agreements 159 International Monetary System 159 Multinational Corporations 160 International Trade Agreements 161 Review Questions and Problems 162 Chapter 10 THE TIME VALUE OF MONEY 169 Learning Objectives 169 Introduction « 170 Simple Interest x 170 Compound Interest WN Simple Interest Compared with Compound Interest 172 Future Value — Annual Compounding 172 Determination of Future Value UsingaTable - 173 Future Value with Intraperiod Compounding 174 Nominal Interest Rate Compared with Effective Interest Rate 175 Determination of the Future Value of a Stream of Payments 176 Stream of Unequal Payments 176 Stream of Uniform/Equal Payments 177 Ordinary Annuity 117 Annuity Due 178 Present Value 179. Discounting 179 Determination of Present Value Using a Table 181Unit IV Chapter Chapter Determination ofthe Present Value of a Stream of Payments Unequal or Uneven Stream Payments Uniform or Equal Stream Payments : Determination of the Present Value of a Perpetuity Determination of Annual Growth or Interest Rate Review Questions and Problems Evaluating Operating. and Financial Performance 12 UNDERSTANDING FINANCIAL STATEMENTS Learning Objectives Introduction How Business Activities are Reported General Objectives of Financial Statements Information about a Business Enterprise . Benefits of | Disclosure Costs of Disclosure Constraints on Relev, Financial Statement Linkage of Financial Statements Balance Sheet Statement Statement of ‘Comprehensive Income Statement Of Stockholders’ Equity Statement of Cash Flows ‘ant and Reliable Information Review Questions and Problems ANALYsis OF FINANCIAL STATEMENTS, Learning Objectives Anaelal Analysis Defined nalyzing the Broader Busin i ess Envir {asics °f Profitability Analysis en ‘Mitations of Financial Statements Analysis Ra na 0 Analysis 8 Used to Ey, ut Short-term Ringn ite 18} 181 182 183, 184 185 192 193 193 194 195 197 197 198 198 199 200 203 205 207 208 210 221 222 222 223 224 225 226 227 229 192 221Chapter Chapter Mlustrative Case 12.1. Financial Statements Analysis using Ratios The DuPont Disaggregation Analysis Review Questions and Problems 13 CASH FLOW ANALYsIS Learning Objectives Introduction Usefulness of the Statement of Cash Flows How the Statement of Cash Flows is Used in Measuring the Firm's Financial Liquidity Financial Flexibility Free Cash Flow The Basic Approach to a Cash Flow Statement Definition of Cash Classification of Cash Flow Activities Operating Activities Investing Activities Financing Activities Content and Form of the Statement of Cash Flows Calculating Cash Flow from Operating Activities Direct Method Indirect Method Illustrative Case 13-1. Worksheet Preparation (Indirect Method) Review Questions and Problems 14 OPERATING AND FINANCIAL LEVERAGE Learning Objectives Introduction Leverage in a Business CVP Analysis Basic Concept Breakeven Planning Revenue and Cost Planning Assumptions and Limitations Sales Mix Operating Leverage Degree of Operating Leverage Limitations of Analysis 232 252 257 272 273 274 277 277 277 278 278 278 278 279 280 281 283 283 283 290 300 301 301 302 302 303 304 304 306 307 307 309 272 300xi Unit V Chapter Chapter Financial Leverage Degree of Financial Leverage pasiterions to Use of Financial Leverage Comping Operating and Financial Leverage Review Questions and Problems Financial Forecasting, Planning and Control 15 16 FINANCIAL FORECASTING FOR STRATEGIC GRowTH Learning Objectives Introduction Concept of Financial Planning Growth as Financial Management Goal Perspective of Financial Planning Benefits from Financial Planning Financial Planning Models ‘Elements of Financial Planning Determinants of ‘Growth Rates Financial Planning Process The Project Fi ‘inancial Statement Method Illustrative Case 15.1. Financial Forecasting (Percent af Sales Method) Illustrative Case 15.2. Projected Financial ‘Statements with Financing Feedback Analysis of the Forecast Review Questions and Problems / fi FORECASTING SHORT-TERM (OPERATING) FINANCIAL REQUIREMENTS. Learning Objectives Financial Planning and Control Process Budgeting Defined Purposes of the Budget Advantages and Limitations of Budgets Types of Budgets Steps in Developing a Master Budget Illustrative Case 16.1. Comprehensive Master Budget Preparation . Review Questions and Problems 313 316 317 317 320 337 338 338 338 339 339 341 341 341 343 344 345 349 354 355 364 366 367 367 368 369 370 371 382 337 364Unit Vt Working Capital Management Chapter 17 | POLICIES RM ASSETS Learning Objectives Introduction; Reasons Why Working Capltal Management is Important Factors Affecting the Firm's Working Capital Policy Tracing Cash and Net Working Capital The Operating Cycle The Cash Conversion Cycle How Operating Cycle can be Reduced Some Aspects of Short-term Financial Policy Alternative Policies as to the Size of Investment in Current Assets Costs Relevant to Investment in Current Assets Alternative Strategies in Financial Working Capital Which Financial Policy Should be Chosen Review Questions and Problems Chapter 18 CASH AND MARKETABLE SECURITIES MANAGEMENT Learning Objectives Introduction Objective of Cash Management Reasons for Holding Cash Balances Determining the Target Cash Balance Cash Budget Cash Break-even Chart Optimal Cash Balance The Baumol Model The Miller-Orr Model Other Factors Influencing the Target Cash Balance Cash Management Techniques ‘Synchronizing Cash Flows Using Floats Accelerating Cash Collections Slowing Disbursements Reducing the Need for Precautionary Balance Marketable Securities Management 396 397 398 399 400 403 405 405 407 409 412 414 421 422 422 423 424 424 424 426 426 429 431 431 432 432 433 434 435 438 wlll 395 421Chapter Chapter 19 20 Objective of Marketable Securities Management Reasons for Holding Marketable Securities Factors Influencing the Choice of Marketable Securities Types of Marketable Securities Review Questions and Problems ACCOUNTS RECEIVABLE AND INVENTORY MANAGEMENT Learning Objectives Accounts Receivable Management Introduction Objectives of Accounts Receivable Management Credit Policy Costs Associated with Investment in Accounts Receivable Summary of Trade-offs in Credit and Collection Policies ‘Analyzing Proposed Changes in Credit Policy Marginal or Incremental Analysis of Credit Policies Inventory Management Introduction Objective of Inventory Management Functions of Inventories Cost ‘Associated with Inventory in Inventory Inventory Management Techniques Inventory Planning Level Monitoring and Inventory Control Systems Review Questions and Problems SHORT-TERM SOUKCES FOR FINANCING CURRENT ASSETS Learning Objectives Introduction Factors in Selecting a Source of Short-term Funds Estimating Cost of Short-term Credit Accruals Cost of Trade Credit Cost Bank Loans Cost of Commercial Paper 438 438 438 440 442 “453 454 454 454 454 457 458 458 459 461 461 461 462 462 463 463 467 469 478 479 479 480 480 481 482 487 453 478Sources of Short-term Funds Unsecured versus Secured Credit Spontaneous Short-term Financing versus Nonspontaneous/Negotiated Short-term Financing Accruals Trade Credit Short-term Bank Loans Line of Credit Commercial Paper Pledging of Assignment of Accounts Receivable Cost of Financing Advantages and Disadvantages of Pledging Factoring Accounts Receivable Cost of Financing Inventory Financing Review Questions Appendix Table FUTURE VALUE OF P1 PRESENT VALUE OF P1 FUTURE VALUE OF AN ORDINARY ANNUITY OF PI PRESENT VALUE OF AN ORDINARY ANNUITY OF P1. FUTURE VALUE OF AN ANNUITY DUE OF PI PRESENT VALUE OF AN ANNUITY DUE OF P1 List of References 1 2 3 4 5S 6 488 488 488 489 489 490 491 491 492 493 494 494 494 496 498 A-l A3 ASS A-T A-llPART | =| FUNDAMENTALS OF FINANCIAL MANAGEMENTUNIT I Introduction to Financial Management Chapter 1 Nature, Purpose and Scope of Financial Management 4 Relationship of Financial Objectives to Organizational Strategy and Other Organizational Objectives Fanctions of Financial Management Forms of Business OrganizationCHAPTER NATURE, PURPOSE, AND SCOPE OF FINANCIAL MANAGEMENT LEARNING OBJECTIVES After studying Chapter 1, you should be able to: ns Describe the nature, goal and basic scope of financial management. Explain briefly the three major types of decisions that the Finance Manager makes. Discuss the importance or significance of financial management. Describe the relationship between Financial Management and Accounting. Describe the relationship between Financial Management and Economics. on ae ae ate 0% ae afo ofo ao oeCHAPTER 1 NATURE, PURPOSE AND SCOPE OF FINANCIAL MANAGEMENT NATURE OF FINANCIAL MANAGEMENT Financial Management, also referred to as managerial finance, corporate Jinance, and business finance, is a decision-making process concerned with planning, acquiring and utilizing funds in a manner that achieves the. firm’s desired goals. It is also described as the process for and the analysis of making financial decisions in the business context. Financial management is part of a larger discipline called FINANCE which is a body of facts, principles, and theories relating to raising and using money by individuals, businesses, and governments. This concerns both financial management of profit-oriented business organizations particularly the corporate form of business, as well as, concepts and techniques that are applicable to individuals and to governments. THE GOAL OF FINANCIAL MANAGEMENT Assuming that we confine ourselves to for-profit businesses, the goal of financial management is to make money and add value for the owners. This goal, however, is a little vague and a more precise definition is needed i objective basis for making and manager in a business enterpi He must act in the-owners’ or shareholders’ best interest by making decisions that increase the value of the firm or the value of the stock. The appropriate goal for the financial manager can thus be stated as follows: The goal of financial management is to maximize the current value per share of the existing stock or ownership in a.business firm. fuse ee Ave ors ha fers4 = Chapter! The stated goal considers the fact that the shareholders in a firm are the residual owners. By this, we mean that they are entitled only to what is left after employees, supplicr, creditors and anyone else with a legitimate claim are paid their due. If any of these groups go unpaid, the shareholders or owners get nothing. So, if the shareholders are benefiting in the sense that the residual portion is growing, it must be true that everyone else is being benefited too, Because the goal of financial management is to maximize the value of the share(s), there is a need to learn how to identify investments, arrangements and distribute satisfactory amount of dividends or share in the profits that favorably impact the value of the share(s). Finally, our goal does not imply that the financial manager should take illegal or unethical actions in the hope of increasing the value of the equity in the firm. The financial manager should best serve the owners of the business by identifying goods and services that add value to the firm because they are desired and valued in the free market place. SCOPE OF FINANCIAL MANAGEMENT Traditionally. financial management is primarily concerned with acq financing and management of assets of business concern in order to maximize the wealth of the firm for its owners. The basic responsibility of the Finance Manager is to acquire funds needed by. ‘the firm_and investing those funds in profitable ventures that will maximize the firm’s wealth, as well as, generating Peturns to the business concem. Briefly, the traditional view of Financial Management \ooks into the following functions that a financial manager of @ business firm will perform: 1. Procurement of short-term as well as long-term funds from financial institutions 2. Mobilization of funds through financial instruments such as equity shares, preference shares, debentures, bonds, notes, and so forth 3. Compliance with legal and regulatory provisions relating to funds Procurement, use and distribution as well as coordination of the finance function with the accounting functionNature, Purpose and Scope of Financial Management _5. With modern business situation increasing in complexity, the role of Finance Manager which initially is just confined to acquisition of funds, expanded to judicious and efficient use of funds available to the firm, keeping in view the objectives of the firms and expectations of the providers of funds. More recently though, with the globalization and liberalization of world economy, tremendous réforms in financial sector evolved in order to promote more diversified, efficient and competitive financial system in the country. The financial reforms coupled with the diffusion of information technology have brought intense competition, mergers, takeovers, cost management, quality improvement, financial discipline and so forth. Globalization ‘has caused to integrate the national economy with the global economy and has created a new financial environment which brings new opportunities and challenges to the business enterprises. This development has also led.to total-reformation of the finance function and its responsibilities in the organization. Financial management has assumed a much greater significance and the role of the finance managers has been given a fresh perspective. In view of modern approach, the Finance Manager is expected to analyze the business firm and determine the following: a. The total funds requirements of the firm b. The assets or resources to be acquired and c. The best pattern of financing the assets TYPES OF FINANCIAL DECISIONS The three major types. of decisions that the Finance Manager of a modern business firm will be involved in are: 1. Investment decisions : 2. Financing decisions 3. Dividend decisions All these decisions aim to maximize the shareholders’ wealth through maximization of the firm’s wealth. «“© Chapter? ANVESTMENT DECISIONS: The investment decisions are those whieh determine how scarce or limited rosounees in terms of finds of the business firms are committed to projects, Generally, the firm should select only those capital investment proposals whose net present value is positive and the rate of return exceeding the marginal cost of capital, It should also consider the profitability of each individual project proposal that will contribute to the overall profitability of the firm and lead to the creation of wealth, FINANCING DECISIONS Financing decisions assert that the mix of debt and equity chosen to finance investments should maximize the value of investments made. The tinance decisions should consider the cost of finance available in different forms and the risks attached to it, The pridciple of financial leverage or trading on the equity: should be considered when selecting the debt-equity mix or capital structure decision, Uf the cost of capital of each component is.reduced, the overall weighted average cost of capital and minimization of risks in finaneing will lead to the profitability of the organization and create wealth to the owner, DIVIDEND DECISIONS The dividend decision is concerned with the determination of quantum of profits to be distributed to the owners, the frequency of such payments and the amounts to be retained by the firm. The dividend distribution policies and retention of profits will have ultimate effect on the firm's wealth, The business firm should retain its profits in the form of appropriations or reserves for financing its future growth and expansion schemes. If the firm, however, adopts a very conservative dividend payments share prices in the market could be adversely affected. An of policy, the firm's optimal dividend distribution policy therefore will lead to the maximization shareholders’ wealth, vidend To summatize, the basic objective of the investment, financing and di ity and decisions is tocmaximize the firm's wealth Nf the firm enjoys the stabi growth, its share prices in the market will improve and will lead to capital appreciation of shareholders’ investment and ultimately maximize the shareholders’ wealth,Nature, Purpose and Scope of Financlal Management 7 SIGNIFICANCE OF FINANCIAL MANAGEMENT The importance of financial management is known for the following aspects: BROAD APPLICABILITY Any organization whether motivated with earning profit or not having cash flow requires to be viewed from the angle of financial discipline. The principles of finance are applicable wherever there is cash flow. The concept of cash flow is one of the central elements of financial analysis, planning, control, and resource allocation decisions. Cash flow is important because the financial health of the firm depends on its ability to generate sufficient amounts of cash to pay its employees, suppliers, creditors, and owners. Financial management is equally applicable to all forms of business like sole traders, partnerships, and corporations. It is also applicable to nonprofit organizations like trust, societies, government organizations, public sectors, and so forth. REDUCTION OF CHANCES OF FAILURE A firm having latest technology, sophisticated machinery, high caliber marketing, and technical experts, and so forth may still fail unless its finances are managed on sound principles of financial management. The strength of business lies in its financial discipline. Therefore, finance function is treated as primordial which enables the other functions like, production, marketing, purchase, and personnel to be effective in the achievement of organizational goal and objectives. MEASUREMENT OF RETURN ON INVESTMENT Anybody who invests his money will expect to earn a reasonable return on his investment. The owners of business try to maximize their wealth. Financial management studies the risk-return perception of the owners and the time value of money. It considers the amount of cash flows expected to be generated for the benefit of owners, the timing of these cash flows and the risk attached to these cash flows. The greater the time and risk associated with the expected cash flow, the greater is the rate of return required by the owners,8 Chapter I RELATIONSHIP BETWEEN FINANCIAL MANAGEMENT, ACCOUNTING AND ECONOMICS FINANCIAL MANAGEMENT AND ACCOUNTING Just as marketing and production are major functions in an enterprise, finance too is an independent specialized function and is well knit with other functions, Financial management is a separate management arca. In many organizations, accounting and finance functions are intertwined and the finance function is often considered as part of the functions of the accountant. inancial management is however, something more than an art of accounting and bookkeeping. Accounting function discharges the function of systematic recording of transactions relating to the firm’s activities in the books of accounts and summarizing the same for presentation in the financial statements such as the Statement of Comprehensive Income, the Statement of Financial Position, the ‘Statement of Changes in Shareholders’ Equity and the Cash flow Statement, The finance manager will make use of the accounting information in the analysis and review of the firm’s business position in decision making, In addition to the analysis of financial information available from the books of accounts and records of the firm, a finance manager uses the other methods and techniques like capital budgeting techniques, statistical and mathematical models, and computer applications in decision making to maximize the value of the firm’s wealth and value of the owner’s wealth. In view of the above, finance function is considered a distinct and separate function rather than simply an extension of accounting function, Financial management is the key function and many firms prefer to centralize the function to keep constant control on the finances of the firm. Any inefficiency in financial management will be concluded with a disastrous situation. But, as far a3 the routine matters are concerned, the finance function could be decentralized with adoption of responsibility accounting concept. It is advantageous to decentralize accounting function to speedup the processing of information. But since the accounting information is used in making financial decisions, prope controls should be exercised in processing of accurate and reliable information '° the needs of the firm. The centralization. or decentralization of accounting 4" finance functions mainly depends on the attitude of the top level management. ilNature, Purpose and Scope of Financial Management 9 FINANCIAL MANAGEMENT AND ECONOMICS The finance manager must be familiar with the microeconomic and macroeconomic environment aspects of business. Microeconomics deals with the economic decisions of individuals and firms. It focuses on the optimal operating strategies based on the economic data of individuals and firms. The concept of microeconomics helps the finance manager in decisions like pricing, taxation, determination of capacity and operating levels, break-even analysis, volume-cost-profit analysis, capital structure decisions, dividend distribution decisions, profitable product-mix decisions, fixation of levels of inventory, setting the optimum cash balance, pricing of warrants and options, interest rate structure, present value of cash flows, and so forth. Macroeconomics \ooks at the economy as a whole in which a particular business concern is operating. Macroeconomics provides insight into policies by which economic activity is controlled. The success of the business firm is influenced by the overall performance of the economy and is dependent upon the money and capital markets, since the investible funds are to be procured from the financial markets. A firm is operating within the institutional framework, which operates ‘on the macroeconomic theories. The government’s fiscal and monetary policies will influence the strategic financial planning of the enterprise. The finance manager should also look into the other macroeconomic factors like rate of inflation, real interest rates, level of economic activity, trade cycles, market competition both from new entrants and substitutes, international business conditions, foreign exchange rates, bargaining power of buyers, unionization of labor, domestic savings rate, depth of financial markets, availability of funds in capital markets, growth rate of economy, government’s foreign policy, financial intermediation, banking system, and so forth.10 Chapter 1 REVIEW QUESTIONS AND PROBLEMS 1. Questions 1 What is the purpose of financial ieans pert Describe the kinds of activities that financial management deals with. What is the difference in perspective between finance and accounting? Explain the shareholder wealth maximization goal of the firm and how it can be measured. Make an argument for why it is a better goal than maximizing profit. ‘Name and describe as many corporate stakeholders as you can. What conflicts of interest can arise between managers and stockholders? What are the three types of financial management decisions? For each type of decision, give an example of a business transaction that would be relevant. What goal should always motivate the action of a firm’s financial manager? IL. Multiple Choice Questions What is the primary goal of fin: Increase earnings Maximizing cash flow Maximizing shareholders’, wealth Minimizing risk of the firm ancial management? pe se Proper-risk return man: a. — the firm should take as few risks as ossibl - b. consistent with the obj cae tl Jectives of the firm, de off between risk and return should be determined. Pn” . A te na could earn highest Teturn possible. i . ¢ firm should value f Sei ‘uture profitsNature, Purpose and Scope of Financial Management 11 Which of the following is not a major area of concern and emphasis in modern financial management? a. Inflation and its effect on profits b. Stable short-term interest rates Changing international environment d. Increased reliance on debt Which of the following is not a major area of concern and emphasis in modern financial management? a. Marginal analysis b. — Risk-return trade-off ¢. Commodity trading d. — \Sanging financial institutions A financial manager's goal of maximizing current or short-term earnings may not be appropriate because a. _ it fails to consider the timing of the benefits. b. increased earnings may be accompanied by unacceptably higher levels of risk. ©. earnings are subjective; they can be defined in various ways such as accounting or economic earnings. d. All of the given choices.CHAPTER RELATIONSHIP OF FINANCIAL OBJECTIVES TO ORGANIZATIONAL STRATEGY AND OBJECTIVES LEARNING OBJECTIVES After studying Chapter 2, you should be able to: 1. Discuss the importance of objective setting in a business enterprise. Describe the primary financial objectives of a business firm. Explain the responsibilities of a Finance Manager to achieve the firm's financial objectives. Understand the nature of environmental (“green”) policies and their implications for the management of the economy and firm. ° ° Me ate oh 5 a0 ao fe oe 4 4CHAPTER 2 RELATIONSHIP OF FINANCIAL OBJECTIVES TO ORGANIZATIONAL STRATEGY AND OTHER ORGANIZATIONAL OBJECTIVES INTRODUCTION Finance permeates the entire business organization by providing guidance for the firm’s strategic (long-term) and day-to-day decisions. For long range planning and management control, a business firm establishes its overall objectives. Such objectives are developed by the top management and they usually consist of general statement or a series of statements in general terms stating what the company expects to achieve. Objective setting is thus, an important phase in the business enterprise since upon correct objectives setting will the entire structure of the strategies, policies and merous goals but not every goal can be plans of a company rest. Firms have nun attained without causing conflict in reaching other goals. Conflicts often arise because of the firm’s many constituents who include shareholders, managers, employees, labor unions, customers, creditors, and suppliers. There are those who claim that the firm’s goal is to maximize sales or market share; others believe the role of ‘business is to provide quality products and service; still others feel that the firm has a responsibility for the welfare of society at large. For example, the objective may be stated in such broad terms as: © It is the goal of the company to be a leader in technology in the industry, or ¢ Toachieve profits through a high level manufacturing efficiency, or * Toachieve a high degree of customer satisfaction.14 Chapter 2 For the purpose though of measuring performance and degree of control, it j necessary to set objectives or goal in more precise terms. The objectives a, usually in quantitative terms and are set within a time frame. The setting o physical targets to be accomplished within a set time period would provide th basis of conversion of the targets into financial objectives. STRATEGIC FINANCIAL MANAGEMENT Strategic planning is long-range in scope and has its focus on the organization a a whole. The concept is based on an objective and comprehensive assessment o the present situation of the organization and the setting up of targets to b achieved in the context of an intelligent and knowledgeable anticipation ¢ changes in the environment. The strategic financial planning involves financi planning, financial forecasting, provision of finance and formulation of financ policies which should lead the firm’s survival and success. The responsibility of a finance manager is to provide a basis and information fc strategic positioning of the firm in the industry. The firm’s strategic financi: planning should be able to meet the challenges and competition, and it wou! lead to firm’s failure or success. The strategic financial planning should enable the firm to judicious allocation funds, capitalization of relative strengths, mitigation of weaknesses, ear identification of shifts in environment, counter possible actions of competitc reduction in financing costs, effective use of funds deployed, timely estimation funds requirement, identification of business and financial risk, and so forth. The strategic financial planning is likewise needed to counter the uncertain a imperfect market conditions and highly competitive business environment. Whi framing financial strategy, shareholders should be considered as one of t constituents of a group of stakeholders, debenture holders, banks, finance institutions, government, managers, employees, suppliers and customers. T strategic planning should concentrate on multidimensional objectives li profitability, expansion growth, survival, leadership, business succe positioning of the firm, reaching global markets and brand positioning. T financial policy requires the deployment of-firm’s resources for achieving | corporate strategic objectives. The financial policy should align with ' company’s strategic planning. It allows the firm in overcoming its weakness enables the firm to maximize the utilization of its competencies and to direct prospective business opportunities and threats to its advantage. Therefore, |Relationship of Financial Objectives to Organizational Strategy and 15 finance manager should take the investment and finance decisions in consonance with the corporate strategy. A company’s strategic or business plan reflects how it plans to achieve its goals and objectives. A plan's success depends on an effective analysis of market demand and supply. Specifically, a company must assess demand for its products and services, and assess the supply of its inputs (both labor and capital). The plan must also include competitive analyses, opportunity assessments and consideration of business threats. Historical financial statements provide insight into the success of a company’s strategic plan and are an important input of the planning process. These statements highlight portions of the strategic plan that proved profitable and, thus, warrant additional capital investment. They also reveal areas that are less effective and provide information to help managers develop remedial action. Once strategic adjustments are planned and implemented, the resulting financial statements provide input into the planning process for the following year, and this process begins again. Understanding a company’s strategic plan helps focus our analysis of the company’s short-term and long-term financial objectives by placing them in proper context. SHORT-TERM AND LONG-TERM FINANCIAL OBJECTIVES OF A BUSINESS ORGANIZATION Among are the primary financial objectives of a firm are the following: SHORT AND MEDIUM-TERM Maximization of return on capital employed or return on investment © Growth in earnings per share and price/earnings ratio through maximization of net income or profit and adoption of optimum level of leverage © Minimization of finance charges ¢ Efficient procurement and utilization of short-term, medium-term, and Jong-term fundsy LONG-TERM secu tnsinizat sty shares through max'm ion of value of the caro jn dividend to shareholders in the marke © Growth in th stall the firm’s market share and growth of the firm of different, well-developed business 1 objectives of the Survival and sustained viewpoints concerning There have been a number firm should be. The what the primary financial competing, viewpoints are: re which hold that the only appropriate goal is to The owner’s perspectiv r owner's wealth, and maximize shareholder 0 The stakeholders’ perspective which emphasizes social responsibility over. profitability (stakeholders include not only the owners and shareholders, but also include the business’s customers, employees and local commitments). While strong arguments speak in favor of both perspectives, financial practitioners and academics now tend to believe that the manager’s primary responsibility should be to maximize shareholder’s wealth and give only secondary consideration to other stakeholders’ welfare. ‘Adam Smith, an 18” century economist proponent of this viewpoint He argued tha in Sa st aT aa his own interest tends al , an individual pursuing : ends also to promote the good of his community. He also pointed out that acting through competition and the free price syste: B eae weavers oe thoi and beneficial to society as a whole ol ares in the Owners of the fe Nie anges tek also profit the individual most morally stall, and legally required to act in viele bet, so the manager is secondary fo the objec the manager and other firm Ne anoties aes ests eh jective that shareholders give to their hired manag necessarily anagers. The financial manager must have some involving the management of the fi priorities must be set to resolve confli ieee ee to guide decision ting goals. iabilities and equity. Hence,17 ‘Relationship of Financial Objectives 10 Organizational Strategy and ... he wealth of its firm is to maximize U i he overriding premise of financial to enhance owner(s) well-being. .d the market price of To reiterate, the primary financial goal of the ers. Therefore, tl existing shareholders or own management is that the firm should be managed a Shareholder’s wealth depends on both the dividends paid ans the equity shares. Wealth is maximized by providing the shareholders with the target attainable combination of dividends per share and share price appreciation. While this may not be a perfect measure of shareholders’ wealth, it is considered one of the best available measures. ing grounds: The wealth maximization goal is advocated on the follow! e Itconsiders the risk and time value of money « Itconsiders all future cash flow, dividends and earnings per share © ft suggests the regular and consistent dividend payments to the shareholders The financial decisions are taken with a view to improve the capital appreciation of the share price « Maximization of firm's value is reflected in the market price of share vee it depends on shareholder's expectations regarding profitability, Jong-run prospects, timing difference of returns, risk distribution of returns of the firm Critics of the wealth maximization objective however say that, this objective is narrow and ignores the concept of wealth maximization of society. since society’s resources are used to the advantage only of a particular firm. The optimal allocation of the society’s resources should result in capital formation and growth of the economy which should ultimately lead to maximization of economic welfare of the society. RESPONSIBILITIES TO ACHIEVE THE FINANCIAL OBJECTIVES INVESTING The finance manager is responsible for determining how scarce resources or funds are committed to projects. The investing function deals with managing the firm’s assets. Because the firm has numerous alternative uses of funds, the financial manager strives to allocate funds wisely within the firm. This task ‘18 Chapter 2 Fequires both the mix and type of assets to hold. The asset mix refers to amount of pesos invested in current and fixed assets. » The investment decisions should aim at investments in assets only when they , expected to earn a return greater than a minimum acceptable return which is al called as hurdle rate. This minimum return should consider whether the mon raised from debt or equity meets the returns on investments made elsewhere , similar investments. The following areas are examples of investing decisions of a finance manager: a. Evaluation and selection of capital investment proposal b. Determination of the total amount of funds that a firm can commit f investment ¢. Prioritization of investment alternatives d. Funds allocation and its rationing ¢. Determination of the levels of investments in worki ing capital (i inventory, receivables, cash, marketable Securities and its management f. Determination of fixed assets to be acquired g- Asset replacement decisions h. Purchase or lease decisions i. Restructuring reorganization mergers and acquisition j. Securities analysis and portfolio management FINANCING The finance manager is concerned with the '¢ ways in which the firm obtains a manages the financing it needs to support its investments. The financi objective asserts that the mix of debt and equity chosen to finance investmet should maximize the value of investments made. Financing decisions call ! good knowledge of costs of taising funds, financial instruments and obligation attachRelationship of Financial Objectives to Organizational Strategy and ...__19 ‘The finance manager will be involved in the following finance decisions: a. Determination of the financing pattern of short-term, medium-term and long-term funds requirements b. Determination of the best capital structure or mixture of debt and equity financing ¢. Procurement of funds through the issuance of financial instruments such as equity shares, preference shares, bonds, long-term notes, and so forth d. Arrangement with bankers, suppliers, and creditors for its working capital, medium-term and other long-term funds requirement ¢. Evaluation of alternative sources of funds OPERATING This third responsibility area of the finance manager concerns working capital management, The term working capital refers to a firm short-term asset (ie., inventory, receivables, cash, and short-term investments) and its short-term liabilities (ie., accounts payable, short-term loans). Managing the firm’s working capital is a day-to-day responsibility that ensures that the firm has sufficient resources to continue its operations and avoid costly interruptions. This also involves a number of activities related to the firm’s receipts and disbursements of cash. Some issues that may have to be resolved in relation to managing a firm’s working capital are: a. The level of cash, securities and inventory that should be kept on hand b. The credit policy (i.e., should the firm sell on credit? If so, what terms should be extended?) c. Source of short-term financing (i.e., if the firm would borrow in the short-term, how and where should it borrow?) d. Financing purchases of goods (i.e., should the firm purchase its raw materials or merchandise on credit or should it borrow in the short-term and pay cash?)20 Chapter 2 ENVIRONMENTAL “GREEN” POLICIES AND THEIR IMPLICATIONS FOR THE MANAGEMENT OF THE ECONOMY AND FIRM Private property rights can Promote prosperity and cooperation and at the same time protect the environment, but do they protect the environment sufficiently? Ip recent years, People have increasingly turned to the government to achieve additional environmental improvements, Sometimes, People turned to 80vernment because Property rights failed to hold polluters accountable for the costs they were imposing on others. In these “external cost cases”, government may be able to improve accountability and protect rights more efficiently by regulation. In other instances, people with strong desires for various Environmental amenities (for example, green spaces, hiking trails and wildemess lands) want the government to force others to help pay for them. Courts help owners Protect their property against invasions by others, including polluters. In some cases however, it is difficult — if not impossible — to define, establish and fully Protect property rights. This is particularly true when there is either a large number of polluters or a large number of people harmed by the emissions, or both. In these large numbers of cases, high transaction costs undermine the effectiveness of the Property rights — market exchange approach. For example, consider the air quality in a large city such as Manila or Quezon Property rights alone will be unable to handle large-number cases like this efficiently. More direct Tegulations may generate a better outcome. reducing them. Second, by its very nature, regulation overrides or ignores the information and incentives provided by market signals, Accountability of regulators for the costs they impose is lacking, just as accountability for polluters is missing in the market sector when secure and tradable property rights are not in place. The tunnel vision of regulators, each assigned to oversee a smiall part of the economy, is not properly constrained by readily observable costs, I hitd. regulation allows special interests to use political Power to achieve objectives that may be quite different from the environmental goals originally announced. The global warming issue illustrates all of these problems and the uncertainties that they generate.Relationship of Financial Objectives to Organizational Strategy and... 24 People turn to government to get what they cannot get in markets. In many cases, they are seeking to get what they want with a subsidy from others. Government can provide protection from harms, as in regulation that reduces pollution, or production of goods and services, as in the provision of national parks. Government can indeed shift the cost of services from some citizens to others, and can do the same with benefits from its programs. There is little reason, however, to expect a net increase in efficiency when the government steps in. ‘That is true in environmental matters, as well as in many other areas of citizen concern, When it is difficult to assign and enforce private property rights, markets often ult in outcomes that are inefficient. This is often the case when large numbers of people engage in actions that impose harm on others. Government regulation has some premise but also poses some problems of its own. Global warming could exert a sizeable adverse impact on human welfare, but there is considerable uncertainty about both its cause and the potential gains that might be derived from regulations such as those of the Kyoto treaty. Global temperature changes have been observed previously. We do not know that the current warming is the result of human activity. We do not even know whether ‘on balance, a warming would exert an adverse impact. These uncertainties inctease the attractiveness of adaptation as an option to regulation. Market-like schemes can reduce the costs of reaching a chosen environment goal, but the programs provide little help in choosing the right goal. Government ownership of national parks, as with other lands, has brought troublesome results along with benefits, but there séems to be progress in moving closer to market solutions that provide better information and incentives for government managers, Given that stock market investors emphasize financial results and the maximization of shareholder value, one can wonder if it makes sense for a company to be socially responsible. Can companies be socially responsible and oriented toward shareholder wealth at the same time? Many businessmen think so and so do most big business establishments that they have adopted well-laid environmental-saving strategies that can observe such as recycling programs, pollution control, tree-planting activities and so forth. The benefits come a little at a time but one can be sure they will add up. If an investor wants wealth maximization, management that minimizes wastes might do the other little things right that make a company well-run and profitable22 Chapter 2 L REVIEW QUESTIONS AND PROBLEMS Questions Suppose you were the financial manager of a not-for-profit business (a not-for-profit hospital). What kinds of goals do you think would be appropriate? Evaluate the following statement: Managers should not focus on the current stock value because doing so will lead to an overemphasis on short-term profits at the expense of long-term profits, If a company’s board of directors wants management to maximize shareholders’ wealth, should the CEO’s compensation be set as a fixed amount, or should the compensation depend on how well the firm performs? If it is to be based on performance, how should performance be measured? Would it be easier to measure performance by the growth rate in reported profits or the growth rate in the stock’s-intrinsic value? Which would be the better performance measure? Why? Should stockholder wealth maximization be thought of as a long-term or short-term goal? For example, if one action increases a firm’s stock price from a current level of P 1,000 to 2,000 in 6 months and then to P3,000 in 5 years but another action keeps the stock at P1000 for several years but then increases it to P4,000 in 5 years; which action would be better? Think of some specific corporate actions that have these general tendencies. What are some actions that stockholders can take. to ensure that management’s and stockholders’ interests are aligned? The president of Southern Tagalog Corporation (STC) made this statement in the company’s annual report: “STC?s primary goal is to increase the value of our common stockholder’s equity”. Later in the report, the following announcements were made: a, The company contributed P1.5 million to the symphony orchestia.Relationship of Financial Objectives to Organizational Strategy and... _23 b. The company is spending PS00 million to open a new plant and expand operations. No profits will be produced by the operation for 4 years, so earnings will be depressed during this period versus what they would have been had the decision been made not to expand. ¢. The company holds about half of its assets in the form of government treasury bonds, and it keeps these funds available for use in emergencies. In the future, though, STC plans to shift. its emergency funds from treasury bonds to common stocks. Discuss how STC’s stockholders might view each of these actions and how the actions might affect the stock price. 7. Miguel Enterprises recently made a large investment to upgrade its technology. While these improvements won't have much effect on performance in the short run, they are expected to reduce future costs significantly. What effect will this investment have on Miguel Enterprises’ earnings per share this year? What effect might this investment have on the company’s intrinsic value and stock price? IL. Multiple Choice Questions 1. Which of the following statements is true? a. The higher the profit of a firm, the higher the value of the firm is assured of receiving in the market. b. Social responsibility and profit maximization are synonymous. ¢. Maximizing the earnings of the firm is the primary goal of financial management. d. There are some serious problems with the financial goal of maximizing the earnings of the firm 2. Corporate social responsibility is a. effectively enforced through the controls envisioned by classical economics. b. _ the obligation to shareholders to earn a profit, c. — the duty to embrace service to the public interest. d. _ the obligation to serve long-term organizational interests.24 Chaprer 2 3. A common argument against corporate involvement. in Socig responsible behavior is that a. Irencourages government intrusion in decision making, b. asa legal person, a corporation is accountable for its conduct, It creates goodwill, in a competitive market, such behavior incurs costs that pls the company at a disadvantage. ; a9 4 Which of the following statements is false? a Because socially desirable goals can impede profitability many instances, managers should not try to operate under { assumption of wealth maximization. b. As finance emerged as a new field, much emphasis was pla on mergers and acquisitions, ©. Timing is a particularly important consideration in finan decisions. d. During the 1930s, the government assumed a much greater r in regulating the securities industry, Which of the following statements is false? a. In the mid 1950s, finance began to change to a more analytic decision oriented approach. Recently, the emphasis of financial management has been the relationships between risk and returns. ¢. Inflation has led to phantom profits and undervalued assets. d. For as long as satisfactory level of profit is earned, the finan: manager need not be concerned with unethical behavior.CHAPTER FUNCTIONS OF FINANCIAL MANAGEMENT LEARNING OBJECTIVES After studying Chapter 3, you should be able to: 1. Describe the role of Finance Manager in achieving the primary goal of the firm. . Understand how finance fits in the organizational structure of the firm. . Enumerate the fundamental activities of the Treasurer and the Controller. . Explain how the finance function relates to the other functional areas of a business. . Learn the importance of corporate governance in achieving the goals of a business organization. . Appreciate the importance of ethics in finance. % oe 2 fo % aCHAPTER 3 FUNCTIONS OF FINANCIAL MANAGEMENT ROLE OF FINANCE MANAGER Having examined the field of finance and some of its more recent developments, let us tum our attention to the functions of the financial manager. Figure 3-1 shows the financial manager's role in achieving the primary goal of the firm. Financial Manager Makes Decisions Involving Utilization of Funds Analysis Acquisition and Planning of Funds Impact on Risk and Return Affect the Market of Common Stock ice Lead to Shareholder’s Wealth Maximization Figure 3-1. The financial manager’s role in achieving the goal of the firmFunctions of Financial Management 27 In Striving to maximize owners’ or shareholders’ wealth, the financial manager makes decisions involving planning, acquiring, and utilizing funds which involve & Sof risk-retum trade-off, These financial decisions affect the market value of the firm's stock which leads to wealth maximization. In the short run, many factors affect the market price of a firm’s shares which are beyond management's control. Some of the changes in market price do not reflect a fundamental change in the value of the firm. In the long run, increased Prices of the firm’s stock reflect an increase in the value of the firm. Hence, financial decision making should take a longer-term perspective. It is the responsibility of financial management to allocate funds to current and fixed assets, to obtain the best mix of financing altematives, and to develop an appropriate dividend policy within the context of the firm’s objectives. The daily activities of financial management include credit management, inventory control, and the receipt and disbursement of funds. Less routine functions encompass the sale of stocks and bonds and the establishment of capital budgeting and dividend plans. The appropriate risk-return trade-off must be determined to maximize the'market Value of the firm for its shareholders. The risk-return decision will influence not only the operational side of the business (capital versus labor) but also the financing mix (stocks versus bonds versus retained earnings). THE FINANCE ORGANIZATION The financial management function is usually associated with a top officer of the firm such as a Vice President of Finance or some other Chief Financial Officer (CFO). Figure 3-2 is a simplified organizational chart that highlights the finance activity in a large firm. As shown, the Vice President of finance coordinates the activities of the treasurer and the controller. The Controller’s office handles cost and financial accounting, tax payments, and management information systems. The Treasurer’s office is responsible for managing the firm’s cash and credit, its financial planning, and its capital expenditures. :28 Chapter 3 Board of Directors Chairman of the Roard and Chief Executive Officer (CEO) President and Chief Operations Officer (COO) = Vice President Vice President Vice President Marketing Finance (CFO) Production Controller Cash Credit Tax Manage Manage Manage Capital Financial Financial t Expenditure Planning Accounting Prov Manager Ma Figure 3-2, A Sample of Simplified Organizational Chart RELATIONSHIP WITH OTHER KEY FUNCTIONAL MANAGERS THE ORGANIZATION : Finance is one of the major functional areas of a business. For exam functional areas of business operations for a typical manufacturing fi manufacturing, marketing, and finance. Manufacturing deals with the desi production of a product. Marketing involves the selling, promotio' distribution of a product. Manufacturing and marketing are critical survival of a firm because these areas determine what will be produced atneta Management 29. —_— these products will be sold, However, the: other functional areas could not operate without funds. Since finance is concerned with all of the monetary aspects of a business, the financial manager must interact with other managers to ascertain the goals that must be met, when and how to meet them, Thus, finance is an integral part of total management and cuts across functional boundaries. CORPORATE GOVERNANCE managers and aligning their use shareholders are usually ent. Generally speaking, Corporate governance is the process of monitoring incentives with shareholders goals. In reality, beca inactive, the firm actually seems to belong to managem the investing public does not know what goes on at the firm's operational level. Managers handle day-to-day operations, and they know that theit work is mostly unknown: to investors. This lack of supery ion demonstrates the need for monitors. Figure 3-3 shows the people ‘and organizations that help monitor corporate activities. Monitors =” Anside the company: Board of Directors Qutside the Company ‘Auditors ¢ >| Managers : Analysts Bankers . Credit Agencies —S ea Government SEC, BIR, BSP Figure 3-3. Corporate Governance Monitors ublic firm are the board of directors, who are appointed to represent shareholders’ interest. The board hires the CEO, evaluates management, and can also design compensation contracts to tie managements salaries to firm performance. The monitors inside a p\30_Chapter J = — The monitors outside the firm include auditors, analysts, investment banks, credit rating agencies, Lxternal auditory examine the firm’s accounting y A and comment on whether financial statements fairly reprovent the firm’s finan position. Investment analysts keep tract of the firm's performance, Conduct y own evaluations of the company’s business activities, and report to investment community, Investment banks, which help firms access cap markets, also monitor firm performance, Credit analysts examine a fir financial strength for its debt holders, ‘The Government also monitors busin activities through the Securities and Exchange Commission (SEC), Bureay Internal Revenue (BIR), Bangko Sentral ng Pilipinas (BSP), and so forth, ETHICAL BEHAVIOR Ethicy are of primary importance in any practice of finance. Finan professionals commonly manage other people’s money. For instance, corpore managers control the stockholders’ firm, bank employees perform cash receiy and disbursements functions and investment advisors manage peopl investment portfolios, These fiduciary relationships oftentimes create tempting opportunities for finan professionals to make decisions that either benefit the client or benefit t advisors themselves. Strong emphasis on ethical behavior and ethics training a1 standards are provided by professional associations such as the Finan Executives of the Philippines (FINEX), Bankers Assoctation of the Philippine Investment Professionals, and so forth. Nevertheless, as with any profession wi millions of practitioners, a few are bound to act unethically. In a number | instances, the corporate governance system has created ethical dilemmas and h failed to prevent unethical managers from stealing from firms which ultimate means stealing from owners or stockholders, Governments all over the world have passed laws and regulations meant | ensure compliance with ethical codes of behavior, And if professionals do not 4 appropriately, governments have set up strong punishment for financial fraud a! abuse. Ultimately, financial manager must realize that they owe @ owners/shareholders the very best decisions to protect and further sharehold interests, but they also have a broader obligation to society as a whole.Functions of Financial Management 31 REVIEW QUESTIONS AND PROBLEMS L Questions In a large corporation, what are the two distinct groups that report to the chief financial officer? Which group is the focus of corporate finance? Can our goal of maximizing the value of the equity shares conflict with other goals, such as avoiding unethical or illegal behavior? In particular, do you think subjects like customer and employee safety, environment and general good of society fit in this framework, or are they essentially ignored? Think of some specific scenarios to illustrate your answer. Would our goal of maximizing the value of the equity shares be different if we were thinking about financial management in a foreign country? Why or why not? . Critics have charge that compensation to top managers in the United States is simply too high and should be cut back. For example, focusing on large corporations, Ray Irani of Occidental Petroleum has been one of the best-compensated CEOs in the United States, earning about $54.4 million in 2007 alone and $550 million over the 2003-2007 period. Are such amounts excessive? In answering, it might be helpful to recognize that superstar athletes such as Roger Federer, top entertainers such as Justin Bieber and Manny Pacquiao and many others at the top of their respective fields eam at least as much, if not a great deal more. Why should effective corporate governance be in place? Distinguish the role of an external auditor from the role of an internal auditor. Distinguish the functions of a controller from the functions of the treasurer.——_ 2 Chapter 3 II. Multiple Choice Questions All of the following a" functions of the financial manager except a. Analyzing and planning the company 's performance, b. Anticipating the company’s financial needs. of the company’s stock c. Assigning the market price d. Allocating funds to the most profitable asset. which of the following statements is false? ; a. The financing decision involves the process of allocating fund: in competing assets. b. The treasurer would be. ‘responsible for activities such a managing cash balances, granting credit to customers: anc managing the process of issuing new S' The optimal capital structure js the best com! term debt and equity. d. It is necessary tO determine the appropriat f the firm for to maximize the market value © scovered that her company anager who has dis tal regulations. If her immediate superior is securities. bination of long fe risk-return trade-ofl r its shareholders. Regine is a financial m is violating environmen' involved, her appropriate action is to a. do nothing since she has a duty of loyalty to the organization b. consult the audit committee. c. _ present the matter to the next hig! ediate superior. d. confront her imm If a financial manager discovers unethical conduct ization and fails to act, he/she will be in violation 0! ethical standard(s)? a. “Actively or organization’s legiti b. “Communicate unfa c. “Condone the commission of organizations.” d. _ Allof the answers are correct. her managerial level. in his/her f which passively subvert the attainment of the mate and ethical objectives.” vorable as well as favorable information.” , f such acts by others within theltFunctions of Financial Management _33 Integrity is an ethical. requirement for all financial managers. One aspect of integrity requires a. ©. d. performance of professional duties in accordance with applicable laws. avoidance of conflict of interest. refraining from improper use of inside information. maintenance of an appropriate level of professional competence. A financial manager discovers a problem that could mislead users‘of the firm’s financial data and has informed his/her immediate superior. He/she should report the circumstances to the audit committee and/or the board of directors only if a. b. the immediate superior, who reports to the chief executive officer, knows about the situation but refuses to correct it. the immediate superior assures the financial manager that the problem will be resolved. the immediate superior reports the situation to his/her superior. the immediate superior, the firm’s chief executive officer, knows about the situation but refuses to correct it.CHAPTER FORMS OF BUSINESs ORGANIZATION LEARNING OBJECTIVES After Studying Chapter 4, you should be able to: 1. Explain the basic legal forms. of business Organizations such as, sole Proprietorship, Partnership and Corporation. 2. Know the advantages and disadvantages of adopting the a Sole Proprietorship b, Partnership c Corporation form of business organization, 3. etermin the f it aieenine Sines Organization most oho oh oe,CHAPTER 4 FORMS OF BUSINESS ORGANIZATION THE ORGANIZATION OF THE BUSINESS FIRM The business firm is an entity designed to organize raw materials, labor, and machines with the goal of producing goods and/or services. Firms 1. purchase productive resources from households and other firms, 2. transform them into a different commodity, and 3. sell the transformed product or service to consumers. For business firms engaged in retail or trading activities, transforming purchased goods into a different commodity does not necessarily take place. Every society, no matter what type of economy it has, relies on business firms to organize resources and transform them into products. In market economies, most firms choose their own price, output level, and methods of production. They get the benefits of sales revenues, but they also must pay the costs of the resources they use. Business firms can be organized in one of three ways: as a proprietorship, a partnership, or a corporation. The structure chosen determines how the owners share the risks and liabilities of the firm and how they participate in making decisions. LEGAL FORMS OF BUSINESS ORGANIZATION PROPRIETORSHIP A sole proprietorship is a business owned by a single person who has complete control over business decisions. This individual owns all the firm’s assets and is responsible for all its liabilities. More businesses are sole proprietorship than any form of business organization. From a legal point of view, the owner of a36_Chapter 4 ble from the business and sowever usb . Propr © is tive, however, the Using Sena ‘ounting prospec Mess debts of the aay aged own et (proprietor). Therefore, the f , an entity separate from d liabiliti inane business present only those assets and liabilities Pertaining Statements of the business the business. from the business. Inst id salary or wages 3 eee from the business. These tren ieee of eee or financial interest ra h phar The business itself does not pay any income taxes, € income f the business is reported on the owner’s personal income tax retu, o supporting schedule. lead, the own i er withdrawal, ate he owner in the OF Loss TM ong Among the advantages of a sole Proprietorship are: 1. Ease of entry and exit A sole proprietorship requires no formal charter and is inexpensive to form and dissolve, 2. Full ownership and control The owner has full Control, reaps all Profits and bears all losses, 3. Tax Savings The entire income generated by the Proprietorship passes directly to the Gwner. This may result in a ‘ax advantage if the Owner’s tax rate is les than the tax rate ofa corporation, 4. Few Bovernmeny regulations A sole Proprietorship fy Fm of business Orn Sreatest freedom as compared with ni) Ship form includ iMimited labitiyy es is all i any and all busine le or Tes; - "8 Personal ac Potsible for Ls Faults on ig Obligate imed by the cred Scan be cla;Forms of Business Organization _37 2. Limitations in raising capital Fund-raising ability is limited. Resources may be limited to the assets of the owner and growth may depend on his or her ability to borrow money. 3. Lack of continuity Upon death or retirement of the owner, the proprietorship ceases to exist. Therefore, the proprietorship may be an ideal form of business organization when the following conditions exist: : ¢ The anticipated risk is minimum and adequately covered by insurance. © The owner is either unable or unwilling to maintain the necessary organizational documents and tax returns of more complicated business entities. 5 © The business does not require extensive borrowing. PARTNERSHIP A partnership is a legal arrangement in which two or more persons agree to contribute capital or services to the business and divide the profits or losses that may be derived therefrom. Partnership may operate under varying degrees of formality. For example, a formal partnership may be established using a written contract known as the parmership agreement which is filed with the Securities and Exchange Commission. Partnership may be either general or limited. A general partnership is one in which each partner has unlimited liability for the debts incurred by the business. General partners usually manage’ the firm and may enter into contractual obligations on the firm’s behalf. Profits and asset ownership may be divided in any way agreed upon by the partners. A limited partnership is one containing one or more general partners and one or more limited partners. The personal liability of a general partner for the firm’s debt is unlimited while the personal liability of limited partners is limited to their investment. Limited partners cannot be active in management.', Ease of formation i i rt and low i artnership may require relatively little ef fo, lor Stary Forming a partners costs. Additional sources of capital : 2. ditional sources of Partnership he nancial resources of several indiv duals. A ‘ship has the financial resources of id Management base ; A partnership has a broader management base or expertise than a Sole Proprietorship, Tax implication Disadvantages of Partnership are: 1. Untimitea Nabitity General Partners have unlimited liability for the debt the business, Lack of continuity A Partnership mar issoly A . ul i Partner, depending ©n the Povo oye anal Hi oe at ‘ership, 3, ifficuty of Wansferrin : 8 Ownership Mis dittioult 4 Fa partner 0 ligy date of Tansfer ow, diffieu liqui f ership With condit 'ONs set forth in the Patnertig Teement " i agi . Limitations in raising CApitay © Upon A Partners); hip becaus, Nave CHU Se, Many Sources of funge ems Taisi arg a ne ital **ailabIe ne amounts of capit © Corporations, iForms of Business Organization _39 CORPORATION A corporation is an artificial being created by law and is a legal entity separate and distinct from its owners. This legal entity may own assets, borrow money and engage in other business entities without directly involving the owners. In many corporations, owners who are also called shareholders do not directly manage the firm. Instead they select managers designated as the Board of Directors to run the firm for them. The Board of Directors is authorized to act in the corporation’s behalf. The incorporation process is initiated by filing the articles of incorporation and other requirements with the Securities and Exchange Commission (SEC). The articles of incorporation includes among others the following: © Incorporators Name of the corporation © Purpose of the corporation © Capital stock e Authorized shares After the corporation is legally formed, it will then issue its capital stock. Ownership of this stock is evidenced by a stock certificate. The corporate bylaws which are rules that govern the internal management of the company are established by the board of directors and approved by the shareholders. These bylaws may: be amended or extended from time to time by shareholder. Advantages of a corporation are: 1. Limited liability Shareholders are liable only to the extent of their investment in the corporation. Thus, shareholders can only lease what they have invested in the firm’s shares, not any other personal assets. However, limited liability is not all-encompassing. Government may pass through the corporate shield to collect unpaid taxes. Also, it is not uncommon for creditors to require that major shareholders personally co-sign for credit extended to the corporation. Thus, upon default by the business, the creditors may sue both the corporation and shareholders who have co- signed.40 Chapter 4 2. Unii ted life : ; fi : Corporations continue to exist even after death of the owners Ease in transferring ownership i it hip interest in most Corporat, Shareholders can easily sell their owners on by elling their stock without affecting the legal form of busines, organizations. The ability to sell stock provides Corporations with stronger financial base and the capital needed for expansion, Ability to raise cupicat Corporations can nds to investors Securities such as raise capital through the sale of secu who are lending Money to the corporati, common stock to investors who are the ities Such as ‘ons and equity Owners, Disadvantages of a corporation include: 1. Time and cost °f formation Registration of public companies with the SE i ing and costy, C may be time-consuming - Regulation Corporati: Forms of bush net {0 greater Sovernment regulations than other assets from the business tions. Shareholders can not just withdraw dividends are Clared and these Cu Teceive Corporate assets when Imposed by law, amounts -m; lay Subject to limits Taxes Corporations : Pay taxes On ji the subj 3 n income : Veet Of taxation demands the @ have eamed. The complexity o The need of large busi "© OF a qualified tax accountant. comport FM yi SS Lr us inve form not He chapel be tne bei ft creditors is such that manage, ly locally bu because gp (Or Such firms. We focus of Howmet ius, such 9 in one oF the j ortance of the corpora r, asineseg of all ty Sivideng - “conomieg, Also, a few financid! of tt © Subjects Ui s ssi eto corporat eed fin, iq! _ ane; ig 1 Y form of, t! Management, so ti Usiness,Forms of Business Organization 41 REVIEW QUESTIONS AND PROBLEMS I. Questions 1 What are the three basic forms of business ownership? What are the advantages and disadvantages to each? Between the three basic forms of business ownership, describe the ability of each form to access capital. Explain how the founder of a business can eventually lose control of the firm. How can the founder ensure this will not happen? Who owns ‘a corporation? Describe the process whereby the owners control the firm’s management. What is the main reason that an agency relationship exists in the corporate form of organization? In this context, what kinds of problems can arise? Il. Multiple Choice Questions One of the major disadvantages of a sole proprietorship is a. _ that there is unlimited liability to the owner. b. the simplicity of decision making. c. low organizational costs. d. low operating costs. The partnership form of organization a. avoids the double taxation of earnings and dividends found in the corporate form of organization. b. _ usually provides limited liability to the partners, c. has unlimited life. d. simplifies decision making. A corporation is a. owned by stockholders who enjoy the privilege of limited sible between owners. * c. _ a separate legal entity with perpetual life. d. _allofthe above,42 Chapter 4 TH. Case- Super Delicious Reyes formed the : ¢ In early 2008, Dee and Sue full line of cakes and its Speciatie Company, onan a pound cake, double-iced ae a doubje aE The couple formed the spepany a3 a0 4 si de int both i it jobs, a3 ym i ‘k at their current jot ; F ‘mn ae and distribution. With Sod Product quality sound marketing plan, the company grew rapi ly. a In early 2913) the in a widely distri treprencurial mage: ‘d in a widely distributed ent : Vater that year mei wie ste in Best Desens, pat Specialty food magazine, After the article appeared in Best Desserts, sales Reise and the company began Teceiving orders from all over the world, le, Proposal to put four of i ' and a national restaurant chain has connected the company about Selling Super Delicious cakes without a brand name, Dee and Lyn hi ‘aVe Operated the Company as a sole MoPrictorship. They have @pProached you 4 help manage ang direct the company’s. growth. Specifically, they have asked you to answer th le following questions, L ‘Nhat = ‘the Aivantages and disadvantages Of changing the nae Banization TOM a sole Proprietorship toa limited Partnership? 2. What i hes Ba i fivantages and disadvantages of changing the compaty TOM a sole Pro) ristorship toa Corporation? Ultimately What act; : act eral? Wi “ON. woutg YOU recommend. the companyUNIT Il The Framework of Financial Management Chapter 5 Applications of Microeconomics Theory as a Basis for Understanding the Key Economic Variables Affecting the Business 6 Applications of Macroeconomics Theory as a Basis for Understanding the Key Economic Variables Affecting the Business 7 Competition and Policies towards Monopolies and Oligopolies, Privatization and DeregulationATION OF CHAPTER APPLIC HEORY AS A BAig ICS MICROE MO ERSTANDING THE R UM” VARIABLES AFFECTING KEY ECONOM' BUSINESS 2 ee ee LEARNING OBJECTIVES After studying Chapter 5, you should be able to: _ Understand the significance of microeconomics theory as applied to business. 2. Know the nature of and the factors affecting the demand for product other than its price. 3. Distinguish between elastic and inelastic demand how they affect the price of goods and services, 4. Discuss the factors affecting the supply of product other than its price. ua 5. Understand the signi hr and pricing, ignificance of market equilibrium 1 6. Know the nat cost, ure of short-run and long-run total 7. Explai relatonshp ele ey in the economy and the S Suppl 8. Understand Pply and demand. the naj rates are determina” Of interest and how interest ? th 0% oe oe hms 2 Hh feCHAPTER 5 APPLICATIONS OF MICROECONOMICS THEORY AS A BASIS FOR UNDERSTANDING THE KEY ECONOMIC VARIABLES AFFECTING THE BUSINESS INTRODUCTION TO MICROECONOMICS Microeconomics focuses on the behavior and purchasing decisions of individual and firms. In a market economy goods and services are distributed through a system of prices. Goods and services are sold to those willing and able to pay the market price. The market price is determined based on demand and supply. Rationing is an allocation of a limited supply of a good or resource to users who would like to have more of it. Various criteria, including charging a price, can be utilized to allocate the limited supply. When price performs the rationing function, the good or resource is allocated to those willing to give up the most “other things” in order to obtain ownership rights. DEMAND Demand is the quantity of a good or service that consumers are willing and able to purchase at a range of prices at a particular time. Therefore, market demand for a product’ is actually a schedule of the amount that would be purchased at various prices, with all other variables’ that affect demand being held constant. Graphically, a demand curve shows an inverse relationship between the price and quantity demanded. That is, less products are demanded at higher prices. Illustrated on the next page is the demand schedule and demand curve for Product X.pees a 46 Chapter 5 SO duct X and for Pro Market Dem: Quantity Demanded Price per unit 000 8.000 P 70 P 40 5,000 12,000 60 30 6000 20,000 50 20 Demand Curve 80 70 60 50 40 30 20 E 10 D a 0 4000 “3000 12000 16000 "20000 24009 Quantity Figure 5-1, Demand Curve As illustrated, at price of P50, 6,000 units Price of Product X chan, of Product x will be bought. If the '8€S, more or less wil] be bought, DEMAND CURVE Suiry A demand CUrVe shifts When dema example, if the Price of g than price Change. For demand for Product u Or Product crease in price, the Would shift “Upward ang to the tight,inevications of Microeconomics Theory as a Basis for Understanding ..__ 47 Qi Q@ Quantity Figure 5-2. Demand Curve Shift Factors Affecting the Demand for a Product other than Its Price Factors Effects Consumer income and wealth Generally a direct relationship. As, consumer income (wealth) goes up, the demand for many products (normal goods) goes up. However, there are certain goods that are inferior (e.g., bread and potatoes) and the demand for such goods actually goes up as consumer income (wealth) goes down. This is because consumers buy more inferior goods when they are short of money. Price of other goods and services (e.g., Substitute goods) Direct relationship. As goods that may be purchased instead go up in price, the demand for the product goes up. As an example, if the price of pork increases, the demand for beef may increase. Price of complement products (i.e., products that must be used with the product or enhance its usefulness) Inverse relationship. As the prices of complement goods go up, the demand for the product goes down. As an example, if the price of hamburger increases, the demand for hamburger buns decreases. Consumer tastes Intermediate relationship. The effect depends on whether the shift is towatds or away from the product. Group boycott Inverse relationship. \f a group of consumers boycott a product, demand will be decreased._ for a Product other tha { Direct relationship. As the size of the market in nanan fe domand for the product will increase Pease, i ionshi ice of the good i | Expectations ct relationship. If the price of the good is ex | Expectarions of price ree fase in the future, there will be an incrense! in | demand. in Variables that may cause a demand curve shift include changes in the Price gr other goods and services, consumer tastes, spendable income, wealth, ang the size of the market. The table above summarizes the effect of these factors on demand for a particular product. THE ELASTICITY OF DEMAND Price Elasticity of Demand is defined as the relationship between Percon Change in Quantity Demanded and Percent Change in Price. This indicates the degree of consumer response to variation in price. The demand for the product is elastic if a small rise in price causes consumers to choose a much smaller amount of a product. On an elastic demand curve, the quantity demanded is highly sensitive to a change in price. The demand is inelastic if a substantial increase in price results only in a small reduction in quantity demanded. An inelastic demand indicates flexibility or little consumer response to variation in price. Price Demand for Price Demand for Cigarettes Heroin (a) Quantity/time (6) Quantity/time49 Demand curve of unitary elasticity Price (@) Quantity/time (©) Quantity/time Demand for farmer Price Juan's corn (e) Quantity/time Figure 5-3. Elasticity of Demand Perfectly inelastic. Despite an increase in price, consumers still purchase the same amount. The price elasticity of an addict’s demand for heroin or a diabetic’s demand for insulin might be approximated by this curve. b. Relatively inelastic. A percent increase in price results in a smaller percent reduction in sales. The demand for cigarettes has been estimated to be highly inelastic. Unitary elasticity. The percent change in quantity demanded’ is equal to the percent change in price, thus, a curve of decreasing slope results. Sales revenue (price times quantity sold) is constant. d. Relatively elastic. A percent increase in price leads to a larger percent reduction in purchases. Consumers substitute other products for the more expensive good. Perfectly elastic. Consumers will buy all of farmer Juan’s corn at the market price, but none will be sold above the market price. SUPPLY Law of Supply is a principle that states that, there will be a direct relationship between the price of a good and the amount of it offered for sale. Other things constant, a higher price will increase the producer’s incentive to supply the good.x coking personal gain will enter the market ang Ry New entrepreneurs seeking pe will expand the scale 4 Pei, supplying the product. Established Ce euioue le of then operation leading to an additional expansio A supply curve shows the amount of a product Saas one a at Vatioy Prices. Graphically, a supply curve shows a ee ts Would be si i Tice ang Quantity sold. The higher the price, the more product PPlied, Suppiy schedule and supply curves for Product X are presented below. Market Demand for Product X Price per unit Quantity Demanded P70 P40 30,000 8,000 60 30 20,000 4,000 50 20 14,000 2,000 Supply Curve 80 sq 70 P 60 r $0 i aol c : 30 20 10 i of Ty 9 1000035000 oe; —— 0 30000 Quantity 40000 Fi gure 5.4, Supply Curve A change in the market prig, Supply curve. For Buce of the Product 7 i price changes PE Pe at PSO, the rw ae along the existing UPPly 14,000 units but i » the amount suppl; PPlied wi) 5. SUPPLY CURVE Suey Pst wil increase 20,000. when Supply yar; 'Y variab| the Product tis cther than price change. Asa “A shiftin the ge ly cur: the supply curve woul Curve is illustrated next.Applications of Microeconomics Theory as a Basis for Understanding 51 Shift in Supply for Beer Price Qi Q2 Quantity Figure 5-5. Supply Curve Shift Factors Affecting the Supply of a Product other than Its Price Factors Effects Prices of other goods Inverse relationship. \f other products can be produced with greater returns, producers will produce those goods. Number of producers Direct relationship. Generally, an increase in the number of producers will cause an increase in the amount of goods supplied at a given price. Government price controls Price controls would tend to limit the amount of goods supplied by holding the price artificially low. Price expectations Direct relationship. If it is expected that Prices will be higher for the good in the future, production of the good will increase. Government subsidies Direct relationship. Subsidies in effect reduce the Production cost of goods and, therefore, increase the goods supplied at a given price. Change in production costs or technological advances Inverse relationship. As production costs g0 up, fewer Products will be supplied at a given price. If costs go down, more products will be produced.os in The NUMDEr of gi ~ 1 - ohange i jnolude Cee Te n 1 ais (WARES? rents and raw materi! §2_ChaverS ’ ae apply ome Sy costs fc Variables that cause +a ppoxtuction COS “phe effects of these variant producers, changes it ¥ id aa Padvances and 8°". pages ; the previous P in the quantity supplieg of, technological table on th go change The elastici The elasticity of g a LUpply « Pply ig are shown in the op percent Elasticity of supply measures the ae oduct price. product resulting from change in te P calculated as follows: . 3 : Percentage change in quantity supplied _ Dervel hange in price ——Perventage © ary elastic if Es l,and inelastic slastic if Bs? 1, unite a percentage increase in price will creat, ea ply is said to be ¢ E.<1 ¢ Blastic supply means that, larger percentage increase i supply. MARKET EQUILIBRIUM AND PRICING A market is an abstract conce| c S! ni 3 pt that encompasses the forces ae and selling decisions of economic participants. A Narcan by the baits if for example, the market for razor blades). Alternatively, it nay be uite aggregate diverse goods into a single market such as the mee market for “consumer goods”, Equilibrium is a state of ate of balance be icti ee ° nce between conflicting fo and producers aera nen can be attained the de ets Speen : en n be att , lecisi rought into harmony with one nore = ae ene elite Smt : ities must be The graph illus trates the supply and demand cine of market equilibrium (ie., th ; -€., the intersection of ion ofa Ss pS é = Equilibrium Price = Equilibrium (market Clearing) QuantityApplications of Microeconomics Theory as a Basis for Understanding .._53 Short-run market equilibrium is a time period of insufficient length to permit decision makers to adjust fully to a change in market condition. For example, in the short-run, producers will have time to increase output by using more labor and raw materials, but they will not have time to expand the size of their plants or to install additional heavy equipment, Long-run market equilibrium is a time period of sufficient length to enable decision-makers to adjust fully to a market change. For example, in the long-run, producers will have time to alter their utilization of all productive factors including the heavy equipment and physical structure of their plants. A balance between amount supplied and amount demanded will bring about market equilibrium in the short-run. However, if the current market price is going, to persist in the future, an additional condition must be present. The opportunity cost of producing the product must also be equal to the market price. IMPACT ON EQUILIBRIUM OF SHIFTS IN THE SUPPLY AND DEMAND SCHEDULE Market prices will bring the conflicting forces of supply and demand into balance. If the quantity supplied to the market by producers exceeds the quantity demanded by consumers, price will decline until the surplus is eliminated. On the other hand, if the quantity demanded by consumers exceeds thé quantity supplied. by producers, price will rise until the shortage is eliminated. When a market is in long-run equilibrium, supply and demand will be in balance and the producer's opportunity cost will equal the market price, If the opportunity cost of supplying the good is less than the market price, profits will accrue. The profits will attract additional suppliers, cause lower prices, and push the market toward an equilibrium. On the other hand, if the opportunity cost of producing a good exceeds the market price, suppliers will experience losses. The losses will induce producers to leave the market, causing price to rise until equilibrium is restored. Changes in consumer income, prices of closely related goods, preferences and expectations as to future prices will cause the entire demand curve shift. An increase (decrease) in demand will cause prices to rise (fall) and quantity supplied to increase (decrease).that influe, ther factors Neg Ist . Shift . es, af caus 4 ‘ © Changes in ine Production weil cause prices to fall (rise) ang \ducer’s cost in supply ny itctenso (decrease) in d (decline). quantity demanded to expan ily limits the ability of consumer, porar! Fi of time, a price incre, The constraint of fin with the ety demanded. Similarly, - adjust to nee a inget reduction in sr veiess to a change in Price . will usually elicit paige b curve time period. fase than during the short-term ‘libri buyers wil] Want t equilibrium, buy to we low the marke * When a price is re are willing to supply. ee sorte wil Purchase more va rs such as waiting lines, quality de tae ation and reat eres) ea play a more important role in the rationing illegal transac Process, Wh Price is fixed above the market equilibrium level, sellers will . len a want to supply a larger amount than buyers are willing to Purchase at the Current price, thus, surplus will result, SHORT-RUN TOTAL Cost In the short-run, firms have both fixed and variable Costs. Total fixed Costs are those that are committed and will not change with different levels of Production, An example of a fixed Cost is the rent paid ona long-term lease for a factory, * Variable Cost VO ~ Costs of variable inputs, such as raw materials, ariable labor i ° Average Fixeg Cost (AFG ~ Fixed Cost down Consistently 4S more u; Per unit of Production. It Boes nits are Produced, ° Average Variable Cost i number ole re ar ~ Total variable Costs divided by the inefficiencies Of produci ced. It initially Stays Constant until the fciene Producing 1a fixed-size F ili i Bin to rise. “cility cause variable costs to ° Margingy Cc (MQ Mar ~ The add italy dere then begin = of Producing one extra unit. It Ue to inage.-.55, Applications of Microeconomics Theory as a Basis for Understanding © Average Total Cost (ATC) — Total cost divided by the number of units produced. Its behavior depends on the makeup of fixed and variable costs. This is sometimes called per unit cost. © Fixed Cost (FO) — Cost that does not vary without output. However, fixed cost will be incurred as long as a firm continues in business and the assets have alternative uses. “Law of Diminishing The cause of inefficiencies described is referred to as the nd more output with a eee a This law states that, as we try to produce more al fixed productive capacity, marginal productivity will decline. LONG-RUN TOTAL COST available because additional plant capacity can be In the long-run, all inputs are n factors by a given built. If in the long-run, a firm increases all productio proportion, there are the following thrge possible outcomes: 1. Constant returns to scale. Output increases in same proportion. 2. Increasing returns to scale. Output increases by a greater proportion. 3. Decreasing returns to scale. Output increases by a smaller proportion. In many industries, especially those that are capital intensive, increasing returns to scale occur up to a point generally, as a result of division of labor and specialization in production. However, beyond a certain size, management has. problems controlling production and decreasing returns to scale arise. PROFITS There are two different types of profit. 1. Normal profit. The amount of. profit necessary to compensate the owners for their capital and/or managerial skills. It is just enough profit to keep the firm in business in the long-run. excess of normal profit. In a 2. Economic profit. The amount of profit in fit cannot be experienced in perfectly competitive market, economic pro the long-run.ae cet er the relationship betwe, don the additional evens. PRODUCTION ‘ions base con decisions venue 1S le tion der ginal is oduct. A good should 4. yroduc' nt makes products. ; 5 1d margin’ © ional un f producing the goog ; ae revenine ale of one ae nal cost ( Ota ofthat posae oe i Ie frown produced and sold aS tong foi revenue (MR) fi : less than or equal to the m aterials and so forth) ; “ . sources (€-89 labor, ee ‘apot increases, demand yi® The oe fed a aod supply. If eS if the price declines. In making determin, nd will i ment considers decline. On the other ied nf resources, manag the decisions about the emp me marginal product for each input resou! Manageme MARGINAL PRODUCT additional gutput obtained from employing one The change in total revenue from employing one The marginal product is the the marginal revenue product. additional unit of a resource. additional unit of a resource is referred to as To be competitive, management must produce the optimal output in the most efficient manner. The cost of production in the long-run is minimized when the marginal product (MP) per peso of every input is the same. Similar to utility maximization for a consumer, the least cost formula is: MP of Input A _ _MPofinputB_ _ __MPofInputC MP of Input D Price of Input C Price of Input D Price of Input A Price of Input B MONEY AND INTEREST RATES THE ROLE OF MONEY IN THE ECONOMY ney is composed i called currence by t ~ OMposed of the bills and 2). But money alsg inches thera el Government (these are and savings aceounts, S stored as electronic entries- Applications of Microeconomics Theory as a Basis for Understanding ...__ $7 Because money in a modem economy is not directly backed by intrinsic value (e.g the coin’s weight in gold or silver), the financial system works on an futively fiduciary basis, relying on the public's confidence in the established forms of monetary e hange. Money serves three main purposes: 1. Medium of exchange. \t is acceptable in exchange for goods and Services. This critical function avoids the inefficiencies of barter exchange. A market economy would be impossible without money. 2. Store of Value. It is durable for exchange at a later date. This requires a Stable value so that purchasing power is retained over time. 3. Standard Value or Unit of Account. It is usable for quoting prices. THE SUPPLY AND DEMAND FOR MONEY Money facilitates the flow of resources in the circular model of macroeconomy. Not enough money will slow down the economy, and too much money can cause inflation because of higher price levels. Either way, monitoring the supply and demand for money is vital for the economy’s central bank’s monetary policy, which-aims to stabilize price levels and to support economic growth, The Money Supply Although the general description of money is relatively straightforward, the precise definition of the overall supply of money is complex because of the wide variety of forms of money in modern economies. The Key Measures for the Money Supply are: ¢ MI. The narrowest measure of the Money supply. It includes currency in circulation held by the nonblank public, demand deposits, other checkable deposits, and traveler’s checks. M/ refers primarily to moncy used as a medium of exchange. M2. In addition to M1, this measure includes money held in savings deposits, money market deposit accounts, noninstitutional money market mutual funds and other short-term money market assets (e.g,,| loney used as $8 Chapter 5 ). M2 refers primarily to money 8 Store lars). “overnight” Eurodol Value. F the financial j Stitug: Judes tion is measure inc! Eurodollars) 3 rep * M3. In addition to mane deposits and term Me Tefen inatior (e.g., large-denomin: rt. it of accoun Primarily to money used as a unit . liquid and near-liquiq is measure includes ial ts * L Inaddition to re nats, highrade commercia Paper ang k (€.g., short-term Tre: acceptance notes). 7 ae tory institut its of the public at banks and ies anes supply ane deposits 0 and are therefore included in mone as person considered money froma Bink Sonus i il afer en fublic withdraws ary the increase in inactive money will affect © bank? ress”), 7 the matt . f money. aon extend loans and will influence the supply o ¥ are The Bangko Sentral ng Pilipinas (BSP) is Fesponsible for determining the Supply of money. it Uses daily open market operations to influence the Creation of money by banks and to guide the availability of Money in the €conomy, Bsp also ‘as an impact on the creation of Money by banks thro reserve Tequirements and the discount rate that is, the interest Tate at which banks can borrow fiom the BSP as a lender Of last resort, Changes in the Supply of Money will affect the interest rate and therefore the Cost of | borrowing Money. This will have an impact on consumption and investment levels in the &conomy, The Demand for Money The Sources Of the Demand for Money are: Transaction demang, Mon demand, -tO- ait throug balance held by eB fanded for day-to-day paym Olds and '™s (instead of stocks, bonds Ssets). Thi kind of ine ce as not depend on the tof intr” Smand varies with GDP; it does35 Applications of Microeconomics Theory as a Basis for Understanding * Precautionary demand. Money demanded as a result of unanticipated Payments. This kind of demand varies with GDP. * Speculative demand. Money demanded because of expectations about interest rates in the future. This means that people will decide to expand their money balances and hold off on bond purchases if they expect terest rates to rise. This kind of demand has a negative relationship with the interest rate. The rate of interest is the price paid in the money market for the use of money (or loans). The rate is a percentage of the amount borrowed. If a person holds P1,000 in currency, the opportunity cost of holding the money is the interest that could be earned on the 1,000 in an interest-bearing account. The opportunity cost of holding money goes up if the interest rate increases, which may lead to decreased consumption and increased saving. Conversely, if the interest rate is low, it is relatively cheap to borrow money and the quantity of money demanded goes up. Therefore, the demand for currency has a negative relationship with the interest rate. t Changes in other factors will lead to shifts in the demand curve for money. Increases in the economy’s price level will increase the demand for money (note that the demand for money is tied to the interest rate, not the price level). If the real GDP increases, the demand for money increases because of the higher demand for products. Also, when banks develop new money products that allow for easier, low-cost withdrawal, the demand for money will decrease, such as, banks offering savings accounts with shorter (or less stringent) time deposit requirements and lower penalties for withdrawal. THE IMPACT OF MONEY In the macroeconomic short-run, some prices (c.g., wage rates affected by labor contracts) will be inflexible. This causes economic fluctuations, with real GDP either below potential GDP (recessionary gap) or above potential GDP (inflationary gap). The BSP’s monetary policy has an immediate, short-run impact on the economy. In particular, higher interest rates will decrease investment because it becomes more expensive to borrow money, and will also decrease consumption because consumers will tend to save more as interest rate returns increase. In addition, as higher Philippine interest rates increase the demand for Pesos on the foreign80 Cheyer 5 ove real on Philippines Cepositg) > increasingly expensive te ow when the BSP raiggs ts the rat’ rate is lowered. rns oa exchange markets (becaus’ ports i higher esos wil ores oa the inflation ot means that real GpP growth rs when the int interest rate, The reverse ocus enn when the €CONOMY fag ; + appli in the SC rp), The BSP may then py a Monetary poli tT spPe Is poten uantity of money and raisin Ue inflationary gap (reel he 4 i poligy 0 wid inflation by (oor decreases investment, el and» interest rate, The higher interes e deme id will decrease real . ae lower export, This decrease in BB! ic Tong-run, prices are assumed to be fy, price level. In the maeroeeon pp towal rd potential GDP. ly flexible, and this will m supply, it will increase agg! ‘as well as the real GDP. TI ‘actual unemployment rate bein, market will lead to a rise in the If the economy is at its long-run quill rogate deman his means 1g, below th rium and the BSP increases the mo, id. Consequently, the price level goes hat an inflationary gap exists, with fa e natural rate. The tightness in the labe rate. Because of higher labor cost, money wage g real GDP to the level of will increase returnin the short-run aggregate supply potential GDP. Tue QUANTITY THEORY OF MONEY The quantity theory of money holds that chan; i y Mi rv Q) ges in the mone: directly influences the economy's price level, but nothing else. Tien E i cory follows trom the equation of exchange: MXV where i = quantity of | money = velocity of money (i f ney (i.e., the av i fs of Money is used during Hehe etn 5, Soteand seven) year to purchase GDP’s . = price level =~ real GDP The equation o fe) endirs re 7 etl States that th nity erred theory ah actually eb nominal GDP o m m the econ M x V veloci : omy (M x }). : pe V is not affected by the quantity of m "y Considere 01 constay » f mone; Mand is nsidered ; Also, 7 Constant: wt. Also, potenti im eeApplications of Microec GDP G.e., long-run equilibrium) is not affected by Mand is considered constant: Y= Yoonstan HW not follows directly from the equation of exchange (M X V constam) (PX Y conta) that changes in M are ‘equal to the changes in P, in the long-run, This view of the equation of exchange expresses the (nco) classical neutrality of money, that is, money affects only nominal values but not real values. In other words, the money supply leaves real output unaffected. Historical evidence suggests that the money growth rate and the inflation rate are peel related in the long-run. However, the year-to-year relationship is weaker, The equation of exchange does not hold in the short-run, as the economy does not immediately adjust because of price inflexibility. Although, the relationship between M and P may not be casual, as suggested by quantity money theorists, it ‘appears that there is a correlation between M and P in the jJong-term. Therefore, growth in M can be used as a statistical estimate for the rate of inflation, that is, ~ the Central bank can be effective in stabilizing prices. It is less clear what the Central bank’s impact on short-term real GDP and real interest rates is. INTEREST RATES The interest rates link the future to the present. It allows individuals to evaluate the present value (the value today) of future income and costs. In essence, it is the market price of earlier availability. From the viewpoint of a potential borrower, the interest rate is the premium that must be paid in order to acquire goods sooner and pay for them later. From the lender’s viewpoint, it is a reward for waiting — a payment for supplying others with current purchasing power. The interest rates allows the lender to calculate the future benefit (future payments earned) of extending a loan or saving funds today. In a modern economy, people often borrow funds to finance current investments and consumption. Because of this, the interest rate is often defined as the price of loanable funds. This definition is correct. But we should remember that, it is the earlier availability of goods and services purchased, not the money itself that is desired by the borrower,ETERMINED How INTeREsT RATES ARE DETE Asha lea, . i Pheidemneate sie! Sets that they beyie fing, re ome to finance capital asse Y belie, wt lnvestors demand funds in o § demang I ously, consumers loan ft simultane CE. They preg *nah! Funda oe Outbut and have a pesitive rate of time prefere Y Prefer an funds because they have a Mer availability, Interest rates a stems from the Productiyis i nable funds ity The demand of aa ia order to Finance the tse of capi Sapital. Investors are wil pete fae expanding future outp il b vide tn iat mean than oY pet ‘0 repay the amount borrowe (the Principg) ith more and the interest on the loan AS Figure 5.7 illustrates, the interest rate brings the choices Of invest consumers i Nde willing to Supply funds. Higher interest rates make it More costly for investo re - Ie that would be Profitable at a low interest rate will be unprofitable at higher Fates ‘ome Consumers wil] reduce their current consumption rather than Pay interest Premium when the interest fate increases, Therefore, demanded by rowers is inversely Telated to the interest rate, The interest Tate also rewards People (lenders) willi consumption in order to provide loanable funds to 80ing to borrow in Order to Undertake an inve: iment Project (or consume More than their Current income), others must Curtail their Current Consumption by an qual amo, nt. In €ssence, the interes rate Provides lenders With the incentive to Teduce their Current consy, Ption so that, borr, TS can either invest of Consume yor Pl : Higher interest p, 8 give peo le Willin, to save (willing to supply losnable funds) iy. ability to purer mee goods in the ay xchange for Sacrificing Cure Consumy ion. Even though People have g up Current Consumption to i Price is Tight. Higher sare 2 Ore, as the interest rate rises, the the loanable funds mark Will increase, ing to reduce their Current others. If so,Applications of Mi plications of Micro rheory ay a Basis for Understanding... 63 Supply Interest rate Demand @ Loanable Funds Figure 5-7. Determining the Interest Rate As Figure 5-7 illustrates, the interest rate will bring the quantity of funds demanded into balance with the quantity supplied. At the equilibrium interest rate, the quantity of funds borrowers demand for investment and consumption now (rather than later) will just equal the quantity of funds lenders save. So, the interest rate brings the choices of borrowers and lenders into harmony. The rate of interest functions as the price in the money market. Money has a time value, and its use is bought and sold in the money market in return for the payment of interest. The financial institutions that deal in government securities and loans, gold and foreign exchange make up the money market. The money market is not a specific physical location but consists of transactions made electronically or by phone. Equilibrium in the money market occurs when the MD and MS curves intersect at the equilibrium interest rate, as shown in Figure 5-8. If the BSP were to decide to increase the quantity of money from MS to MS’, the supply of money curve would shift to the right, resulting in a decrease in the equilibrium interest rate. The lower cost of borrowing could spur higher consumption and investment. wn from r’ to r’” as the money supply curve The equilibrium interest rate goes do’ C when the BSP increases the quantity of shifts to the right from MS to Ms! (e.g., money).Ms Ms! MD — M MY Figure $8. Money market equilibrium According to Keynesian theory, the rate of interest is determineg 2 Dricg ; ™o markets: 1, Investment . The rate of interest balances the de, (required for Mand fo, fing, investment) and the supply of funds TOM say; Mvestors can e, ital {2 Savings) i ‘am a 10 percent return on a capi 'estm, Projeg, (eg, building a factory), they will willing t a rate of st af UP to 10 percent. Households delay consum, Saving (, ae Tewarded by ing interest) depending on their time refer nd the rate of interest, a tages can iffer sj ificant} IM One Nation to another, 2. Liquid assets, Households and businesses assets in liquid form ¢j i ay have Teasons to hold 1, readily available Money). Be use borrowers Fequire cash in le | ng-term ( doesn’t Need to be Tepaid to the lender immediately), are willing to Compensate lend for giving up liquidity, Keynes introduced the in luenc, the interest Tal : Teo the liquidity Preference on fond art ate te Classical “conomists, who Considered eae wands as the critiog Market for the int is topic liquidity Preference, st ate, niatanted she ; Although, intermediaries CaN achieve Markets, the Potentiay lack of Was essential to short-run, quality between the rates of interest te 5 Ween the j ney mari -Ynesian 8, Who chai in eestment and money Unemployment in the— Applications of Microeconomics Theory as a Basis for Understanding. 65 THE NOMINAL OR MONEY RATE VERSUS THE REAL RATE OF INTEREST We have emphasized that the interest rate is a premium paid by borrowers for earlier availability and a reward received by lenders for delaying consumption. However, during a period of inflation (a general incresse in prices); the nominal interest rate or money rate of interest is misleading indicator of how much borrowers are paying and lenders are receiving, Inflation reduces the purchasing Hower of a loan’s principal. Rising prices means that, when the borrower repays the principal in the future, it will not purchase as much as it would have when the funds were initially loaned, When inflation is common, lenders will recognize they are being repaid with pesos of less purchasing power. Unless they are compensated for the anticipated inflation by an upward adjustment in the interest rate, they will supply fewer funds to the loanable funds market, At the same time, when borrowers anticipate inflation, they will want to purchase goods and services now before they become even more expensive in the future. Thus, they are willing to pay an inflationary premium, an additional amount of interest that reflects the expected rate of future Price increases. For example, if borrowers and lenders fully anti ipate a 5 percent rate of inflation, they will be just as willing to agree on a9 percent interest rate as they were earlier to agree on a 4 Percent interest rate when both anticipated price stability. Unlike when the general price level is stable, the supply of loanable funds will decline (the supply curve will shift to the left) and the demand will increase (the demand curve will shift to the right) once decision makers anticipate future inflation. The money interest rate thus, rises overstating the “true” cost. of borrowing and the yield from lending. This true cost is the real rate interest, which is equal to the money rate of interest minus the inflationary premium. It reflects the real burden to borrowers and payoff to lenders in terms of their being able to buy goods and services. Our analysis indicates that, high rates of inflation will lead to a high money rate of interest. The real.world is consistent with this view.— a ee INTEREST Rate: AND RISK ingle interest rate present in the loa is only a single it interest ma have id thar et eae many rates, the ames ‘ the prime interest rate (the nd the credit card rate wo sng oe rages aoe! oan te Om 1B credit ratings), uta few, ill differ main}; Interest rates in the loanable funds eae vel skies tea ses mpc differences in the eee eee ica well-established ibaa » to | al Money to an unem, loyed worker th OL substantiat assets, Simitery, credit card loans are rises ala eicured b pSset. An example of a secured loan would oe a morteag The rish also If “rower defaults, the lender can repossess the a with the duration of the loan. The longer. the time period fie oe loan, likely it is that the borrower's ability to repay the loan will deteriate or ma Conditions changes in an highly unfavorable manner, ness As Figure 5-9 shows, the money rate of interest on a loan has thre Ne pure-interest component is the real Price one must availability, The inflationary-premium component reflects the e compon Pay for eq &Xpectation Pure interest Figure 5-9. The Three Components Errecr OF CHANGE IN] of Money Interest NTERESy Rates Control over Short-term j ntrol Herm j rates j achieve its main com ‘ Of the mai e B and ensuring finan smooth” tools of th OF contro e’s 8 one - re In i ial stability, "8 inflation thing out the businessApplications of Microeconomics Theory as.a Basis for Understandi Short-term interest rates are relevant for loans with a relatively short length for See aan while long-term imerest rates on the other hand, are relevant for loans such as long-term corporate borrowing and 10-20-30 year fixed rate mortgages. If the BSP pushes short-term interest rates up or down, the effects of its actions are felt most directly by interest-rate sensitive sectors of the economy. When it is more expensive to borrow, people make fewer purchases that require borrowing. But when the BSP cuts the short-term interest rate, that encourages borrowing and spending in the economy and puts upward pressure on prices. On September 10, 201 l, ; The Business Section of the Philippine Daily Inquirer published the following: “BSP: Rate hikes did not dampen economic growth” The Bangko Sentral ng Pilipinas said that, its decision to raise interest rates and hike the reserve requirement earlier this year, did not slow down growth of the economy in the first half. The central bank stressed that, the poor developments in the first semester was due largely to weak public spending and poor demand for the country’s exports. It added that the existing interest rate environment and level of liquidity in the economy remained favorable to the economy. “It is clear that the slower-than-expected growth in the first half was driven by weak global economic activity, which affected the country’s ability to export to different markets, and the state of public spending”, BSP Deputy Governor Diwa Guinigundo said, reacting to a comment that the prevailing interest rates and reserve requirement somehow dampened growth of the economy in the first six months. The economy, measured in terms of gross domestic product, grew by 4 percent during the period, which led to concerns that the country might not be able to attain its full-year growth target of between 5 and 6 percent. In the second quarter alone, the economy grew by 3.4 percent, a stark deceleration from the 8.9 percent in seen the same period last year. The BSP decided to raise its key policy rates, which affect commercial interest rates twice this year by a total of 50 basis points to head off inflation threats. This brought the rates at overnight borrowing rate now stands at 4.5 percent while overnight lending is at 6.5 percent.$8_Chaper s W QUESTIONS AND PROBLEMS REVIE 1 Questions in general? I What does the elasticity of demand measure g a id, the income elasticity of demang ice elasticity of demand, c , * code ec of demand measure in general’ 3. What fi Bovern the size of the coefficient of Price Clasticity of lat factors demand? i 2 4. What does the price elasticity of supply measure in general? i j it to a change in the price of » How does the length of the time of, adjustment i : come affect the price elasticity of the supply of the commodity, 6 Asa result of the high wage settlement in Metro Manila taxi Several years ago, taxi Owners increased taxi fares. Wag thi decision? i Strike of: S the right If the market demand for agricultural Commodities js Price inelastic, would a bad h it larvest lead to an increase or g decrease in the incomes of farmers as a 8roup? Why? 8. a. What are some of the implicit Costs incurred by an entrepreneur in running his firm? How are these implicit Costs estimated? Why must they be included as Part of costs of, Production? 5. What price does the firm Pay to purchase or hire the factors it does NOt own? iN? Of a goods total value? Are prices a (alte? What's the difference? rh total val ut low marginal value? it 'Y Profess; g despite the fact that nurse, brobabh I Wrestlers €am more than ‘nurses, 'Y Create More total Value to society.Le Applic i i ipplications of Microeconomics Theory as a Basis for Understanding ...__ 69 “The fi 5 fu ye ure of our industrial strength cannot be left to chance. Somebody leoeea," eae notions about which industries are winners and which are beeccats is statement b: i ” is thi somebody"? yy a newspaper columnist true? Who is this “Production should be for people and not for profit.” “Answer the Pllowing questions concerning this statement: (a) If production is oa: are people helped or harmed? Explain. (b) Are people helped a : Predation Tesults in a loss than if it leads to profit? Is there a tween production for people and production for profit? - Do business firms operating in competitive markets have a strong incentive to serve the interest of consumers? Are they motivated by a strong desire to help consumers? Are “good intentions” necessary if individuals are going to engage in actions that are helpful to others? Discuss. Il. Multiple Choice Questions Ts The demand video store’s business increased by 12% after the movie theater raised its prices form ?6.50 to P7.00. Thus, relative to movie theater admissions, videos are substitute goods. superior goods. complementary goods. ; public goods. Be op A decrease in the price of a complementary good will a. Shift the demand curve of the joint commodity to the left. b. _ Increase the price paid for a substitute good. c. Shift the supply curve of the joint commodity to the left. d. Shift the demand curve of the joint commodity to the right. The movement along the demand curve from one price-quantity combination to another is called a(n) a. change in demand. b. _ shift in the demand curve. c. change in the quantity demanded. d. — increase in demand.ne 1 lar Produg, a ott a pal 70 Chapter 5 nsumers decide 10 boye the 0 If a group of expected result would be price to make up lost revenue the prod duct An increase in i for the product. | a. ‘A decrease in the demant ly because of increased Availabiy; i supp! , An increase in sens product would become complete, That deman¢ inelastic. . in which demand jg , In a competitive market for labor in whic! ii Stable, it b. re 4. 5. ; workers try to increase rd wage, t must fall. x b. oom aa set a maximum wage below the Cquilibriun wage. c. fiams in the industry must become smaller. d. products supply must decrease. 6. Assuming the price elasticity of demand is calculated USing the simple or point method, Price is inelastic in which Tange of the following demand schedule? Price Quantity Demanded P22 100 i 200 if 400 A 600 e 800 a P22-pig b. PI8—pi4 c. Pl4—pig 4. Pl0~p¢ 7. If the price elastic ity of dema, id i 2 aK Feduction in t is brice ae ae eae " l0tlal revenue to fall by 5%, ms UC to fall by 15 < ° Y 12.5% quantity deman €d to tise by 12 SY ity ©mande to decrease f, . Y S%,Applic ” ipplications of Microeconomics Theory as a Basis for Understanding .. 7 A perfectly inelasti i i perfectly inelastic supply curve in a competitive market implies a vertical demand curve. exists when firms cannot vary input usage. implies a horizontal market supply curve. can exist only in the long run. ae ge A supply curve illustrates the relationship between a. price and quantity supplied. b. Price and consumer tastes. ¢. price and quantity demanded. d. supply and demand. An improvement in technology that in turn leads to improved worker productivity would most likely result in a. a shift to the right in the supply curve and a lowering of the price of the output. b. a shift to the left in the supply curve and a lowering of the price of the output. an increase in the price of the output if demand is unchanged. c. d. wage increases. Price ceilings a. are illustrated by government price support programs in agriculture. create prices greater than equilibrium prices. c. create prices below equilibrium prices. d. — result in persistent surpluses. The competitive model of supply and demand predicts that a surplus can arise only if there is a a. maximum price above the equilibrium price. b. minimum price below the equilibrium price. c. maximum price below the equilibrium price. d. minimum price above the equilibrium price. In any competitive market, an equal increase in both demand and supply can be expected to always a. _ increase both price and market-clearing quantity. decrease both price and market-clearing quantity. b. ¢. increase market-clearing quantity. d. _ increase price.22 Chapters demand for a good increase, the mai Ph chapers the 14. If both the supply and ; iy function, Price will ase of an inelastic ane function, a. tise only oe of an inelastic supply fall only in ts. b. : ith only these fact ; ©. Not be predictale 5 f an inelastic demand function. d. rise only in ae istic of ; i ;omics, the distinguishing characteristic of the lonig 8 In microecon a ide is that / on the supply side is that say prod ond cutee ly factors determine pric : . a deren factors determine price eae °. fits are not allowed to enter or exit the industry. d. all inputs are variable. 16. Marginal revenue is a a. veaial to price in monopolistic competition. a , ; The change in total revenue-associated with Mcreasing Prices, ice it etition. c. greater than Price in pure comps 1 . ; d. the change in total revenue associated with Producing and selling one more unit, 17, The measurement of the benefit lost by using Tesources for a Riven Purpose is 2. economic efficiency, b. Opportunity cost. . comparative advantage, d. absolute advantage, 18 The definition of economic Cost is a. all the costs employers Pay for all j i Puts purchased, he PPortunity cot of all inputs 1 Ch ce betwee, i minus the Cost of those inputs, nal icit ici business fre 'mplicit ang explicit costs of the The sum OF all explicit and implicit Costs of the business firm. " rt run, the Supph fi ae POSitive elationshj b re ane ma “ompetitive market shows a a, Consumers wil onl red Price and qWantity supplied because bad of diminish a 4 product at a higher price. oS Me size of t busin, pa 4. inctea: Sin in firm Increases, price must rise. Allowing a high ; iply a shift ; " Consumer preferences,20. 21. 22. Applications of Microeconomies Theory as a Basis for Understanding 73 In the long run, a firm may experience increasing returns due to a, Law of diminishing returns. b. — opportunity costs. & comparative advantage Because of the existence of economies of scale, business firms may find that ji a, each additional unit of labor is less efficient than the previous unit, i b. as more labor is added to a factory, increases in output will diminish in ‘the short run. c. increasing the size of a factory will result in lower average costs. increasing the size of a factory will result in lower total costs. Which of the following do you think would lead to an increase in the current demand for beef? a. Higher pork prices b. Higher consumer income c. Higher prices of feed grains used to feed cattle d. ‘Botha&b eCHAPTER 1, 2. APPLICATION OF MACROECONOMICS THEORY AS A BASig THE FOR UNDERSTANDING KEY ECONOMIC VARIABLES AFFECTING THE BUSINESS LEARNING OBJECTIVES After studying Chapter 6, you should be able to: Understand the significance of macroeconomic theory as it impacts the Operations of a business. Explain the flow of goods and services in the economy. Know how the various measures of economic Output, employment, inflation, trade surpluses/deficits impact the major segments of the economy such as the Consumers, business and government. : . Explain aggregate demand and Supply as. they DP. affect G Understand the inputs of Production Namely labor, capital, land, intermediate inputs and business know-how. Understand the nature of moneta Olicies and their effect on the &conomy, an Enumerate the various Monetary policy tools that the BSP can use to achieve its objectives, 1% Me ot, %P Me ae o% 6%CHAPTER 6 APPLICATIONS OF MACROECONOMICS THEORY AS A BASIS FOR UNDERSTANDING THE KEY ECONOMIC VARIABLES AFFECTING THE BUSINESS INTRODUCTION To MACROECONOMICS Macroeconomics is the study of national economy and the determination of national income. It involves the major sectors of the national economy, that is, households, business firms, government and foreign sector. A straightforward model of the flow of resources and money movement across the sectors of the national economy is a major tool for the analysis of the economy’s performance. Figure 6-1 shows the flow'of goods and services. Suppliers of labor and other inputs Flow of goods and services — eee Business . ~-— Inputs Production beatin td | Profit Cost of inputs} Maximization Revenue from Flow of money selling outputs Figure 6-1. Flow of Goods and Services— ts to sell to its buyers, = owes open ce outputs 76 Chapter 6 —, 15 10 prods it sells t0 Customers, ‘The ig and a ses (0 produce the outputs, |, its suppliers. Any money 'A business uses inputs fT T- good: an S The outputs e busines pays inputs are the 8 and ite return, it receives lof a business °° i ods and SerVie% vers nd cost: ns an om buy nee betwee? venues and costs, the differe! a market econom, fit. Profit is Taassiil business in want to operate it in that remains is pro! in tI " For better or for worse, the malt chr i a business is profit maximization. That is ie a petween revertue and costs. While 4 away that yields the a als, includiN providing jobs for the loca 8 i citizen, it must try to make g f the business ang sponsible cOrPO! ference ween the revenue of t will have trouble surviving in a competitive business might hi population, or being a $0 good profit - defined as the diff its total cost of production or it world. ofit of a business is difficult. Managers have ng world, tough competitors and tougher ucts not acceptable to consumers, ' ulty of consistently producing ive of large corporations get st of them have such a short In the real world, maximizing the pr to deal with a constantly changin employees, machines that break down, prodi corporate scandals and natural disasters. The diffic vessful chief executi a good profit is the reason suce it is also the reason why mo: G paid so handsomely, and tenure on the job. Businesses with profit-maximizin 3 g goal are not the only source of : fg ; rodu a dete are proauave enterprises with other goals. Nonprofit oreanizaon , universities and’ hospitals also supph i ¢ pees ar 4 pply goods and services. Gi Lk al arse oe as, police forces and education. Most child a ‘ites yy parents or other household members and most famili Sa milies are not run as profit-making enterprises, SIGNIFICANCE OF MACROECONOMICS Macroeconomics | looks at the economy as a whole. It foci ; uses on measures of economic output, empl b 101 ployment, inflation and trade surp| so luses or deficits. It al examines the spendi : ing of the ‘ business and government, three major Segments of th i economy, consi , CONSUMETS, services prod ic Prod, prices. Produced by a domestic (GDP) ~ The pri '¢ economy for Fi Price of all goods and year at current markelApplications of Macroeconomics Theory as a Basis for Understanding .._77 Real GDP — The price of all goods and services produced by the clini’ at Price level adjusted (constant) prices. Price level adjustment minates the effect of inflation on the measure. ten GDP ~ The maximum amount of production that could take Place in an economy without putting pressure on the general level of Prices. The difference between potential GDP and real GDP is called the GDP gap. When it is positive, it indicates that there are unemployed resources in the economy and, we would expect unemployment. Alternatively, when it is negative, it indicates that the economy is running above normal capacity and prices should begin to rise. Net Domestic Product (NDP) — GDP minus depreciation. Gross National Product (GNP) ~ The price of all goods and services produced by labor and property supplied by the nation’s residents. CALCULATION OF GDP Two ways to calculate GDP: The income’ (output) approach — Adds up all incomes earned in the production of final goods and services such as wages, interests, rents, dividends, and so forth. The expenditure (input) approach - Adds up all expenditures to purchase final goods and services by households, businesses and the government. Specifically, it includes personal consumption expenditures, gross private investment in capital goods (e.g., equipment) and also the country’s net exports. The tables below illustrate these computations. The Income Side of GDP - Compensation to employees P 12,020 _ Corporate profits 1,534 Net interest 1,108 Proprietor's income 1,486 Rental income of persons 286 National income 16,434 1,588 Plus: Indirect taxesincluding statutoY pene (02) 20,404 Minus: Others: Net national product copitl Plus: Consumption of fix ° - a + Core national Produc ato other CP counties (670) Plus: Payments of factor income ner er count ft Minus: Receipts of 120° incom Gross domestic product — The Product Side of GDP P 14,130 jtures personal consumption expend Gross private domestic fixed investment ve Business ez Residential Government purchases eu Federal ya State and local a Net exports @ 0 Changes in business inventories te) F20876 Gross domestic product AGGREGATE DEMAND AND SUPPLY EFFECTS OF CHANGES IN PRICE LEVEL ON THE AGGREGATE DEMANDS es sapepte demand curve illustrates the relationship between the quantity of eal es ie pie rice holding other things constant. The lemand of consumers, businesses 1 s and government as well as, foreign purchasers for the i aaa e goods and services of the economy at For example, if the price level i 5 3 el is 110, the services demanded i: any » the as ‘i intertemporal substion ota Due to emcee ne of goods and quantity of real GDP iene and the intemational Ee ances: effect, the aggregate demand curve is a as the price ernie ete . ly sh rises. us, the related to price level. loped, In other words, it is inverselyApplications of Macroeconomics Theory as a Basis for Understanding -. 9 The price level affects aggregate demand for several reasons, namely: \, Effect of Change in Interest Rate As price level increases (due to inflation), nominal interest rate increases, thereby causing a decrease in interest sensitive spending such 8s spending for houses, cars and appliances. Effect of Change in Wealth When price level increases, the market value of certain financial assets decreases (e.g,, fixed rate bonds) causing lesser wealth of individual which will likewise cause a reduction in their consumption. we Effect of Change in International Purchasing Power When domestic price level increases relative to foreign currencies, foreign products become cheaper causing an increase in imported goods and decrease in exported goods. Thus, a decrease in aggregate demand for domestic products would be observed. When consumers, businesses or governments are willing to more or less or when there is an increase or decrease in the demand for domestic products abroad, the aggregate demand curve shifts. Government can affect aggregate demand through its own spending levels, taxes and monetary policy. For instance, a rediiction in individual or corporate taxes increases the spendable income of consumers or businesses thus increasing their spending. AGGREGATE SUPPLY The aggregate supply (output) schedule on the other hand, presents the relationship between goods ‘and services supplied and the price level, on the assumption that all other variables affecting supply are constant. The aggregate supply curve is generally depicted as follows.80 Chapter 6 Real Output e Supply Curve stable or constant until the economy Figure 6-2. Aggregate ease at a significant rate, remain relatively ‘ices A 1 ‘As can be observed, pri h time prices begin to incr reaches near capacity at whic Shifts in the aggregate supply curve may be caused by: Technology improvements © Changes in resource availability, or © Changes in resource costs Equilibrium GDP occurs when the output level of the economy creates just enough spending to purchase the entire output. The multiplier refers to the fact that an incr i i e ease in spending by consumer: pusineses en the government has a multiplied effect on eailibgtans GDP. The fei Prec saan ‘pending generates increases in income to ich in in + n . ete mn um increases their spending ripples through save (MPS). The additional income ig ej is either spent or save : : ed (MPS + MPC >= 1) The multiplier may be calculated ag foll low; 1 ete, MPS* (%: Change in SpendingApplications of Macroeconomics Theory as a Basis for Understanding 81 PRODUCTION At the core of a wea pasioter willl peer ti is production - turning inputs into outputs that aided inte ae ie INU used by a business in the production process e08 business Rndyi- Roig). seen aber, capital, land, intermediate inputs and © Lab , eaakne ie to the inputs supplied by the various types of workers that usiness to function. Labor inputs can be measured either by the number of workers a busi worked. a business employs or by the total number of hours Capital is another name for all the long-lived physical equipment, software and structures-a businesses uses in its production process. Land is the actual ground used by a business. Factories need land as do office buildings, agriculture, and mining are especially land-intensive. © Intermediate inputs refer to any goods and services purchased from other businesses and used up in production. For example, almost every business needs to buy electricity and telephone services. In fact, much economic activity consists of business-to-business transactions, in which businesses buy and sell intermediate inputs. © Business know-how includes all the knowledge and technology necessary for the production process. Business know-how can spell out a company’s success or failure. Most companies do not officially report all their business know-how costs. However, expenditures on research and development, are reported on the annual financial statements of the business. The production function summarizes the output of a business, given the levels of its inputs. The marginal product of | labor is the extra amount of output a business can generate by adding one or more worker. The total cost production is the sum of-costs for each of the inputs. ‘The cost function for a business reports how much it will cost to produce a given level of output. Marginal cost is the added cost to produce one more unit of output. Revenue on the other hand, is the amount of money companies get from selling their products or services. Marginal revenue \s the added revenue from producingn, the marginal revenye fe ti utput. In perfect compe! and selling one more unit of ot will be equal to the price. ase production 4S long as marginal will incre A. profit-maximizing busines revenue exceeds marginal cost. JON AND. LONG-TERM DECISION SHORT-TERM PROFIT MAXIMIZAT! | on achieving the highest _ profit, ic ycuses tio cannot be changed. Short-term profit maximize oe tant and assuming that fixed costs are cons In contrast; assumes that a business can vary all its inputs This also includes the results of a company’s Long-term profit maximization with new products, entering new even going as far as shutting down. Th big strategic decisions such as, coming up ni t " markets, offering low prices or trying to get maximum efficiency from their workforce. BUSINESS CYCLES A business cycle is a fluctuation in aggregate economic output that lasts for several years. It reflects the recession and expansion in an economy and depicted as a series of peaks and troughs, The peak is the date on which a recession Starts — that is, when the economy hits 4 high. points and starts headin, I r 1g downward, It i economic expansion and the beginning of rcveision eee amie A recession is a period of negati ; legative GDP i ; rowth, eas ee Consecutive quarters of negative ODP ee See recession is referred to as depression, Browth. A deep and long-lastingApplication ; nS Of Macroec oe r ‘onom The trough is the Theory as a Basis for Understanding 83 heading up again, “SO whi aoe hhich the recession ends and the economy st The expansion is the the next time fro xt peak, m the trough, through recovery and all the way to Figure 6-3 sho E, ws the typi . recession, and the Pical business cycle. Thi to the next. trough marks its end. A ee nae oan oon eal full business cycle runs from one peak Peak. Output (increasing) ——— 7“ —” Recession Expansion <——_—_—_— Business Cycle Time (increasing) Figure 6-3. Typical Business Cycles ‘THE IMPACT OF RECESSION ON BUSINESSES Recessions hurt businesses as well as workers. As an economy slows, the demand schedules of most businesses shift to the left. For the same price, the quantity demanded falls and therefore the quantity supplied also falls. Figure 6-4 shows the effect of most recessions in the economy._ sim the Economy ns in the Eeonomy — iwhat Happens it @ Recess Businesses Tay of workers and eut back on | gir real incomes drop _| | Retail sales Home ‘construction jouschold income, a ake less money _ inflation Business profi _ its s ls =—al capital such —_— spend less 0” physical capital such | computers and bu — Business investment jes produce Fess —_ = Industrial production (ihe outpu fi <3) = collect less 1 eS mes they grow too get out ‘of control. ys BI ditions in W! which infty unpleasant stretch which rate. Sometil Market eco! fast for a perio Other times. ™ economists © tr never go. away: But they can be made less F economies wil wie policy (fiscal and monetary) responses: THEIR NATURE AND EFFECT ON ECONOMY debt in , taxes. andUnderstanding run fiscal policy. Soe nce? TePutabl : the econorey fey Some Favor a a le economists disagree about the right way to is in a slump becaus, al role for the government, especially when because’ they argue eas celts that managing the economy is the: araup oft Prefer: ese governance Deemnment spending and taxation onomist focuse: ‘nment interference and oversight. And a third differencé S on reduci i ¢ between spending and mene the size of the budget deficit which is the ue. In the short term, an increase Fs in A increases Gross Domestic Pee spending lowers unemployment and essence of the Keynesian Appr ic DP), all other things being equal. This is the government spending and ipproach to Macroeconomics, which uses increases in Coverriieit sparkling end Cuts in taxes to fight recessions. Such increases in involve changes in fiscal Cuts in taxes are called fiscal stimulus because they economic activity that fees The multiplier effort is the overall boost in multiplier is determined Rowe, fon the spending increase. The size of the iat Goattoak leakawe part by the marginal propensity to consume and the Meee propensity to consume is the portion that households spend of each ad itional peso they receive. The higher the marginal propensity to consume, the bigger the multiplier will be all other things being equal. The amount 0 overseas leakages refers to the transfer of domestic economic stimulus to foreign market. It occurs when the money spent on goods and services produced locally are less than the amount spent on imports. loyment and increases GDP, all other Also,'a decrease in taxes lowers unempl taxes tends to boost wages and prices, things being equal. That same decrease in all other things being equal. ate the economy, boosting employment up interest rates and crowd f servicing the debt would those expenditures. Increasing the budget deficit can stimul: ment borrowing can push and GDP. However, govern t. In the end, the costs ©! out private sector investmen' : outstrip the economic resources available for covering ‘As overseas leakage grows; the multiplier from fiscal stimulus shrinks. That is especially true when the government purchases directly from overseas suppliers which completely skips any job creation domestically. affect employment, output, inflation, the positive and negative impacts of nt can take. jons put together can e 6-5 summarizes ational governme! All the fiscal policy acti and interest rates. Figur the different actions the ni—— 86 Chapter 6 _——— = +t GDP, and provide MNCeNtiye, ; 0% vo 4 can create jobs, BO the budget deficit and pump 3 For example, lowering taxes wide! 0 can als for work and investments but it interest rates, rk int The effects listed in Figure 6-5 WO a Id. have that. wou! the government raised taxes. T! ne opposite di ducing inflation and interest rates irection as well, Suppose contractionary effect on 1 ntially Fe r things being equa}, employment and GDP while potentially Ti othe rowing, because the government would be bot 7 include is a What Figure 6-5 does not inc tl different effects, That is partly Ce business cycle. It is also because evo bigger. of the relative sizes Of the a depend on where we are in the erties about which impacts are ; Hel Fiscal Policy Action How It Can Help How It Can Hurt ts Increase government | Can create jobs and boost Can boost inflation and widen the budget deficit, GDP. Other impacts depend on the particular combination of spending and tax changes eee paar the _ | leading to higher interest spending — for example, rates and lower private building new bridges and investment highways os Lower taxes Can create jobs and boost | Can boost inflation and GDP, and provide widen the budget deficit, incentives for work and leading to higher interest investment Tates and lower private investment Accept wider budget Can create jobs and boosts | Can lead to higher interest deficit The monetary policies of the count fe the central bank Pertain to the Us vilated institutions and other Policy too} re 5 S to j financial system, ‘0 influence le and ey fates and lower private investment. Over the long Tun, can lower Productivity and GDP rowth ventually implemented by S, direct lending to financial Sconomy and support theex Theory as a Basis for Understanding = 87 Applications of Macroeconomic GOALS OF MONETARY Poicies The main goals of monetary policies are (1) controlling inflation, (2) smoothing out the business cycle, and (3) ensuring financial stability. Comrolling Inflation Inflation is 4 sustained upward movement in the average price level of goods ae services, usually measured on an annual basis. Deflation on the other hand, 's described as a decrease in the price levels. Deflation is very damaging because businesses do not want to borrow mon’y and pay it back with money that has more purchasing power, and they do not want to favest in plant and equipment even if the cost is declining. High rates of inflation are not good for the economy either because it generally causes economic activity to contract or redistributes income and wealth. There are generally two causes for inflation: 1, Demand-pull inflation. This occurs when aggregate spending exceeds the economy’s normal full-employment output capacity. This generally happens at the peak of a business cycle and characterized by real GDP exceeding potential GDP. Because labor is short, bid up the price and inflation océurs. an increase in the cost of producing aracterized.by decreases in aggregate onsumers are not willing to pay the 2. Cost-push inflation. Occurs from goods and services. It is usually ch: output and employment because inflated prices. between inflation and unemployment. ‘There is an inverse relationship lation tends to increase. Inflation tends When the inflation rate is low, infl to decrease when the unemployment rate is high. Economists generally think that policy makers should aim to keep the inflation rate around 2 percent. Today the top goal of monetary policy is to keep inflation under control because rising prices eat away as the value of money. Maintaining public trust in the value of a currency is paramount for a well-functioning economy. A low stable inflation rate is considered the best way towords, the Mgnt goal fo, enn y her cae 88 Chapter 6 ie grow In a to a situation in Whig, mn side the & saving and investmen, . ono! conomny, achieve strong ec? ide ; their to gue th is ‘ , is making tained generalized pricg monetary policy 'S in makin a households and business possibility of decisions can safely ignore increases or decreases» icy in Action ; Monetary Policy in f the Philippine Daily Inquirer, the ‘ ion 0! In the September 7, 2011 Business Sectior w” “August Inflation Rates to 4-month Lo e slowed to a four-month low in August, orities will keep interest rates at The annual inflation rat ry auth d on September 6, 2011 boosting prospects that moneta low levels. The National Statistics Office reporte that based on 2006 prices, the rate of increase slowed down for food and non-alcoholic beverages; clothing and footwear; housing; water; electricity; gas and other fuels; recreation and culture; and education. Annual headline inflation in August was 4.3 percent based on year 2000 prices, a notch lower than market forecasts and near the lower end of a central bank estimate of 3 to 5 percent per year. Economists said that the lower inflation rate was to be expected since there were no sharp changes in food, fuel, light, and water prices given the slow-moving econom inti ly and uncertaii : worldiide: inties on future economic growth89 Applications of Macroeconomics Theory as a Basis for Understar “Bangko Sentral to Keep Policy Rates Steady” According to Governor Amando M. Tetangco Jr. of the Bangko Sentral ng Pilipinas, there is no strong reason for monetary authorities tO change policy rates soon given the weakening inflation. The BSP Chief said that with the year-to-date average of 4.3 percent, the BSP 1s poised to meet the full-year inflation target of 3 to 5 percent. The August turnout supports their assessment of a manageable inflation environment over the policy horizon and such direction of inflation numbers meant that there has been some slowdown in economic growth. He also said that such prevailing environment should prompt banks to give out more loans which would help support domestic growth. Smoothing Out the Business Cycle In the Philippines, the Bangko Sentral ng Pilipinas (BSP) has the primary responsibility for fighting recessions. As the country’s central bank, the BSP was designed to have quite of independence. If the BSP were not independent, it could come under pressure to adopt monetary policies that could benefit the political party in power but are not necessarily good for the country as a whole. For instance, the BSP could cut interest rates just before election in order to gain votes for the party in power. So when the economy slows and the unemployment rate starts to rise, the first thing that economists, businessmen, and politician want to know is this; “What is the BSP going to do about it?” ¢ main thing that the BSP can do is cut In response to rising unemployment, th ulate purchases of things like cars and interest rates. Lower interest rates stim homes, thus boosting the economy.9 6 bility the et 1987, when the stock mu ty jn the worst St0K f t Depress E = rea id have Or" tocks that coul Mn vi t day: it ites UNEXpected}, united Stat since the 1929 crash at the + $500 billion in one day, Ty oon, investors IOS! 1) their money from the ue om takin} some of the big banks and n Greenspan issued a one. Ensuring Financial Sta On October 19.1 plunged by 22% beginning of the Great reassure investors and P! \ \f their st Sa sear rete bankruptcy opened the nex sentence statement before the mar es she ation’ cg “The Federal Reserve, consistent with its ies Of liquidity to support the bunk affirmed today its readiness £0 serve a economic and financial system. ee A ; jing one of its main Tul 5 7 lender Sree for Re This is also the role of the Fed played during the housing bust of 2007 and 2008. Having a lender of last resort is necessary for a well-functioning market economy. In many ways, that is still the central bank’s biggest job because a meltdown in the financial market would paralyze the economy making it impossible for companies and individual to borrow the money they need to continue operation, to expand and improve their businesses. MONETARY POLICY VERSUS FISCAL POLICY What are the similarities and di ces, A poly? ies and differences between Monetary policy and fiscal Both can speed up or down the econom: interest rates and Congress can Y. The central bank can cut or raise box i ost or cut spend; 'Ng or cut or raise taxes, 1. Monetary policy; . Policy is ty Policy. The central rae More flexible and | President becaus, al Process of passin it - 11, cs Political than fiscal Mor Political thai a does not havs'ta Quickly than Congress and the eiBslaton, 8 through the lengthy politicalApplications ions of Macroeconomics Theory as a Basis for Understanding 7 The . steps That tk when it does act, ean take action in a series of small the economy re s it can cut or raise rates a little bit at a time and see how expend sé pereaels before it goes further. In contrast, Congress has to ca be done ieee litical energy to pass a big tax or spending bill that it faoneiar loys once a year (or sometimes not at all), That makes ¥ policy much more flexible than fiscal policy. hi When the economy recovers from a downturn, the central bank can take back a monetary stimulu il Ss, more take back a tax cut or added spending, easily than Congress can LONG-TERM EFFECTS OF MONETARY POLICY Economist generally ‘agree however, that monetary policy affects the long-term rate of inflation but has little direct effect over the long-term on the rate of unemployment or the potential rate of growth. That is, if the central bank stimulates the economy in an attempt to keep unemployment rate low, the main result will be accelerating inflation. Workers will push up wages and businesses will push up prices potentially leading to a wage-price spiral. The best way to improve long-term growth has nothing to do with the Central bank. Instead, the country has to invest in physical and-human capital and in the creation of knowledge. These sorts of investment can help cut unemployment as well because firms that are growing and succéeding can hire plenty of workers and keep them employed. There are however, two indirect ways by which effective monetary policy can improve long-term outcomes. 1. Low inflation makes the future more predictable making it easier for the business and individual to plan and make good decisions. This will improve growth and employment in the long run. 2 If the Central bank is able to smooth out the business.cycle, recessions will be few and mild. This act makes it easier for business to take more risks in terms of investing in new technologies and opening up new business line. In other words, the central bank’s best long-term contribution to the economy through its monetary policies is to manage it well by minimizing its ups and downs rather than stimulating it excessively.92 Mol Chapter 6 NETARY POLICY TOOLS seve its goals? / hieve its goa How does the Bangko Sentral ng Pilipinas (BSP) acl ise. These are icy that the BSP can u: There are three main tools for monetary Py aes lending to banks and other (1) control over short-term interest rates, int Window), and (3) changes in the financial institutions in times of crisis (Discou! F i ulations. reserve requirement and other financial reg ts Control over Short-term Interest Rates. The monetary regulator’s mst used policy & aly recat stort i en market operations. i, is flevantg te with a relatively short length for repayment, like credit card balances, auto loans and for adjustable rate mortgages (these are home loans whose interest rates are allowed to rise at set time). Long. term interest rates on the other hand, are relevant for loans such as 30. year fixed rate mortgages and long-term corporate borrowing, The BSP can influence short-term ‘interest rates via open market operations which increase or decrease the amount of money available to banks for lending out. When.the. BSP wants to change Monetary policy by lowerin, ; i 8 OF raising interest rates, it takes a more roundabout route, To j Ilustrate: (a) pati are required to keep a Portion of their deposits in cash in their vaults or on reserve with the BSP. The More more they can hn reserves they have, the nancial institution now lend extra Money to “Test rates, or the bank can lend then can do more lendingApplications of Macy 93 onomi Theory as a Basis for Understanding a it reduces the e's Some government securities it already a a that, loss r Money in the account of the purchaser, ‘The net offor ig Money is available to be loaned out and interest rates FINE. (©) Open market operations In practice, the BSP doe: $ not directly control credit card on auto loans but rather targets a. parti ere iene cular short-term rate called the CB overnight he rate banks charges each other for lending reserves overnight. Generally speaking, if the economy is running above potential GDP and inflation is too high, the BSP wilf raise the funds rate to slow the economy down. If the economy is running below potential and inflation is tame, the BSP will lower the funds rate to stimulate growth. The consumer of course does not pay the BSP funds rate because it is an interest rate that bank charge each other. However, the fund rate affects all other interest rates including rates on money market rates, credit cards, auto loans, and adjustable rate mortgages. It is also true that these rates do not necessarily move in exact direction such as, funds rate. Some car companies, for example, might offer a lower interest rate on their cars even if the funds rate goes up. But in general, most short-term rates move more or less together with the funds rate. It is also true that the BSP’s influence over interest rate does not extend to long-term loan. The Discount Window The Central bank’s prime weapon against a financial crisis is its ability to lend vulnerable financial institutions as much money as they need. To do this, it uses a monetary tool called the discount window. ‘The discount window, broadly speaking, includes all of the different ways in which the Central bank can lend money directly to financial institutions that are in trouble. The purpose of the discount window is to give financial institution access to funds if they run short. Under normal circumstances, the use of the discount window is usually viewed as a sign that a bank is mismanaged, so bank are reluctant to use it, But in a financial crisis, it is an indispensable tool for getting money into the financial system quickly. In the United States of America, when the two planes hit the World Trade Center on September 11, 2001, and Killed almost 4,000 people, the biggest financial center in the world, the Wall Street, shut down and the New York operations of many banks and other large financial operations paralyzed. To prevent the economic disaster from happening, the Federal94 Chapter 6 than $45 billion to make Sure th A s more BOs ey ft dear ames ee rah no bank failed in the aftermath and thy id not run out o money. Ms €conomy kept functioning. ve in 2007 made extensive Use oft i Federal Reserve in 7-208. The hor 7 ae ain onde the housing bust of oe becabe motsng tscount mow ‘and 2006 turned to bust in pi en 100. many boom between I built-and because too many loans ‘ad _been made bo ane ee not afford them. Te falling raoeae Prioes scant a . Hor Iso haq identi: tion dropped sharply. v W to cue he och fecon colo aoe cal Pog 2Rting the value of their homes. In addition to cutting the interest rates, the BSP can ra the discour, windows by encouraging financial institutions to borrow Tom the BSP ag needed, and charged them the discount rate which Usually is one Percentage point higher than the overnight funds rate, Also, the BSP created a new variant of the discount window or Tew ways to lend to financial institutions (eg., Term Auction Facility — where banks can borrow from the BSP at an interest rate-set by an auction), The main point of all of the new variant is to get financially stressed banks and other financial institutions the funds they need to Stay afloat. The Reserve Requirement and Other Regulations The monetary authority or BSP also has the Power to change the reserve and marginal Tequirer tl k ion’ th ie Itisa Well-known fact that banks have to €eP @ Portion. of their deposits either in cash in the; rve with the BSP. n their vaults or on rese pend reat influence Over bank lending by controlling the less Money banks haye no" Money they have to keep on reserve, ‘S hay i . banks means les, spending ial le nds to lend. Reduced lending by economy orrowers Which results to slowdown it Alternatively, Cuttin, : 8 the re A to borrowing and lending eve Tequirement caja:Applications of iq econo} Thee ‘ory as a Basis for Understanding ... 95. th, MerRin reauireme they buy stock. ‘The 1acetermines how much people can borrow when Percentage of cach quater th he margin requirement, the higher the i low borrowing to buy securities Payment’ a purchaser must make when Raising the margi , stock, and this Ree Fequirement makes it harder for investors to buy as the effect of holding down the stock market. Changing ei lank te ae the reserve requirement or the maigin requirement is a instruments, theo’ Policy that the BSP or SEC rarely use. These them, Ue: are always available if the monetary regulators need SUPPLY-SIDE POLICIES The link between taxes and incentives is the essential insight of supply-side economics, This economic theory holds that bolstering an economy's ability to supply more goods is the most effective Way to: stimulate growth. A decrease in taxes (especially for businesses and individuals with high income) increases employment, savings, and investments; and is an effective way to stimulate the economy. The tax revenue lost from the reduction in-taxes is more than offset by the increase in taxes from increased economic activi ity. However, this predicted effect only occurs when rates are too high. Supply-side economics focuses on the marginal tax rate, the tax one pays on the last peso of income he/she earns. For example, when the marginal tax rate is 35%, if one earns an extra peso, the government gets 35% and the individual gets 65%. Different people may have different marginal tax rates depending on their level of income and the tax code. The marginal tax rate is important because it determines one’s incentives for working a bit more. If a person’s marginal tax tate were 90%, for example, it would not encourage that person to increase his. hour of work because the government would be taking 90% of every additional peso he made. But if the marginal tax rate were only 10%, the government’s share would be minimal. Supply-side economics argues that cutting taxes gives people incentive to work and invest more._ ne es that cutting taxes y-side econom Si eta tax revenues, Bu One extreme version of supp to re sal ax entes sling) decreases at mattlate enough work and in Se peavily lessens thelr incentive ¢ Most economists today aE ing the ch foo heavily other hand, taxi reve 0 arn. In the enues. On the Mo mot get to keep what they e same Work hard use they do d poverty employment and po ty ig F i eve the fear of un home and imporent fi totvting the pot work rather than stay at depeng nt for moti only on government Support or welfare.Application = ns of My - of Macroeconom Theory as a Basis for Understandi 97 REVI EW QUESTIONS AND PROBLEMS 1. Questions 1. What are the five bro, two examples of each, ad classifications of factors of production? Give 2. Describe a mixed economy What i . oe maton by scarcity? Why does the existence of scarcity mean that nake choices and why will cooperation not eliminate scarcity? Explain the difference between wants and demands. 5. List three events that would likely cause an increase in the demand for peanut butter. What effect would such an increase in demand have on the price of peanut butter and the quantity traded? . 6. Explain how a fall in price eliminates a surplus. 7. The price of personal computers has continued to fall even in the face of increasing demand. Explain. 8. A tax on crude oil would raise the cost of the. primary resource used in the production of gasoline. A proponent of such tax has claimed that it will not raise the price of gasoline using the following argument: While the price of gasoline may rise initially, the price increase will cause the demand for gasoline to decrease which will push the price back down. What is wrong with this argument? 9. What is meant by the value of money? Why does the value of money fall when there is inflation? ; 10. Consider borrowers and lenders. Who benefits and who is hurt when the » rate of inflation is less than anticipated? Explain. 11. In the aggregate economy, why does income equal expenditure? 12. What is meant by macroeconomic equilibrium?mae. - Explain how ar m explaining the steag '3. What are the most nportant factors 2” ana ime in the Philippi Persistent increases in the price level over time in th PPines » What is meant when we say that money serves as a unit of account ; ee How do financial intermediaries create liquidity? » What are the three main monetary policy tools of the Central Banko How does an Open market purchase of government Securities leaq to an increase in the Monetary base? - What are the three main motives for holding money? in increase in the money supply leads to an i Ncrease jn Aggregate Planned expenditure via the exchange rate effect, MW. Multiple Choice Questions Which of the following would not be included in the calculation of the gross national product (GNP)? a. Purchase of a new home An automotive Worker's wages A doctor’s fee Purchase of, common stock aes Under the incor Ne approach, 8rOss_ national Product (GNP) is Measured as a. Depreciation charges and indirect business taxes + Wages + Rents + Interest + Profits ~ Net income earned abroad, b. Wages + Rents + Interest + Profits; Depreciation charges and indirect business taxes + Wages + ents — Interest + Profits, d Wages + Rents + Interest ~ Profits + Net income earned abroad. Assume that real &8ross National rod rl Pesos raised from P3,000 billion aust (GNP), Measured in Year ‘ ; far | to P4,500 billion in Year —— rote Price index rose from 100 to 200 during the prices is TONS SNP For Year | *pressed in terms of Year 10a pp ge eeeeconomies Theory as a Basis for Understanding... 99 00% ion. equilibrium investment : Positive gross investment, * POSitive net investment, " the Patong income terms, aggregate demand is the : Money by the community in a period of full employment, b. total xpenditure on capital goods by entrepreneurs during a Period of full employment. ¢. demand that is needed if a country’s economy is to operate at optimum level'and the level of investment is to be raised. d. total expenditure on consumer goods and investment, including government and foreign expenditure during a given period. For a given level of tax collections, prices and interest rates, a decrease in governmental purchases will result in a(n) a. _ increase in aggregate demand. b. increase in aggregate supply. c. — decrease in aggregate demand. d. decrease in aggregate supply. Which of the following may provide a leading indicator of a future increase in gross national product (GNP)? A reduction in the money supply ; : b. A decrease in the issuance of building permits c. An increase in the timeliness of delivery by vendors d. An increase in the average hours worked per week of production workers a. The trough of a business cycle is generally characterized by hi ae es of essential raw materials and rising costs. ma ecneing purchasing power and increasing capital investments. in b.“4 100 Chapter 6 s to risk new investments, ind an unwillingnes: i Saar 9. During the recessionary phase of a Sie eee er a the Purchasing power of money is ui ely dna e ry. the natural rate of unemployment will increase iamatically, Potential national income will exceed actual ational income, €ctual national income will exceed potential national income, aoe 10. The Keynesian analysis of monetary and fiscal Policy a. assumes the economy is stable and self-regulating. - places Primary emphasis on monetary policy, ©. assumes that Velocity is stable. 4. Focuses on aggregate expenditures, Il. Which of the following instruments of monetary policy is the Most important means by which the Money supply is controlled? a Changing the reserve ratio Open-market operations © Manipulation of government Spending d, Changing the discount rate ‘ank notes, d. Providing for the Collection of checks, 13. In order for the B: Policy would be to a, encourage banks to increase th INCrease the discount Tate, c. engage in Spen-market Purchases Of government securities, d. raise Margin Tequirements 0N stock market Purchases. SP to increase the Money Supply, the appropriate eir holdings of excess reserves, 14. ane Pires Purchased @ P10,000 80vernment bond from ank, Which h Bank. The dealer paid fe"! bond bond from the Cental ne th i Therefore, the me, ey supply ne nd by a check drawn on its bank.Applications of Mc mt of Macroeconomics Theory as a Basis for Understanding -~- 15. 17. 101 &. not been affected . decreased by P10 0 &. increased by Pio.oan, lecreased by P10,00 ipli : os required reserve rates muted BY te To A bi 7 4 anking system with a reserve ratio of 20% and a change 1" reserv a. P00. coR can increase its total demand deposits by , b. PS,000,000, c. P1,000,000, 4. P800,000. The discount rate of the Central Bank is a. the specified percentage of a commercial bank’s deposit liabilities that must be deposited in the central bank. b, the rate that the central bank charges for loans granted to commercial banks. the rate that commercial banks charge for loans granted to the public. d. _ the ratio of excess reserves to legal reserves that are deposited in the central bank. When economist are concerned about the liquidity preference function, they are interested in a. the relationship of the demand for money and the rate of interest. b. the proportion of liquid (cash) reserves maintained by commercial banks. c. _ the preference for a currency backed by gold. d. A bank’s desire for accounts receivable as collateral. If a government were to use only fiscal policy to stimulate the economy from a recession, it would raise consumer taxes and increase govern ment spending. lower business taxes and government spending. ly and increase government spending. b. c. _ increase the money supp d. lower consumer taxes and increase government spending. a102 19 20. 21. 22, Chapter 6 ; ee of money supply (Mi) consists only of 1 The narrow definition money burt and deposits. / a. ae nae deposits, other checkable deposits a caper eat it all time deposits, 7 and deposits and sm: t it ‘ ne od deposits, small time deposits ang Money Market Mutual Fund balances. The money supply in a nation’s economy will ree following a. open-market Purchases by the nation’s central : @ decrease in the discount rate, ©. an increase in the reserve ratio, 4. a decrease in the margin requirement. The movement of migrant workers from a poor country to a Tich country with a low unemployment rate will have which of the following effects on the receiving country? a. GNP will increase. b. Average wage levels will increase, ¢. Business incomes will decrease. d. The labor force will decrease, Unemployment that is caused by a mismatch between the composition of the labor force (in terms of skills, Occupation, industries or 8eographic location) and the makeup of the demand for labor is called a. real wage unemployment, defic ient-demand unemployment, ©. frictional unemployment, d. structural unemployment, What is the rate of inflation from one €ar to the next if the consumer Price aa Was 110 in one year and 118 in the next year? a 71.3% 8.0% 18.0% ae ge25. 26. 27. 28. Applications of Mac i a Croeconomics Theory as a Ba for Understanding 103 A period of a. b. c. d. il 18 inflation increases F ; to recehnn Ne Price level, which benefits those who are entitled enhanc © specific amounts of money. the pur ee the positive relationship between the prive level and Purchasing power of money. will not be aff ; fected : i . f payments, ted by contracts that include the indexing o! increases the rice | ich is i to the purchasing re Jevel, which is negatively related to wer of money. Two examples of indirect taxes are a. b. c. d Ere on business, rental property and personal income taxes. Sales taxes and social security taxes paid by employees. sales and excise taxes. social Security taxes paid by employees: and personal income axes. Government borrowing to finance large deficits increases the demand for lendable funds and a. b. cs d. increases the supply of lendable funds. exerts downward pressure on interest rates. has no impact on interest rates. puts upward pressure on interest rates. Which of the following is a typical macroeconomic topic? ee sP The pricing decisions of a company The consumption and saving behavior of households The rate of inflation The growth of the computer industry What is the primary goal of an economic system? a. The organization of the production, distribution, exchange and consumption of goods and services. To maximize profits for producers. To determine the flow and distribution of money. To produce, distribute and exchange goods and services in the fastest possible way.30. Sil 32, 33. 34, 2 What causes the production possibilities curve to shift outward? i iter plants ; F b. ee na soma mnaking computers instead of making Cars ¢. Improving manufacturing efficiency for computers d. — Rehiring workers in the computer or car in ry Which of the following is included in the circular flow Of the economy? a. Firms sell factor services to households. Households sell outputs to firms, Households buy factor services from firms. Households sell factor services to firms, Res Which of the following is required for the mutual benefit of trade between two countries? a. Decreasing marginal returns in production b. Absolute advantage in the production of goods and services c. Each country being able to produce more of one product than the other country d. Comparative advantage in the Production of goods and services If nominal GNP grew by 16 percent and real GNP grew by § percent in the same year, inflation would be —I1 percent. 15 percent, 11 percent, 8 percent, Beep The Consumer Price Index (CPI) Measures which of the following? a. The conomy’s price level b. The gross national product deflator ¢. Changes in the Teal d. Weighted Prices of selecti benefit both Consumers and domestic Producers A a. b. Benefit domestic Producers, ¢, d. lead toa higher Quantity of, domestic and imported cars.40. in Philipmte oe ional Product? €Nse contractor manufactures a satellite for the 1 SHON sells try, ai € Icks from | ° A nae Uys 'mported clothes, er sells his computer to his son last year’s inventory, Cc. Prices d. Investment A decrease in the labor a. increase Bovernm b. decrease government spending. c. have no impact on the rate of unemployment. d. make it easier to teduce the rate of unemployment. force Participation rate will lent spending. The aggregate demand curve is a. the (horizontal) summation of factor demand for all firms, b. the (horizontal) summation of all households’ demand curves, ¢. not found by adding product demand ‘curves. d. the aggregate of demand curves for intermediate goods. and services. Assume that imports increased and at the same time, new technology has increased labor productivity. What will certainly result? a. The price level goes up. b. The price level goes down. c. The price level doesn’t change. d. Real GNP decreases. i ir ite demand? ses the largest increase in aggregat r _ Agi 000 increase in government expenditures b. A P1,000 increase in taxes ' se in taxes d a 61000 peo in government expenditures, together with a P1,000 decrease in taxes_ 106 G, : apter 6 100. IF 41. Th mny’s potential output equals F3,000,000. IF curren, + The economy: 42. 43. 45. 46. Quilibrium output equals P2,500,000 and the marginal Propensity 4. librium out sume synesii nomist be exp ials 0.5, what would a Keynesian ecot cor equ . to recominend? ; 0:00; a. Increase government spending by Pra note Increase government spending by ear . Increase government spending by , 4. Decrease taxes by P250,000. . inflation? Which of the following groups will nor be hurt by inflation? a. Individuals on fixed incomes Borrowers at fixed interest rates | © Individuals with savings earning fixed interest rates d. Retail store owners < If the excess reserves in the banking system are P1,000 and the Bate Tequirement is 25 percent, what is the maximum expansion of the money supply? a 250 b. P2500 ©. P5,000 4. P4,000 If people decide to hold more money as currency (i.e, cash), banks I be a. Less able to expand credit, b. More able to expand credit. c. More able to decrease aggregate supply, d. Less able to decrease aggregate supply. The Central Bank’s monetary policy Supports fiscal Policy when a he Money supply 'S increased when 8overnment Spending goes up. b. pe discount rate ig decreased when Sovernment spending goes own, c. the discount rate is increased when government Spending goes up. d. te Money supply is decreased when government Spending goes What best €xplains how an ec v Onomy could igh inflation and high unemployment at the same time? i ian a. soemnent Increases Spending but doesn’t increase taxes. PPly shocks Cause factor Prices to increase. Oe- Applications of Mac ae ms of Macroeconomics Theory as a Basis for Understanding 47. 48. 49. 50. Sl. 107 ce. Gove 5 ae increases taxes but doesn’t increase spending. ‘ary expectations decline. An increase in a: eregate st y is caused by aod a. Wage rates. sre oot an b. labor productivity. c. interest rates d. government spending. Whi aes of the following is most likely to improve the standard of a. An increase in the number of depository instituti ae umber of depository institutions ¢. Higher productivity of labor d. A decrease in the money supply A trade surplus must be offset elsewhere in the a. current account balance or capital account balance only. b. capital account balance only. ©. current account balance only. d. merchandise balance of trade only. Two countries, originally producing two commodities for domestic consumption, now specialize production according to comparative advantage and trade with each other. What is the result? Production will be more efficient in one country but less a. efficient in the other. The two countries will become more self-sufficient. c. Unemployment increases in at least one country. d. Both countries will be better off. Which of the following policy combinations is most likely to eliminate a recession? Open Market Government Operations Taxes Spending a. Buy securi Increase Decrease b. Buy securities Decrease Increase c. Sell securities Increase Increase d. Buy securities Decrease DecreaseJos 53, 54, 55. NG Chapter 6 : 2 aa de enditures an, 52. Facing a budget deficit, government decreases exp a by the same amount. How will this affect output and inggae Fevenues by the me Output Interest rates rease a. Increase ieee b. Increase Decrest c Decrease Decrsesg 4. No change i 5 wth and stabi ist poli kers emphasize long-run gro ; dues ‘mild reeset policy actions are they most likely to recommend? . Monetary Policy Fiscal Policy a Sell bonds Reduce taxes b, Sell bonds Raise taxes c. Buy bonds No change d. No change Raise taxes If the government simultaneously employs expansionary Monetary and fiscal policies, what will be the likely effect on interest rates ang unemployment? Interest Rates Unemployment a. Decrease Decrease b. Might either increase or decrease Decrease c. Might either increase or decrease Increase d, Increase Might either increase or decrease Which of the following is designed to restrict trade? a Global Corporations GATT ¢. Import quotas 4. European Union