Ba1 Quetions N Formulae PDF

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Copy of CIMA Cert in Business Accounting BA1
Financial Management A (University of Johannesburg)
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CIMA Cert in Business Accounting

BA1: FUNDAMENTALS OF
BUSINESS ECONOMICS
Formulas
● Return on capital employed (ROCE) = (profit before interest and tax) / (average
capital employed) * 100% -- short term measure of performance
● Return on net assets (RONA) = (operating profit before int and tax) / (total assets -
current liabilities) * 100%
● Earnings per share (EPS) (in cents) = (profits after int, tax and preference share
dividends) / (number of ordinary shares issued) -- short-term measure of
performance
---
● Price Elasticity of Demand (PED) (negative) = (percentage change in quantity
demanded) / (percentage change in price)
○ Non-average arc: (new-starting)/starting*100
○ Average arc: (new-starting)/average*100
○ Unit elasticity -1
○ Perfectly inelastic 0
○ Perfectly elastic -infinity
○ Inelastic between 0 and -1
○ Elastic under -1
● PE of Supply (PES) (always positive) = (percentage change in quantity supplied) /
(percentage change in price)
○ Non-average & average arc methods as above
○ Elastic >1
○ Inelastic <1
○ Unit elasticity 1
---
● Dividend yield = (dividend per ordinary share) / (share price) * 100%
○ PV = DPS/SP or PV = DPS/MV because share price = market value of the
share price
○ Net dividend yield = (annual dividend) / (market value) * 100%
● Running rate / interest yield for bonds = (annual interest) / (market value)*100%
○ Gross redemption yield? They said it’s outside the syllabus
● Required yield on corporate bond = (yield on equivalent treasury bond) + (credit
spread or premium)
● Interest rates
○ 1 + real rate = (1 + money rate)/(1 + inflation)

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● Credit/deposit multiplier: the amount by which total deposits can increase as a

result of the bank acquiring additional cash
○ Change in total deposits = 1/(cash ratio) * the initial cash deposit = (cash
deposit) / (cash ratio)
○ Cash ratio: about 10% of the cash deposited will be withdrawn at the same
time (so this is what should be in the bank so people can withdraw it, the rest
can be lent out or invested)
○ Cash ratio of 10% gives the balance sheet multiplier of 10: the total increase
in the money supply is ten times the initial cash deposit
● Equilibrium in the circular flow: I = W
○ Injections = Gov spending + Investments + eXports (GIX)
○ Withdrawals = Savings + iMports + Taxes (SMT)
● Marginal Propensity to Consume (MPC) = (change in consumption) / (change in
income) * 100%
○ Change in consumption = MPC * change in income
● Net investment = gross (total) investment - replacement investment (capital
consumption / depreciation)
○ Capital consumption accounts for the deterioration of the existing capital
equipment stock
● Value of the Multiplier (K) = 1/(1-MPC) = 1/MPS
○ MPC = marginal propensity to consume
○ MPS = marginal propensity to save
○ MPC + MPS = 1
○ E.g. MPC = 0.8, MPS = 1-0.8 = 0.2, K = 1/0.2 = 5, so an injection of £10k
would increase total national income by £50k
● Aggregate Demand (AD) = C + I + G + (X - M) = consumption + investment + gov
spending + net exports
● Current account + capital account + financial account + balancing items = 0
---
● Simple interest V = P(1+r*n)
○ V = total value
○ P = principal
○ r = interest rate
○ n = time unit (usually years)
○ $30k 6 years 1% quarter > V = 30,000 * (1 + 0.01*24) = 37,200
● Compound interest V = P*(1+r)n = P*APR
● Annual Percentage Rate (APR or AEquivalentR) = (1+r)^n
○ 3% every 6 months (2*per year > n=2) > 1.03^2 = 1.0609, so annual rate
6.09%
○ V = P(1+r)^n // r = (V/P)^(1/n) - 1
● Present Value: PV = V * DF
○ Discount Factor (DF) = (1+r)^(-n) TABLES FOR PV IN THE EXAM!!
● Net Present Value is the total of the individual present values, after discounting each

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● Annuity Factor = (1-(1+r)^-n)/r = Cumulative Present Value TABLES!!

○ PV = future cash flow * annuity factor
● Perpetuity Factor = 1/r

○ PV = future cash flow * perpetuity factor
● Advanced Annuity: PV = V * (1+AF)
○ Don’t forget that t0 needs to be taken out of n when you’re looking at the CPV
tables!! (so e.g. n = 5 years, but advanced perpetuity/annuity, look for the AF
n=4)
● Advanced Perpetuity: PV = V * (1+PF)
● Delayed Annuity: PV = V * AF * DF
● Delayed Perpetuity: PV = V * PF * DF
○ Discount factor is -1 of when the payments start (so in 3 years’ time, DF for 2)
● Internal Rate of Return (IRR) =
○ The discount rate at which NPV is zero
○ Trial & error method:
■ Find a discount rate at which the NPV is small and positive
■ Find another larger discount rate at which the NPV is small and
negative
■ Use linear interpolation between the two to find the point at which
the NPV = 0
○ IRR = R1 + (R2-R1) * (NPV1)/(NPV1-NPV2) - given in the exam
○ Calculation method, using proportions:
■ NPV drops from 6.697 to -0.402
■ Drop of 7.099 when the discount rate increases by 5 percentage
points
■ NPV will therefore drop by 1 when the discount rate increases by
5/7.099 = 0.7043 percentage points
■ NPV will reach zero if, starting at its 5% level, it drops by 6.697
■ So an increase of 6.697 * 0.7043 = 4.7 percentage points in the
discount rate

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■ So IRR = 5 + 4.7 = 9.7%

● Terminal value = when you compound all the cash flows to the end & then add them
up
● Sinking fund = an investment in which a constant amount is invested each year,
usually aiming to reach a specified value at a given point in future
○ V = P*(r^n + r^n-1 + r^n-2 + … + r^1)
○ n = however many investments there are in total
○ P = V/(r^n + … + r^1)
---
● Index number = (value in any given year) / (value in base year) * 100
● Percentage increase from one year to the next from their index numbers = (year B
index number) / (year A index number) * 100 - 100
● Rebasing: if only the index numbers are available, they can be indexed as if they
were the original data
○ I.e. divide the index number you’re re-indexing by the base year index
number
● Relative price indices
○ Price index = 100 * (P1/P0)
○ Relative price = P1/P0
○ Relative price index = sum (weight*relative price) / sum(weight) * 100
○ Weights:
○ Base-weighted: base-year quantities (Q0) or values (P0*Q0)
○ Current-weighted: current-year quantities (Q1) or values (P1*Q1)
○ Value = Price*Quantity
● Quantity indices
○ Relative quantity index = sum(weight * (Q1/Q0)) / sum(weight) * 100
○ Aggregate quantity index = sum(w*Q1) / sum(w*Q0) * 100
● Adjusting for inflation

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---
● Pearson’s correlation coefficient (coefficient of correlation - given in the exam)
- this is given in the exam

○ r = Pearson’s correlation coefficient
○ n = the number of data points (i.e. sample size)
○ r = +1 perfect positive linear correlation (data points lie exactly on a
straight line of positive gradient
○ r = -1 perfect negative linear correlation (straight line with a negative
gradient)
○ r = 0 no linear correlation
○ The further away from zero, the stronger the linear correlation
○ Negative values of r also strong, just that y is decreasing as x increases
● Coefficient of determination = r^2
○ Gives the proportion of changes in y that can be explained by changes in x,
assuming a linear relationship between x and y
● Spearman’s coefficient - given in the exam
○ d = difference in ranks, n = sample size

● Regression
○ Linear correlation: y = a + bx where y is dependent on the value of x, which
is independent of y
■ a = the point where the line cuts the y-axis (the intercept), the value
of y when x=0
■ b = the gradient or slope of the line, the increase in y for each unit
increase in x
○ Least-squares regression (given in the exam, except y with crtica =
sum(y/n) & x with crtica which are just averages, see below)
■ Regression line: y = a + bx

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---
● Additive model: Y = T + S + C + R (all components are in the same units as the orig
variable)
● Multiplicative model: Y = T * S * C * R (T in the same units as the variable, the
other 3 components are just multiplying factors)
● Trend
○ Linear regression: T = a + b*t, where t = the time period/quarter
○ Moving averages
● Season
○ S = Y/T or S = Y - T assuming there are no C or R components
○ Seasonal components over the year (each quarter) should add up to 4
(average of 1 each)
○ So once we have the average/mean quarterly seasonal components, we then
reduce them so they add up to 4
○ In the additive model, the 4 seasonal adjustments should add up to zero
● We simplify the model to Y = T * S
● Seasonal adjustment
○ Removing the seasonal component from the figure (e.g. weekly profit,
revenue) to get an estimate of the trend:
○ T = Y/S or T = Y - S

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Ch 1 - Microeconomic and Organisational Context

I: The Goals and Decisions of Organisations
1. Organisations
1.1 What is an organisation?

● Organisations are social arrangements for the controlled performance of
collective goals.
● A group or institution arranged for efficient work.
● Examples: companies, clubs, schools, hospitals, charities, political parties,
governments, etc.
● Organisation can also be a process.
● TEST1: A queue of people standing at a bus stop is an example of an organisation if
they all want to travel to the same place. - FALSE
○ A team of people have come together to travel. - social arrangement
○ The team has a goal: to travel to the same place. - collective goal
○ They have no controlled performance though - no internal system of control to
get them to work together. It’s all on the part of the bus driver/company.
○ Further, there are no different skills or experiences to be applied.
1.2 Why do we need organisations?

○ Share skills and knowledge
○ Specialise
○ Pool resources
● Achieves more than individuals could on their own
1.3 Profit orientation

● Profit-seeking: survival, growth & development, profit
● Not-for-profit: benefit members or sectors of society
● TEST2: Which of the following best completes the statement 'Financial
considerations are a constraint in not-for-profit organisations because...' (D) their
prime objectives are not financial but they still need money to enable them to reach
them.
● TEST3: Which one of the following is not a key stakeholder group for a charity?
Shareholders (B)
● TEST4: Which one of the following would not be a stakeholder for a mutual society?
Shareholders (A)
● TEST5: Some building societies have demutualised and become banks with
shareholders. Comment on how this may have affected lenders and borrowers.
○ Since the org’s main goal is financial now, the interest rates on loans may go
up & saving rates may go down. This means these become less attractive to
members.

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○ However, when demutualising most building societies give their members

windfalls of shares so they become shareholders, benefiting from dividends
and share price increases.
1.4 Classifying organisation by ownership/control

● Public sector: police, military, public roads, transit, education, healthcare, etc.
● Mutual organisations: building societies, co-ops, trade unions, etc.
● Private sector: not controlled by the government
● Co-operatives: autonomous association of persons united voluntarily to meet their

common needs and aspirations through a jointly owned and democratically controlled
enterprise.
○ Similar to mutual organisations, but primarily deal in tangible
goods/services or utilities, rather than intangible products (e.g. financial
services).
● TEST6: Which of the following are usually seen as the primary objectives of
companies? (i) To maximise the wealth of shareholders. (iii) To make a profit. = D
● TEST7: Many schools run fund-raising events such as fêtes, where the intention is to
make a profit. This makes them ‘profit-seeking’. FALSE
2. Shareholder wealth
2.1 Maximising shareholder wealth

● Higher share prices or dividend payments
Measure and increase shareholder value:

● Cash is preferable to profit
● Exceeding the cost of capital
○ Cost of capital = cost of returns to the investors
● Managing long- and short-term perspectives
● Profits = sales - expenses

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● Net cash flows = cash receipts - cash payments

● Profits =/= net cash flows
● Returns
○ Dividends: cash received by the investor from a distribution of profits made
by the company
○ Capital gain from a rise in share price
● TEST:
○ $100 mil debt w/interest rate 6% pre tax = 6mil
○ $200 mil equity - shareholders return 15% = 30mil
○ Profit before interest and tax $36 mil
○ Tax 30%
○ ---
○ $36m - $6m = $30 before tax
○ Tax = $9m
○ Profit after tax = $21m
○ $21m < $30m required by shareholders
○ ---
○ The profit does not cover the cost of equity.
2.2 Short-term measures of financial performance (p10)

● Return on capital employed (ROCE) = (profit before interest and tax) / (average
capital employed) * 100%
○ How well the business uses its capital (or the assets) to generate profits
○ Measure of the net income generated, and not about where that income goes
● Return on net assets (RONA) = (operating profit before int and tax) / (total assets
minus current liabilities) * 100%
● Earnings per share (EPS) = (profits after int, tax and preference share dividends) /
(number of ordinary shares issued)
○ Earnings per share each owner of ordinary shares might expect to receive
○ Directors decide whether/how much to pay out as a dividend
○ To calculate a rate of return for the shareholder, the price of acquiring the
share must be taken into account
● Main weakness of both ROCE and EPS: don’t correlate directly to the goal of
maximising shareholder wealth
● TEST8:
○ ROCE = 150/3000*100% = 5%
○ EPS = 110/1000 = 0.11 = 11c
● TEST9: EPS = 10c (1mil shares in issue)
○ Profit after tax + $25k per annum, issued further 400,000 shares - what is new
EPS?
○ 0.10 = x/1000, x = $100k profit after
○ New profit = $125k
○ New EPS = 125/1400 = 0.089 = 0.89c
○ Since the EPS goes down, presumably shareholders won’t like the change.

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2.3 Long-term measures of financial performance

● Returns to shareholders should be at least = cost of acquiring the capital
required to produce a long-term flow of earnings
● Issues:
○ Establishing the cost of capital to finance the investment project
○ Estimating the flow of income derived from the capital investment
○ Valuing that flow of income
● We calculate the present value of future cash flows by a process of discounting (Ch
Discounting and Investment Appraisal)
2.4 Share values

● Press releases & market rumours affect the share price (e.g. new project
announced: Net Present Value (NPV) of a project = discounted future cash flows -
the capital cost)
○ Suggestion that future cash flows will be higher than previously forecast,
should result in share price rise
○ Bad news - the opposite (higher risk > higher cost of capital > future receipts
less valuable)
● Affected by:
○ External factors (e.g. recession, rise in interest rates)
○ Internal factors (e.g. failure of a new product, expected decline in sales)
● TEST10: NEW PROJECT ANNOUNCEMENT IN HIGH GROWTH MARKET =
Presumably the share price will go up, since new product and high growth market!
But I don’t know what discounted cash flows are, so that’s fun.
○ Future cash flows: if markets believe directors’ claims, then estimates for
future cash flows go up
○ Cost of capital/discount rate: increasing company’s risk, investors will want a
higher return, so a higher discount rate is being used to discount the revised
future cash flows
○ Share price: the impact on the price will depend on the net effect of the above
factors
3. Stakeholders
● Stakeholders = persons/orgs that have an interest in the strategy of an org
● Stakeholder interest = an interest/concern in an org’s actions/objectives/policies
● Stakeholder influence = level of involvement & influence on decisions
● Internal (employees, managers, directors): strong influence on how it’s run
● Connected (shareholders, customers, suppliers, finance providers): contractual
relationship with the org
● External (gov, loca authority, community, environmental pressure groups, trade
unions): varying ability to ensure the org meets their objectives
● TEST11: Which of the following is not a connected stakeholder? C Employees
● TEST12: R = high class hotel

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○ Internal: employees (as they do the work and have direct influence on how
the hotel is run), management (likewise, but even more power)
○ Connected: shareholders (it’s their money, they’re expecting a good return),
financial institutions (we owe them money), customers (they are literally the
only way the hotel can continue working), suppliers (likewise, important to
have good relationships so they supply on time & good quality)
○ External: the city - community, local authority, gov, any trade unions
(otherwise they might present barriers to work)
4. Stakeholder conflict
● E.g. employees vs managers, customers vs shareholders (product quality vs profits),
managers vs shareholders (revenue growth vs profit growth)
● To resolve conflict, asses degree of interest & influence to affect the business
● Profit companies: shareholder wealth generation = primary objective, needs of other
stakeholders = constraints within which to operate
5. Management objectives
● The role of the managers in a company is to make decisions that ultimately lead to
an increase in shareholder wealth
● Managers VS shareholders!!!!! Boohoo
5.1 The principal -- agent problem

● Principals (shareholders / legal owners) vs agents (managers / board of directors
and senior managers, appointed to act on the behalf of the principals)
● In big companies they won’t be the same
● Profit is unlikely to be the sole aim of management (balance of interests of different
stakeholders & also their own objectives)
● Focus on short-term objectives (e.g. sales maximisation) at the expense of long-term
ones
5.2 Possible areas of conflict

● Fat cat salaries and benefits
● Mergers and acquisitions (majority erode shareholder value)
● Poor control of the business
● Short-termism
Resolutions:
● Corporate governance (principles & regulations)
● Review of the remuneration and bonus schemes for the directors (incl. share options)
5.3 The objectives of corporate governance

● Corporate governance: the system by which orgs are directed and controlled / used
to direct, manage and monitor an org & enable it to relate to its external environment
● Objectives:

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○ Control managers/directors by increasing reporting & disclosure

○ Increase confidence & transparency for all investors > promote growth
○ Increase disclosure to all stakeholders
○ Legal & ethical governing
○ Build in control at the top that will cascade down the org
● E.g. chairperson and CEO should be kept separate, limited contracts for directors,
public disclosure of director payments, subcommittees of the board: audit,
nominations, remunerations, etc.
● TEST13: Not a prime objective of corporate gov: C to improve employees' working
conditions
● The UK Corporate Governance Code (2010):
○ Separation of powers
○ Board membership balance (exec and non-exec directors)
○ Transparency, openness, fairness
○ Interests of the stakeholders
○ Board fully accountable
○ Disclosure and reporting
○ Remuneration committees for directors
○ Nomination committees for appointment to the board
○ Annual General Meeting (AGM)
● TEST14:
○ ROCE = Return On Capital Employed, it measures how well the business uses
its capital to generate profits. Measure of the profitability of the capital employed.
○ NFP orgs: state-owned (public sector) activities, mutual societies, charities,
private clubs, QUANGOs and voluntary organisations.
○ Stakeholders = individuals or orgs that have an interest in the org
○ 5 stakeholders for a typical business: employees, managers, customers,
suppliers, shareholders
○ Principal -- agent problem: the conflict of interest between owners (shareholders)
and managers/directors, where they are not the same individuals
○ Shareholders may lose control: orgs too big to effectively control, too
complex to control, individual shareholders may lack
power/knowledge/interest/time to control the companies they own
○ Corporate governance = the system by which orgs are directed and controlled
6. Transaction costs
● Activity in-house or going to market
● Cost of the activity = production costs (direct and indirect costs of producing the
good or service) + transaction costs (indirect costs incurred in performing the
activity, e.g. expenses incurred through outsourcing)
● Outsourced - harder to determine transaction costs:
○ Search and information costs - to find the supplier
○ Bargaining and decision costs - to determine contractual obligations
○ Policing and enforcement costs - to monitor quality
● Better to internalise transactions as much as possible, to remove these costs
● Variables that impact transaction costs:

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○ Frequency
○ Uncertainty (long-term, close relationships are more uncertain, lack of trust
leads to uncertainty)
○ Asset specificity (how unique the component is)
6.1 When transaction costs change

● Changes in transaction costs (e.g. better info systems, flexible contracts) call into
question the need for traditional organisational forms and vertical integration

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Ch 2 - Microeconomic and Organisational Context

II: The Market System
1. Introduction
1.1 Different market systems

● Scarce resources, limited output
● Market economy: supply vs demand, individual consumers and producers
● Command economy: government
● Mixed economy: free market + gov intervention
1.2 Market forces

● Quantity & price determined by interaction between supply and demand
2. Demand
2.1 Individual demand

● Individual demand = how much of a good/service someone intends to buy at
different prices
● For most goods, lower price = higher demand
● Expansion in demand: quantity demanded rises due to a fall in price
● Contraction in demand: quantity demanded falls due to a rise in price
● Demand curve (diagram): relationship between demand and price

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2.2 Market demand

● Market demand: total amount of effective demand from all the consumers in a
market
2.3 Conditions of demand

● Factors other than the price, which have above been held constant, now we switch
● Change in conditions creates shifts in the demand curve
● Increase/rise in demand: shift in the demand curve is to the right (outward)
● Decrease/fall in demand: shift in the demand curve is to the left (inward)
● Main conditions of demand:

○ Income: higher disposable income means higher demand for most goods, but
lower demand in inferior goods (such as PUBLIC FUCKING TRANSPORT
which is apparently inferior to private transport)
○ Tastes: can be manipulated by advertising and producers
○ Prices of other goods: goods can be unrelated, complements (joint demand
e.g. cars and tyres), substitutes (Coke & Pepsi)

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○ Population: increase in population creates a larger market (e.g. seasonal

workers, population distribution, proportion of young vs old ppl)
● Again, price change = expansion/contraction, movement along the curve VS
conditions of demand change = increase/decrease in demand, the curve shifts
● TEST1: Demand curve remains stable, which item can vary? C The price of the
product.
● TEST2: Curve for health supplements shifts to the right? D An increase in the size of
the population due to ppl living longer.
● TEST3: No shift in curve for overseas holidays? D a rise in the exchange rate for the
domestic currency
3. Elasticity of demand
● Elasticity: relationship between two variables; measures the responsiveness of the
dependent variable to a change in the independent variable
3.1 Price elasticity of demand (PED)

● The relationship between changes in quantity demanded & changes in price
● Price elasticity of demand explains the responsiveness of demand to changes in
price.
● Coefficient of PED = (percentage change in quantity demanded) / (percentage
change in price)
● The formula can be applied either at one point on the demand curve, or over part
(arc) of it
● Use percentage of proportional changes!
● Arc method:
○ Non-average arc method: measures (% change in quantity demanded) / (%
change in price) using the starting point of price and quantity as the basis
for the % calculation
○ Average arc method: measures (% change in quantity demanded) / (%
change in price) using the average price and quantity as the basis
○ Point method: will not be taught or tested at this level LOL (PED only
depends on the point chosen)

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● ILLUSTRATION:
○ PED = (percentage change in quantity demanded) / (percentage change in
price)
○ Price = $30, demand = 200/annum
○ Price = $60, demand = 100/annum
○ Non-average arc method:
■ Percentage change in price = (60-30)/30*100 = +100%
■ Percentage change in demand = (100-200)/200*100 = -50%
■ PED = (-50)/(100) = -0.5 price inelastic demand
○ Average arc method:
■ Percentage change in price = (60-30)/45*100 = +66.67%
■ Percentage change in demand = (100-200)/150*100 = -66.67%
■ PED = (-66.67)/(+66.67) = -1 unit price elasticity
● Price and quantity demanded are inversely related, so expect PED to be negative.
● Inelastic: 0 > PED > -1
● Unit elasticity: PED = -1
● Elastic: -1 > PED > -infinity
● If demand is completely insensitive to price, PED=0 (demand is perfectly inelastic),
a vertical demand curve
● Horizontal demand curve: PED = -infinity (demand is perfectly elastic)

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● If the demand curve is fairly steep, a large change in price will cause only a relatively
small change in demand, an inelastic demand curve
● TEST4: 100,000 units/month @ $5; $4.90 105,000
○ PED = (percentage change in quantity demanded) / (percentage change
in price)
○ Quantity change: (105,000-100,000)/100,000*100 = 5%
○ Price change: (4.9-5)/5*100 = -2%
○ PED = 5/-2 = -2.5 (C)
● TEST5: 10,000/month $1; $0.9; PED = -1.5
○ % change in price = (0.9-1)/1 = -10%
○ PED = -1.5
○ % change in demand = -10% * -1.5 = + 15%
○ 10,000*15% = 1,500 > 11,500 (D)
● PED & gradient
○ Same shape/gradient of demand curve doesn’t mean the same elasticity
coefficient AKA if you shift the curve right or left, this will change the PED
○ Gradient = slope of the line (aka how steep it is)
○ Curve further from the origin (0,0) will tend to be less elastic
● Elasticity coefficient varies according to:
○ Is it a price fall/rise
○ Which part of the demand curve is selected: PED falls moving top left to
bottom right (aka the curve becomes relatively more inelastic)
3.2 Factors that influence PED

● Proportion of income spent on the good/service (e.g. cheap stuff has an inelastic
demand (a small price change will be unlikely to have much impact) vs expensive
shit has a more elastic demand)
● Substitutes (easy substitute means an increase in price will cause a much greater
fall in demand, as ppl will just buy the substitute, so elastic)
● Necessities (vital goods demand is stable and inelastic; vs luxuries elastic; change
in living standards push certain commodities from the luxury to necessary category or
the other way around)
● Habit (high habit purchase - inelastic demand; e.g. newspapers, cigarettes)
● Time (a price change can in the short term not have a big impact, but in the long
term consumers may acquire greater knowledge of markets and buy a substitute)
● Definition of market (widely, eg food - demand inelastic VS narrowly eg orange
juice - demand elastic for the individual brands)
● TEST6: demand for petrol: price elastic or inelastic? Inelastic, necessity
3.3 The link between PED and total revenue

● Total revenue increases after a price cut = elastic
● Total revenue increases after a price rise = inelastic
● Total revenue falls after a price cut = inelastic
● Total revenue falls after a price rise = elastic
● ILLUSTRATION: $20/item = 50,000/annum // price cut to $19 // PED = -0.8

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○ Change in demand & total revenue = ??

○ % price change = (19-20)/20*100 = -5%
○ PED = quantity/price
○ % quantity change = -0.8 * -5% = +4%
○ Total revenue = 50,000*1.04 = 52,000 units
○ Current revenue = 20*50k = $1mil
○ Predicted revenue = 19*52k = $988k
○ Revenue has fallen. Given inelastic demand, this was expected. A price
increase would boost revenue here rather than a price cut.
● TEST7: demand = elastic, a fall in price will lead to (i) a rise in unit sales; (iii) a rise in
total sales revenue = (A)
● TEST8:
○ Shape of a typical demand curve: downward sloping from top left to bottom
right
○ What is the PED: it measures the responsiveness of demand to price
changes.
○ % price change = -10%, demand increases 100>120
■ PED = ((120-100)/100*100)/-10% = -2, it’s price elastic
○ Four factors that influence PED: percentage of income, availability of
substitutes, whether the good is a necessity, time, definition of market.
○ A shift in demand = whether the demand is bigger or smaller, means the
curve moves left or right - occurs when the conditions of demand change. An
expansion in demand means a move on the demand curve, due to price fall.
4. Supply
4.1 The supply curve of a firm

● upply curve: shows how much producers would be willing & able to offer for
S
sale, at different prices, over a given period of time // what the firm will provide to the
market at certain prices
● Cost is one of the main determinants of supply
● Usually upward sloping
4.2 The supply curve of an industry

● It’s an aggregate of the supply curves of individual producers
● Similar to that of its individual component firms, but at a higher level

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● Changes in price - movement up and down the curve, a change in the quantity
supplied OR an expansion/contraction of supply
4.3 Conditions of supply

● A change in factors other than the price will move the supply curve
● A decrease in supply:
○ Curve shifts left
○ LESS will now be supplied at the existing prices
○ The cost of supply has increased
○ Results from:
■ Higher production costs: the factors of production become
expensive; e.g. higher wage costs per unit, increased interest rates,
etc.
■ Indirect taxes: makes supply at existing prices less profitable, with an
indirect tax the costs of production are raised directly - the profit
margin is reduced as an indirect effect
● An increase in supply:
○ Curve shifts right
○ MORE will now be supplied at existing prices
○ Cost of production has fallen OR lower profits are being taken
○ Results from:
■ Technological innovations
■ More efficient use of existing factors of production: e.g. shift work,
improvements in productivity
■ Lower input prices: e.g. cheaper raw material imports
■ Reduction/abolition of an indirect tax OR the application of or
increase in subsidies
● Factors of production / economic resources:
○ Land: all natural resources
○ Labour: human resource
○ Enterprise: another human resource, specifically the role played by the
organiser of production (risk-taking, organising, decision making)
○ Capital: man-made resources, fixed (factory) or not (raw materials and wip)
4.4 Elasticity of supply

● PES = (percentage change in quantity supplied) / (percentage change in price)

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● Slope upwards from left to right - suppliers are willing to supply more when the
price they can achieve is higher
● The value of price elasticity of supply (PES) is always positive
● Elastic: change in price induces a larger proportionate change in the quantity
supplied, PES > 1
● Inelastic: change in price induces a smaller proportionate change in the quantity
supplied, PES < 1
● Unit elasticity: change in price induces an equally proportionate change in the
quantity supplied, PES = 1
● Can be calculated by either point or arc methods
● ILLUSTRATION: 200 units / annum @ $36 market price; rises to $40 supply 210
○ Non-average arc method:
■ PES = quantity/price
■ Quantity = (210-200)/200*100 = +5%
■ Price = (40-36)/36*100 = +11.11%
■ PES = 5/11.11 = +0.45
○ Average:
■ Quantity = (210-200)/205*100 = +4.88%
■ Price = (40-36)/38*100 = +10.53%
■ PES = 4.88/10.53 = +0.46
4.5 Factors that influence elasticity of supply

● Time: more elastic in the long run; sometimes it’s fixed in the short run aka perfectly
inelastic (e.g. agriculture)
● Factors of production: trained labour, unused productive capacity, plentiful raw
materials > output can be raised; one firm may be able to expand while a whole
industry may not, so there could be a divergence between a firm’s elasticity and that
of the industry
● Stock levels: extensive stock > elastic supply; stock levels tend to be higher when
business ppl are optimistic and interest rates are low
● Number of firms in the industry: more firms > more elastic, because greater
chance of some having the factors or high stock; also new firms entering the industry
in response to higher prices could expand supply quickly
● TEST9: Supply of fresh milk is inelastic, as it spoils quickly so stock is low. And u’d
have to get new cows. Entry for new firms will depend on country.

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● TEST10:
○ Which factors affect the elasticity of supply: time, factors of production, stock
levels, number of firms in the industry.
○ Higher wages shift the supply curve upwards and parallel to the original
supply.
5. The price mechanism
5.1 Equilibrium
● Equilibrium: when the demand of consumers and the supply plans of sellers
correspond (where D & S intersect on the graph below)
● No tendency for change in the market at this point
P = equilibrium price, Q = equilibrium quantity

● Surplus of supply: at P1, Q2 (excess supply = Q2 - Q1), in the short-term retailers
have unwanted goods, returns are made to manufacturers, reduced orders, some
products being thrown away > suppliers may be prepared to accept lower prices
than P1 for their goods > which then leads to moving towards the equilibrium
● Shortage of supply: P2, Q3 (shortage = Q2 - Q3), short-term retailers empty
shelves, queues, increased orders, high second-hand values; supplier will respond
by increasing prices to reduce the shortage > towards equilibrium
● Supply & demand for money gives an equilibrium price that can be interpreted as the
level of interest rates; particular currency - exchange rates
● TEST11: Price > equilibrium price, C a surplus of the good
● TEST12: price reduced < equilibrium price, NOT C a surplus of the good
5.2 Shifts in supply and/or demand

● Price acts as stimulant: e.g. price rise > firms shift resources into one industry >
higher supply

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● Tastes change positively & demand increases to D1

○ First the original Q means price moves to P1
○ But as the market adjusts, it moves to P2 & new equilibrium is reached
● The more inelastic the supply and demand are, the greater the price volatility when
either demand or supply shifts
● Long-term effects of these changes depend on the reactions of consumers and
producers; depends on production period
● The more inelastic the supply is, the more unstable price will tend to be
● TEST13: storms damage much of the coffee crop
○ Since supply is now smaller but demand presumably stays the same, the
prices would rise in the short term.
○ The supply curve would shift up/left, while the demand curve stays the same.
○ Expansion of demand.
○ In the long term price will fall back down as supply moves back to the right,
either by next harvest or new suppliers are attracted by the industry (e.g.
repurposing other land to grow coffee).
6. Market failure
6.1 Introduction
● Allocation of resources that maximises the benefits for customers
● Market failure: (sometimes markets can lead to suboptimal allocation of resources >
under-/over-production of goods/services), inability of a market to allocate
resources in a way that maximises utility
● Government can then have a role to intervene
6.2 Public goods

● Without gov intervention, some goods would not be provided at all
● Non-excludability: ppl benefit from it without having to pay for it (the ‘free rider’
concept); provision of it for one member of society automatically allows the rest of
society to also benefit
● Non-rivalry: consumption of the good by one person does not reduce the amount
available for consumption by others
● A market for this type of good does not exist, so must be provided by the state
● ILLUSTRATION: do you buy a public lamp if nobody else wants to pitch in?

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● The fact that they are public goods is seemingly leading to their destruction due to
the costs of their use not being internalised in the production/consumption
decisions (e.g. pollution) > solutions: indirect taxation (e.g. green taxes), integrated
reporting
● Examples: defence, police force, lighthouses, street lights, clean air and water, etc.
● Economies of scale: public goods on a nationwide basis; lower costs and industry
would strive for technical efficiency; no allocative efficiency because consumers don’t
have a choice, but could buy additions
● TEST14: Pure public goods are goods (D) where individuals cannot be excluded
from consuming them.
● TEST15:
○ (a) would it lead to a shift in the demand curve for fish or a movement along
the demand curve for fish
■ (i) more substitutes: demand curve would shift left as demand falls
■ (ii) a rise in the price of fish: a movement along the demand curve
towards the left/up
■ (iii) outward shift in the supply curve of fish: this means more supply,
which would lower the prices, so movement along the demand curve
down
■ (iv) rise in income of fish consumers: people have more money, so
they might be willing to spend more on a higher quality of food, so the
demand might go down & the curve would shift left
○ (b) true or false:
■ (i) demand = very price elastic, a fall in supply will raise prices a great
deal > FALSE, price will rise much more if demand is price inelastic
■ (ii) supply = price inelastic, reduction in supply will have a smaller
effect on price than if the supply were price elastic > FALSE, reduction
in supply means supply curve moves to the left and the equilibrium
price will change, movement of the equilibrium price along the
demand curve will be steeper for an inelastic product (with a steeper
supply curve) than a more elastic one (with a flatter supply curve); the
new equilibrium would be further away from the current one for an
inelastic product
■ (iii) price changes affect demand by leading to a shift in the demand
curve > FALSE
■ (iv) effective advertising might raise sales by shifting the demand
curve to the right > TRUE
■ (v) demand = perfectly inelastic, change in income would have no
effect on demand > FALSE, a change in income would shift the
demand curve
■ (vi) longer time period, greater price elasticity of demand for goods >
TRUE (easier to find substitutes)
6.3 Externalities
● Externalities: social costs or benefits that are not automatically included in the
supply and demand curves for a product or service

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○ When the costs or benefits of an economic action aren’t borne or received by

the instigator
○ Spillover effects of production and consumption which affect society as a
whole
○ Hard to calculate social costs as they’re not always attributable & their impact
is not universally identical
○ Prices should reflect the true social cost of production
● Negative externalities: social costs arising from production and consumption (e.g.
health care for smokers, environmental damage from driving, etc.)
● Positive externalities: social benefits
● Supply and demand curves only take into account private costs and benefits
(accrue directly to the supplier/consumer)
● Controlling externalities: fines, indirect taxes & subsidies (e.g. road traffic
congestion charge, levy on use of plastic carrier bags), extend private property
rights so that firms are still liable for the outputs of their activities even after their
product/service has been sold (e.g. compulsory recycling programmes, noise
emission taxes), regulations/policies (e.g. maximum permitted levels of emission),
tradable permits (e.g. permit to emit up to a certain amount of a pollutant; credit for
the difference if it emits less which they can then sell - so distribution is determined
by the market)
● Taxes shift the supply curve to the left as it’s an increased cost to the supplier
● Issues: hard to calculate costs and correct level of taxation, avoidance and
enforcement, administrative costs
● TEST16:
○ Cost of packaging cigarettes is a negative externality = FALSE
○ Benefits to society from education are positive externality = TRUE
○ Fine incurred for polluting is a negative externality = FALSE
○ Damage to pine forests from pollution is a negative externality = TRUE
6.4 Merit goods

● Merit goods: generally agreed they should be available to all, irrespective of the
ability to pay (e.g. education, healthcare)
○ Characterised by external social benefits in consumption OR lack of
knowledge of the private benefits in consumption - would lead to under
consumption of such services
● These CAN be provided by the market, unlike public goods, but may be
underprovided due to:
○ Ignorance of consumers of the private benefits
○ Failure of the market to reflect the social benefits
○ Excessive prices limiting access
● Private sector often provides alternatives, although these are often seen as
different or superior (e.g. private schools, private healthcare)
● Economies of scale

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6.5 Demerit goods

● Demerit good = good/service which is considered unhealthy, degrading, or
otherwise socially undesirable due to perceived negative effects on the consumers
○ Free market results in excessive consumption of the goods
○ E.g. tobacco, alcohol, recreational drugs, gambling, junk food
● Effects on the user vs negative externalities (impact on society)
● Gov responses: regulation, bans (of consumption or advertising), higher taxes (sin
taxes :D)
● TEST17: Merit goods
○ Street lighting FALSE
○ Education TRUE
○ Healthcare TRUE
○ Defence FALSE
6.6 Changing transaction costs and market failure

● Transaction costs: e.g. search and information costs, bargaining and decision
costs, policing and enforcement costs
● Outsourcing might provide best allocation of resources, but it’s an extra cost so orgs
may choose not to do it
6.7 Competition policy and fair trading regulations

● Problem posed by large businesses: unchecked market forces may result in
powerful companies who can abuse their market power aka monopolies
● Competition policy: more controls have been applied to restrictive trade practices
and pricing
○ Economic justifications: higher prices and/or monopoly profits, lower output,
reduce consumer welfare, diminution in allocative efficiency
○ Extra profits may lead to investment in research, which could eventually
benefit customers via new products
● Scope of gov regulation:
○ Mergers and acquisitions: to see if the resulting org has excessive market
power (UK - Competition and Markets Authority; 25% market share or above
warrants further investigation)
○ Restrictive trade practices: UK Competitions and Markets Authority (CMA)
investigates anti-competitive behaviour, USA Federal Trade Commission;
collusion over price fixing
○ State created regional monopolies: privatisation (converting state owned
orgs into private companies) may lead to regional monopolies (e.g. water and
other utilities); govs set up industry regulators (e.g. OFWAT for water and
sewerage providers in England and Wales)
● Regulation in the UK:
○ The Competition and Markets Authority (CMA) - independent public body;
mergers and acquisitions, regulation of the major regulated industries
(ensuring healthy competition); they may e.g. prevent a merger, acquire a

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company to sell off part of its business; substantial lessening of competition

(SLC)
○ Restrictive practices: frustrated retailers threatened by manufacturers that
they will curtail supplies of products if the retailers continue selling at cut
prices or as loss leaders against the maker’s wishes
○ Specific industry regulators (SIRs): for regulation of private monopolies;
SIRs can introduce an element of competition by setting price caps and
performance standards (even when competition doesn’t exist in the market),
can also speed up the introduction of competition by reducing barriers to entry
○ Regulation in the EU: The European Commission to increase the degree
of competition across the EU
○ TEST18: not a valid economic reason for producing a good in the public
sector: (A) it is a basic commodity consumed by everyone (e.g. food)
7. Interference with market prices

● Equilibrium price may sometimes not be the most desirable price
● Government might wish to set prices above or below the market equilibrium price
7.1 Minimum price

● Gov may set it by:
○ Providing subsidies direct to producers (e.g. Common Agricultural Policy)
○ Set legal minimum price (e.g. statutory min wage)
● To be effective, must be above current market price
● Price floor above equilibrium price
○ > surplus of supply (e.g. unemployment)
○ > misallocation of resources (both in the product and/or the factor market)
which causes lower economic growth
○ > waste of resources
● EU Common Agricultural Policy (CAP) > surplus of food sold outside the EU, paying
farmers not to grow the product but instead remove land from agricultural use
○ It has given farmers stability, leading to investments in productivity, food
safety and environmental protection
7.2 Maximum price

● Gov may set it to:
○ Benefit customers on low incomes
○ Control inflation
● Must be below equilibrium price
● Price floor below equilibrium price:
○ > shortage of supply
○ > arbitrary ways of allocating a product (e.g. queuing, rationing,
favouritism, etc.)
○ > emergence of black markets
○ > misallocation of resources (less profitable, so producers reduce output;
e.g. fewer apartments for rent and more offices)

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○ > lower quality (e.g. disrepair of flats)

● TEST19: min price below free market price: (a) no effect on market price or producer
incomes
8. Economies of scale
● Economies of scale / increasing returns to scale: reductions in unit average costs
caused by increasing the scale of production in the long run
● Diseconomies of scale / decreasing/diminishing returns to scale: increases in
unit average costs caused by increasing the scale of production in the long run
○ E.g. when firms grow very large: difficulty communicating, decline in
management control
8.1 Implications for businesses

● Managers need to understand whether economies of scale exist/are possible in their
industry
● Firms need to achieve critical mass in order to be competitive in cost
○ Can result from organic growth and/or acquisition
● Diseconomies of scale will erode the cost advantage of large firms AKA don’t grow
for growth’s sake
● Significant economies of scale leads to:
○ Costs and prices falling
○ Barriers to entry for newer smaller firms
○ Industries dominated by a small number of large firms
8.2 Internal economies of scale

● When the advantages of expanding the scale of operation accrue to just one
firm
● Internal economies:
○ Technical economies: scale of the production, usually in one plant (e.g.
machinery which have a min level of output & research > more
improvements)
○ Financial economies: borrowing money (lower interest rates) & raising funds
on stock exchange is easier for larger firms
○ Trading economies: advantages when buying inputs & selling outputs (e.g.
lower distribution costs); also diversification means less trading risk to the
whole firm
○ Managerial economies: administrative gains, e.g. the need for supervision
doesn’t increase at the same rate as output, specialists can be employed
8.3 External economies of scale

● General advantages obtained by all the firms in an industry
● E.g. when an industry is heavily concentrated in one area: reputation for success, a
pool of skilled labour, lower training costs, specialised training locally, specialist
suppliers, etc.

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8.4 Diseconomies of scale

● Average cost rises with increased production (internal or external)
● Technical diseconomies: optimum technical size of plant may create large
administrative overheads
● Trading diseconomies: products may become standardised & lack of individualism
leads to reduced choice and lower sales; also hard to adapt to changing trends
● Managerial diseconomies: long chain of command, senior management too remote
and lose control > cross-inefficiency / complacency in middle man & shop floor
hostility; red tape and conflict between departments with diff objectives and priorities
○ Poor state of labour relations in large orgs
○ Also cool trade unions mean industrial stoppage is more possible
● External diseconomy: main one is technical (e.g. shortage of labour > higher wages,
shortage of raw materials > lower output)
● TEST20: calculator manufacturer, NOT a source of ec of scale: (D) cost savings
resulting from new production techniques - would reduce costs for producers large
and small

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Ch 3 - Financial Context of Business I

1. Introduction - The financial system
1.1 The financial system

● Umbrella term:
○ Financial markets (e.g. stock exchanges, money markets)
○ Financial institutions (e.g. banks, building socs, insurance companies,
pension funds)
○ Financial assets and liabilities (mortgages, bonds, bills, equity shares)
1.2 Financial markets

● Capital markets: stock markets for shares & bond markets
● Money markets: short-term debt financing and investment
● Commodity markets: trading of commodities (e.g. oil, metals, agricultural produce)
● Derivatives markets: instruments for the management of financial risk (options,
futures contracts)
● Insurance markets: redistribution of various risks
● Foreign exchange markets: trading of foreign exchange
1.3 Financial intermediaries

● Sectors of economy: households, firms, gov organisations
● Cash surpluses: party concerned will seek to invest/deposit/lend funds for economic
return
● Cash deficits: seek to borrow funds to manage liquidity
● To lend/borrow, 3 options:
○ Lenders and borrowers contact directly: high costs, risks of default, inherent
inefficiencies
○ Organised financial market: e.g. bond market
○ Intermediaries: lender obtains an asset which cannot usually be traded, but
only returned to the intermediary (e.g. bank deposit account, pension fund
rights); borrower will have a loan provided by an intermediary
● Roles of financial intermediaries:
○ Risk reduction: lending to a wide variety of individuals and businesses
reduces the risk of a single default
○ Aggregation: pooling many small deposits makes for larger advances
○ Maturity transformation: borrowers want long-term, savers unwilling to lock
up their money for long-term; floating pool of deposits satisfies both lenders
and borrowers
○ Financial intermediation: the process of bringing together lenders and
borrowers
● TEST1: Short-term lending, long-term borrowing, solution C maturity transformation

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2. Liquidity surpluses and deficits

● Lack of sync between payments and receipts has a variety of origins & affects both
businesses and govs
2.1 Business
● Flows of payments and receipts rarely match = the cash flow problem
● Receipts
○ Sales revenue
○ Pattern of receipts will depend on the nature of the business (e.g. is it
seasonal), system of invoicing (monthly), credit terms, whether customers
stick to the payment terms
● Payments
○ Day-to-day costs, e.g. wages, salaries, raw materials
○ Medium and longer term: capital expenditure and research and development
● Need to have access to short (e.g. overdraft), medium (e.g. leasing) and long (e.g.
equity, bank loans) term finance
2.2 Government
● Receipts
○ Income from profitable state industries, charges made to customers for
state-provided services
○ Vast bulk of income comes from taxations:
■ Indirect taxes (sales tax): e.g. VAT, excise duties on alcohol, petrol,
tobacco
■ Direct taxes on individuals: income tax, social security taxes
■ Direct taxes on business orgs: corporation tax
○ Some regular (e.g. income tax through PAYE), many not (e.g. corporation
tax)
● Payments
○ Short term: day-to-day costs e.g. wages, salaries
○ Medium and longer term: major investment (e.g. school and hospital building)
● Lack of synchronization:
○ Credit and savings needs of gov often met by the central bank
○ Central bank acts as banker to the gov and manages gov’s finances
○ May also need the services of financial intermediaries
2.3 Linkages
● The above inflows and outflows are linked:
● E.g. VAT goes up to increase gov revenue, households need to find more cash to
buy the same things, which increases levels of debt and results in cutbacks in
expenditure, knock-on effect on businesses that saw a decline in sales

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2.4 Further detail on finance for business

● Business financial needs:
○ Working capital: funds to finance day-to-day business (wages, salaries, raw
materials, components)
○ Investment capital: funds to finance purchase of new capital equipment or
for acquisitions and mergers
○ Suitable instruments for investing surplus as part of asset management
● Financial instruments for acquiring funds should be appropriate for the use to
which the funds are to be put (aka short-term instruments to finance short-term
needs of working capital VS long-term inst. to finance long-term needs of investment)
● The bulk of financial needs are met by internally generated funds
● Short- and medium-term instruments:
○ Typically acquired from the money markets
○ Short-term bank loans and overdrafts
○ Bills of exchange
○ Commercial papers (which are debt securities issued by the largest
companies)
○ Trade credit (allows to delay payment for supplies)
○ Leasing and hire purchase
● Long-term instruments:
○ Equity finance: issue of shares for ltds, additional shares (‘rights issues’) can
be issued via the Stock Market for publicly quoted comps
○ Debt finance (long-term borrowing): long-term commercial paper for largest
firms, Preference Shares on which fixed rates of interest are paid, mortgages
○ Mezzanine finance: combines aspects of both above; initially given as a
loan, but can be converted to an equity interest in the company if the loan is
not paid back in time/full
● Gov measures to meet the needs of small businesses
● TEST2: chocolate, seasonal, managing cash flow problem before the holiday period
at the end of the year: (B) overdraft
● TEST3: mezzanine finance = (D) finance that is neither pure debt nor pure equity
3. Financial products
● Equities
● Bonds
● CDs
● Credit agreements: a legal contract in which a bank arranges to loan a customer a
certain amount of money for a specified amount of time
● Mortgages
● Bills of exchange: a written order used primarily in international trade that binds one
party to pay a fixed sum of money to another party on demand or at a predetermined
date E.G. CHEQUES

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3.1 Main considerations

● Financial claims: lending and borrowing
● Considerations when choosing which product to use:
○ Yield/cost: e.g. certificates of deposit usually give lower return than equities
○ Risk: main determinant of cost/yield
○ Amounts involved/divisibility: e.g. min for CD is £50k
○ Time period the funds are required/available for
○ Liquidity: how easy it is to sell the asset to release funds early
○ Transaction costs: e.g. the arrangement fees for mortgages
3.2 Capital and money markets

● Capital markets: maturities > 1 year (e.g. equities, bonds, mortgages)
● Money markets: maturities < 1 year (e.g. CDs, bills of exchange)
3.3 Ordinary shares (equity)

● Ownership of companies is conveyed via ordinary shares
● Ordinary shareholders have voting rights
● Shares have a nominal/par/face value (e.g. £1 ords, most likely the value of the
asset at the time it was issued), which usually is different from the market value if
quoted
● Companies often raise funds through the issue of shares
● Characteristics:
○ Return: high, dividends and/or increases in share prices
○ Risk: high, zero or low dividends if profits fall & fall in share value; upon
liquidation shareholders only get paid after everyone else
○ Timescales: long-term
○ Liquidity: for unquoted companies v difficult to sell, for quoted companies
shares are highly liquid
3.4 Bonds
● Bonds: loans broken down into smaller units (e.g. bond may have a nominal/par
value of £100)
● Varieties: debentures, loan stock
● May be issued by companies, local authorities, gov orgs
● Nominal value & a coupon/interest rate (e.g. 5%) and redemption terms (e.g.
redeem at par in 2015)
● Annual interest = nominal value x coupon rate (e.g. £1000 * 5% = £50/annum)
○ Return: low, interest and possibly gain on redemption
○ Risk: low, can be secured & interest fixed; you can get high risk unsecured
(“junk”) bonds tho
○ Timescales: maturity varies & is defined on the bond; some are redeemable
and some irredeemable

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○ Liquidity: for unquoted bonds you have to wait for redemption; quoted will
be easier to sell on bond markets (e.g. gov bonds usually v liquid)
● High risk bonds will be sold at a large discount on face value
3.5 Certificates of deposit (CD)

● CD: a deposit has been made with a bank for a fixed period of time, will be
repaid with interest (coupon rate) at the end
● Min is £50k
○ Return: low
○ Risk: low
○ Timescales: 3-6 month most common
○ Liquidity: high
3.6 Credit agreements

● Credit agreement: one party borrows or takes possession of sth in return for
future payment (e.g. credit cards, store hire purchase contracts)
○ Return: high interest rates (e.g. store cards have 25-30% annual rates)
○ Risk: credit card company faces the risk of default, usually unsecured
○ Timescales: meant to be short-term
○ Liquidity: cannot be resold by the lender, but borrower may be able to
repay early
3.7 Mortgages
● Mortgage: loan to finance the purchase of property
● Usually specified payment period & interest rate
○ Return: low
○ Risk: low, however a fall in house prices would reduce the value of security
offered
○ Timescales: long-term (10-35 yrs)
○ Liquidity: didn’t use to be able to be sold, but now can be in the form of
Collateralized Debt Obligations (CDOs)
3.8 Bills of exchange

● Bill of exchange: issued by companies to finance trade, promises to pay a
certain sum at a fixed future date
● Contract between two traders, with the buyer promising to pay a sum of money
in return for goods on a certain date to the seller
● Similar to a post-dated cheque
● Seller may sell the bill or cash to a financial intermediary who will discount it (aka
selling invoices at a slightly lower value & the buyer of the bill receives the full value
at a later date). The difference is the interest.

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● When a financial intermediary accepts a bill of exchange it is effectively loaning money to

a private trader upon promise of a refund by another trader.
○ Return = full value - discounted amount (e.g. £5,000 bought for £4,900 &
repaid in 3 months = 8.4% annual return)
○ Risk: varies, some may be guaranteed by banks
○ Timescales: short-term (3-6 months)
○ Liquidity: can be resold on money markets
3.9 Inter-relationships
● All the markets in a money market closely inter-mesh
● Brokers!
● TEST4: least risky investment: (A) CD from a global bank
4. Calculating yields on financial products
4.1 Equity
● Total return to shareholders = dividends + growth in share price
● Dividend yield = (dividend per ordinary share) / (share price) * 100%
● This is for current dividend, not future growth expectations
4.2 Bonds
● 3 ways to calculate yield on bonds:
○ Bill rate = as coupon rate
○ Running rate / interest yield = (annual interest) / (market value)*100%
■ Ignores the impact of a capital gain or loss on redemption
○ Gross redemption yield: the annualised overall return to the investor
■ Outside the fucking syllabus
■ Redemption yield is the required return of investors, decided by
perceived risks and interest rates. This determines the market price:
■ Market price = present value of future receipts (interest and
redemption proceeds), discounted at the investors’ required return
■ Redemption yield = given the market value, what discount rate
satisfies MV = PV of future receipts?
● Example:
○ Nominal value = $100, coupon rate = 8%, redemption in 5 years time at par,
current market value = $108.40 AKA if you bought the bond for $108.40, the
annual $8 interest gives you a 7.38% ROI each year
○ Bill rate = 8%
○ Running yield = $8/$108.40 * 100% = 7.38%
○ Gross redemption yield = 6%
■ Bought at $108.40
■ Gets redeemed at $100

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■ Capital loss = -$8.40

■ Also takes into account the interest rate
4.3 The role of risk

● Main determinant of the overall yield to an investor is their perceived risk
● Determines the market price for the bond/share
● E.g. dividend = 20c per share, share price = $1, this is 20% dividend yield
○ Adverse environmental factors cause the investors to consider the shares
more risky, so they want a 25% return > share price falls
○ 0.25 = (0.20/market value) * 100%
○ Revised MV (0.2/0.25) = 80cents
● Net dividend yield = (annual dividend) / (market value) * 100%
● RISK determines REQUIRED RETURN determines MARKET VALUE
4.4 The term structure of the interest rates and yield curves
● Term structure of the interest rate: longer maturity begets higher interest rates
● The longer the term of a security, the higher gross redemption yield (aka ROI)
● The normal shape of the yield curve would suggest it’s cheaper to borrow in the
shorter term (aka get a 5 yr loan, then another 5, instead of 10 yr loan at the start),
however:
○ Risk: 10yr loan could have a fixed rate for the whole term, but the second 5yr
loan interest rate would depend on the rates in 5 yrs’ time
○ Arrangement fees
● Linking risk and yield structures for bonds through credit rating agencies
○ Assess whether a firm that owes money is likely to default on a debt
○ Provide vital info on creditworthiness to
■ Potential investors
■ Regulators of investing bodies
■ The firm itself
● Creditworthiness:
○ For larger firms, credit assessment usually carried out by one of the
international credit rating agencies: Standard and Poor’s, Moody’s, and
Fitch
○ Factors that correlate with creditworthiness:
■ Magnitude and strength of cash flows
■ Size of the debt relative to asset value
■ Volatility of the asset value
■ Length of time the debt has to run

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○ Scale: AAA least risky investment grade, C much more risky (“junk” bonds)
● Credit spreads:
○ To mitigate risk / compensate lenders for risk, firms pay a ‘spread’ or premium
over the risk-free rate of interest
○ Required yield on corporate bond = (yield on equivalent treasury bond)
+ (credit spread)
○ Credit rating agencies publish tables of credit spreads detailing the premium
for bonds of differing risks and maturities
○ E.g. 5 yr bonds with credit rating of BB
■ Expected yield on the yield curve for 5 yrs - suppose this is 4%
■ Premium (the credit spread) to reflect the 5 yr maturity & BB - suppose
it’s 2.5%
■ Required yield on the new bonds = 4% + 2.5% = 6%
● TEST5: $100 stock, MP = $80, dividend = $5, Running yield = 5/80 = 6.25% (C)
● TEST6: which of the yields doesn’t need MV of a bond: (C) bill rate
5. Understanding interest rates
5.1 A central rate of interest

● There are many rates of interest, reflecting varying risk
● Central rate of interest (“base rate”): rate at which the central bank would lend
to the money market, based on the treasury bill rates
5.2 Real and nominal interest rates

● The real interest rate puts interest rates in the context of inflation
● 1 + real rate = (1 + money rate)/(1 + inflation)
● E.g. inflation at 3%, u deposit $100 in a deposit account paying 4% per annum,
nominal/money rate is 4% so you end up with $104, but 3% of that increase merely
covers the inflation, so your wealth has only increase by around 1% (1+r = 1.04/10.3
= 1.0097, so r = 0.97%)
● When nominal rate > inflation, positive real rate. Borrowers r losing in real terms,
savers r gaining
● When negative real rate (nominal rate < inflation) , borrowers gain and savers lose
● TEST7: salary increase £30-£36k, inflation 5%, real rate = about 15%
○ 1.20/10.5 = 1.143, so r = 14.3%
● TEST8: consequences of a fall in interest rates: (C) encourage investment (as
borrowing to service it is now cheaper), so investment will rise.
○ Lower interest rates reduce gov expenditure on servicing the national debt,
encourage consumers to take on more credit, so rising consumption and
borrowing for house purchases.
● TEST9:

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○ (a)(i) 1+real rate of interest for 2013 = (1 + 5.5%)/(1 + 2.3%) = 3.1%

○ (a)(ii) real mortgage rate of interest for 2014 = (1.084/1.035) - 1 = 4.7%
○ (a)(iii) real share prices rose or fell between 2012-13: the share price index
represents the change in money values!
■ % increase in share index 2012-2013 (2,919-2,900)/2,900 = 0.66% vs
2.3% inflation over the same period, so in real terms the prices have
fallen
○ (b)(i) rising real interest rates will encourage savings and investment FALSE
(high interest rates encourage savings but discourage investment)
○ (ii) interest rates will only affect business investment if it’s financed by
borrowing FALSE (raises the opportunity cost of using internal funds to
finance investment)
○ (iii) rising interest rates in a country tend to raise the exchange rate for the
country’s currency TRUE (encourage capital inflows, which increase the
demand for the currency)
○ (iv) producers of consumer durable goods are more sensitive to changes in
interest rates than supermarkets TRUE (because they’re often bought on
credit)
○ (v) central banks cannot increase the money supply and raise interest rates at
the same time TRUE (if the supply of money increases, the price/rate of
interest will go down)
○ (c) the effect of a rise in interest rates will be to INCREASE gov spending &
DEFLATE the economy (discourage expenditure)
6. Financial intermediaries
6.1 Introduction
● Two types of financial intermediaries:
○ Deposit-taking institutions (DTIs): e.g. banks, building socs
○ Non-deposit-taking institutions (NDTIs): e.g. insurance companies,
pension funds, unit trusts, investment trusts
● DTIs:

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○ Deposit liabilities of DTIs form the bulk of a country’s money supply, so

they’re more important to gov economic policy & Central bank attention
○ Subject to more regulation
○ The level customers deposit is more discretionary than other products
(e.g. insurance contracts have monthly payments)
6.2 Banks
● Main business:
○ Offering financial services
○ Taking deposits
○ Extending credit
● UK regulated by Financial Conduct Authority (FCA), US Securities and Exchange
Commission (SEC), China Securities Regulatory Commission (CSRC)
● Banking activities:
○ Commercial banking: taking deposits, extending credit
■ Retail banking: high volume of low value transactions, customers:
individuals & small companies
■ Wholesale banking: low vol of high value trans, large companies
○ Investment banking: financial market activities, advice on mergers and
acquisitions, underwriting new issues
● Retail/commercial banks’ main activities:
○ Safeguarding money: deposit & current accounts
■ Deposit (time) accounts with interest, for savers
■ Current (sight) accounts (small interest if any)
■ The distinction becoming less clear with new products (e.g. high
interest cheque accounts)
○ Transferring money
■ Between accounts within a branch, between branches, between
different banks
■ Each clearing bank has an account at the central bank
■ Money transmission service: cheques, DDs, SOs, credit transfers
○ Lending money
■ Profit-earning function
■ Loans and overdrafts
○ Facilitating trade
■ International trade: accepting of commercial bills, provision of foreign
exchange
■ Domestic trade: advisory services for small firms, participation in loan
guarantee schemes, giving financial advice & market info
● Wholesale / investment / secondary banks
○ Merchant banks: e.g. Morgan Grenfell, banking brokers who bring together
the lenders and borrowers of large sums of money
■ Operate in a high-risk area
■ Industry & commerce
■ Inter-bank market: borrowing from each other
■ Advise companies on money management

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■ Negotiate bills of exchange (= trading contract, usually for 3 months,

upon which a trader can usually get credit)
■ Underwrite the launching of new shares
■ Supervise takeovers on the stock market
■ As accepting houses, guarantee commercial bills
○ Overseas banks operating in countries other than their home country
■ Financing international trade
■ International capital movements
■ International currency transactions
● Discount houses (unique to Britain): they borrow from the commercial banks for a
short period (e.g. overnight) and lend for up to 3 months
● Non-bank financial intermediaries
○ Not officially authorised by the Bank of England, but informally watched
○ Building societies (mutual building societies, or owned by shareholders)
■ Borrow short, lend long (e.g. mortgages)
■ Competitive with banks, esp re home loans and high-interest
instant-access accounts
■ They can lend only a max of 5% of their assets for personal finance
■ Can become banks
● Financial conglomerates
○ Financial institutions tended to specialise, but now they’re branching out into
non-traditional lines of business
○ Diversification brought estate agents, unit trusts and big high street
retailers into financial intermediaries
● Other financial institutions:

○ Investment and unit trusts: accept savings by selling shares and invest
these savings, mainly in company shares
○ Pension funds
○ Insurance companies: invest their premium income
○ Finance companies for medium-term credit for business and individual
customers
○ Leasing companies (leasing out capital equipment)
○ Factoring companies (providing funds to businesses using their receivables
as collateral)
6.3 Credit creation

● Credit/deposit multiplier: the amount by which total deposits can increase as a
result of the bank acquiring additional cash
○ the amount by which credit expands in the economy
● Change in total deposits = 1/(cash ratio) * the initial cash deposit
● Cash ratio: about 10% of the cash deposited will be withdrawn at the same time
● Cash ratio of 10% gives the balance sheet multiplier of 10: the total increase in the
money supply is ten times the initial cash deposit

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○ The credit multiplier is strictly speaking the balance sheet multiplier -1, since
10% of the rise in the balance sheet consists of the initial cash deposit rather
than created credit
● The amount of credit banks can create depends on:
○ The cash and near cash liquid assets they hold
○ The size of the credit multiplier
● E.g. A deposits $1,000
○ Loan to B of $900
○ B pays $400 to C who uses the same bank & C deposits $400
○ At this point, cash = $500, liabilities (deposit accounts) $1,400
○ 10% of 1,400 = $140, so excess $360 invested
6.4 Central banks

● Normally gov-owned, examples:
○ UK: Bank of England
○ US: Federal Reserve Board
○ Eurozone: European Central Bank
○ Japan: Bank of Japan
● Functions:
○ Banker to the banks
■ All commercial banks have accounts here
■ Liquid reserve for the commercial banks, lender of the last resort
■ Facilitates transfer between banks
■ In most countries these accounts are compulsory
○ Banker to the gov
■ Accounts of gov depts
■ Debt management
■ Monetary policy operation on behalf of the gov: managing supply of
the money in economy, interest rates, exchange rates
■ Manages country’s reserves of foreign currency (UK: Exchange and
Equalization account)
○ Supervision of the banking system
■ Capital adequacy: to ensure banks have sufficient capital to meet
problems arising from business losses or loss of value in their assets
(e.g. bad debts)

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■ Liquidity: to ensure banks can meet the day-to-day requirements of

their customers for cash
○ Lenders of last resort
■ Rediscount bills
■ Buy bank gov stock (‘repos’)
○ Sole right of note issue
■ These are liabilities on the central bank’s balance sheet
■ The matching assets are largely gov securities (not gold :(()
● Monetary policy
○ Open market operations:
■ Alter interest rates by selling or buying back/redeeming gov
stock
■ Buys and sells treasury and commercial bills, and gov bonds in
the money market
○ If it seeks a MULTIPLE CONTRACTION OF CREDIT / restriction of credit:
sell bills
■ Cheques paying for them will be drawn on the banks, whose deposits
will fall and their balances at the central bank lower
■ Cash base will be lowered
■ Their potential to create credit will be limited
■ In practice, banks may be able to restore their cash base by
reclaiming money at call from the banks (e.g. discount houses) and
other financial orgs
○ If it seeks a MULTIPLE EXPANSION OF CREDIT: buy bills
■ Increase in the commercial banks deposits at the central bank
■ Their cash base increased
■ Ability to create credit raised
○ Discount houses
■ Always sell bills to the central bank when they need cash
■ At the prevailing market rate, which the bank can accept or reject
■ Interest rates rise: rejects & offers a higher interest rate (penalising the
discount houses)
■ As the discount houses don’t want to make losses on their own loans,
they raise interest rates & the increase is thus transmitted through the
money market
○ Summary: central bank can restrict the credit creating ability of banks
by:
■ Reducing the amount of cash in the fin system
■ Forcing a rise in interest rates through the system
○ Similar in the market for gov long-term securities (gift-edged securities):
■ Central bank increases its sales of gov bonds, the price falls &
interest rates rise
■ Decreases its sale of gov bonds, price rises & interest rates (the
yield) falls
○ Gov & central bank can control the ability of commercial banks to create
credit through bank assets ratios

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■ Banks are required to keep a proportion of their total assets in certain

specified assets
■ To ensure prudential standards of liquidity
■ By varying these ratios, the central banks could affect the credit
multiplier
■ In practice little use is made of this nowadays
● Monetary policy in the UK
○ Example of 2008: the threat of rising inflation, interest rates kept relatively
high VS threat of inflation faded, recession became the primary problem,
rapid reversal of monetary policy, interest rate cut to 0.5%
○ Aka to suppress inflation, interest rates either raised or kept relatively high
● Quantitative easing
○ Raising or lowering interest rates: main tool of gov to control growth in an
economy
○ Lower interest rates encourage spending money
○ Quantitative easing (QE): when interest rates are almost zero, central banks
need to adopt different tactics: pumping money directly into the economy
○ Central bank buys assets (e.g. gov bonds) with money it has ‘printed’ or
created electronically
○ Uses this money to buy bonds from investors (e.g. banks and pension funds)
○ This increases the amount of cash in the financial system, encouraging fin
inst. to lend more
○ This should allow them to invest and spend more
○ Increasing growth
● TEST10: not a function of central bank: C conduct of fiscal policy

● TEST11:
○ Cash ratio = the amount of cash kept by banks in readiness to pay
withdrawals as a proportion of their total assets
○ What is the relationship between liquidity and profitability of banks assets?
Most liquid assets are least profitable (e.g. cash). Least liquid assets are most
profitable (e.g. advances and loans to customers).
○ Central bank reduce the supply of credit in the fin system? Would need to
reduce the liquidity of the fin systems, as this is the basis upon which credit is
created. Sell gov stocks to fin institutions.
○ Central bank reduce the demand for credit in the fin system? Raise interest
rates, as interest is the price of credit and a higher price will reduce
demand.
○ What are capital adequacy rules? Central banks need to ensure banks have
enough capital to cover bad debts on risk assets.
7. Financial markets
● Money markets
● Capital markets
● International markets

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7.1 Money markets

● Usually fin markets are dominated by the money market
● Banks/companies/loc. authorities/gov operate via the discount houses in
buying and selling short-term debt
● Discount houses: market makers in bills
○ They buy/sell treasury and commercial bills
○ To enable holders to liquefy their assets :D or turn their cash into paper
financial assets
○ Obligated to purchase each week the full issue of treasury bills
○ Treasury bills: issued to make up the diff. between gov expenditure &
reserves
○ Other buyers may purchase most of the treasury bills, but discount houses
guarantee to make good any shortfall in demand
○ Price that discount house pays reflects market rate of interest
○ High bid price > low rate of interest (the diff between price paid & maturity
value is the interest paid on the loan)
● Bill of exchange = main commercial bill
● Often resold before maturity, again facilitating liquidity of the seller
● Discount houses raise their funds by borrowing ‘money at call’ from the banks
at very low rates of interest & then charge slightly higher rate of interest when
buying bills to make profit
● Parallel money markets: created in 70s and 80s
○ Transactions mainly between financial intermediaries, firms, and loc
authorities
○ Not gov!
○ Secondary markets developed in:
■ Bank liabilities (e.g. CDs)
■ Bank assets (e.g. resaleable bank loans)
○ Inter-bank market
■ Enables banks to accommodate fluctuations in customers'
transactions by making loans to one another
7.2 The stock markets

● UK:
○ ‘Full’ equities/securities market: trade of ordinary shares, preference
shares, debentures
○ Alternative Investment Market (AIM): smaller companies gain access to
capital
○ Bonds/gilts market: gov sells short (<5yrs), medium (5-15yrs), long (>15yrs)
and undated stock
● Capital instruments: the means (e.g. shares, treasury bonds) by which orgs raise
finance
● New York stock exchange largest in terms of market capitalisation, followed by
NASDAQ stock market

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● Oct 1986 ‘Big Bang’ in the UK Stock Exchange: broker and jobbing functions were
merged > market-maker
● Equity market
○ Transactions in company securities are the most numerous, divided into
equities and loan capital securities
■ Average only £15k / transaction
○ Equities (ordinary shares): full voting rights, entitlement to dividends, once
the preference shareholders and the holders of loan capital have been paid
out
■ Preference shareholders receive a fixed dividend & get their capital
repaid before ordinary shareholders if a company is wound up
○ Loan capital securities: company bonds and debentures: do not confer
ownership rights, but u get a fixed rate of interest over a set period of time
■ Traded options: an option holder can buy/sell a quantity of a
company’s shares at a fixed price on a specified date
○ Convertible securities: combine debt and equity
■ Holder of debt has the option to convert to equity
○ Securities market
■ 2 main functions:
■ Issuing new shares:
● Primary market for newly issued shares (to issue shares: offer
for sale, placing, tender, public issue)
● Rights issue: existing shareholders can pay to subscribe for
more shares in proportion to their existing shareholdings
(stockbroker obtains stock exchange approval for the issue,
which a merchant bank usually underwrites)
■ Buying and selling existing shares:
● It raises the liquidity of company shares (cuz buyers of new
issues know they can sell in the future)
● The worth of a company can be calculated from its share price
● A company can raise further capital by issuing extra shares
more easily and cheaply if it has a high market share price
○ Stock market is a perfectly competitive market
■ Many buyers and sellers with excellent knowledge & rapid reactions to
price changes
■ Share prices are published daily & reflect demand changes
● Alternative investment market (AIM)
○ Shares in smaller companies
○ No formal requirements for age of the company & market capitalisation
● Government bond market
○ Wide choice of interest payments & redemption dates
○ Fixed certain income
○ Main buyers are pension funds & life assurance companies
○ The market price varies with the interest payment / coupon

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○ E.g. 5% interest rate, bond with a £10 coupon will trade at around £200
(10/200=5%)
■ If interest rises to 6%, the bond price will move to £166 (10/166=6%)
○ Supply of bonds determined by the stock of bonds, which basically constitute
the national debt
○ Public sector borrowing, which necessitates debt sales, will increase the
supply of bonds
● TEST12: will lead to a rise in share prices on the HK stock exchange: (A) a fall in
interest rates
● TEST13: 30yr treasury bond issued last year is sold in a (ii) capital market & (iii)
secondary market (D)
Things to look up:

● QUOTED COMPANY: listed on the stock exchange, actively traded, aka has a
confirmed fucking price
● UNQUOTED COMPANY: not a quoted company, would need to get valuated
● QUOTED BONDS: actively traded, have a price on the market

● UNQUOTED BONDS: not a quoted bond lolol
● MONEY MARKET = market for treasury bills, commercial bills, CDs and other
short-term debt (< 1 yr)
● CAPITAL MARKET = long-term debt (maturity > 1 yr)
● he primary market is where securities

PRIMARY VS SECONDARY MARKET: T
are created, while the secondary market is where those securities are traded
by investors.
○ https://www.investopedia.com/investing/primary-and-secondary-market
s/
○ In the primary market, companies sell new stocks and bonds to the public for
the first time, such as with an initial public offering (IPO).
○ That is, in the secondary market, investors trade previously issued securities
without the issuing companies' involvement.
○ The secondary market is basically the stock market and refers to the New
York Stock Exchange, the Nasdaq, and other exchanges worldwide.
○ In the debt markets, while a bond is guaranteed to pay its owner the full par
value at maturity, this date is often many years down the road. Instead,
bondholders can sell bonds on the secondary market for a tidy profit if
interest rates have decreased since the issuance of their bond, making it
more valuable to other investors due to its relatively higher coupon rate.
● Bonds: e.g. Treasury Bills (short-term), 25-year corporate bonds, etc.

● When interest rates rise, bond prices tend to fall

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● Deposit taking institutions: banks, building societies

● Non-deposit taking institutions: insurance companies, pension funds, investment
trusts

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Ch 4 - Macroeconomic and Institutional Context I:

The Domestic Economy
1. Macroeconomics and government policy goals,
1.1 Macroeconomics
● The workings of the economy as a whole:
○ Aggregate demand: overall demand for goods and services
○ National output/product: output of goods and services
○ Supply of factors of production: land, labour, capital, enterprise
○ National income: total incomes earned by providers of factors of production
○ National expenditure: money spent in purchasing the national product
○ Government policy
1.2 Gov macroeconomic policy

Four macroeconomic policy objectives:
● Economic growth: increase productive capacity
● Inflation: make sure general price levels don’t increase
● Unemployment: everyone who wants a job has one
● Balance of payments: financial relationships and trade with other countries
1.3 Stagnation and economic growth

● Growth should result in an improved standard of living & higher profitability for
businesses
○ More goods demanded & produced
○ Ppl earn more & can afford more goods
○ More people should have jobs
● Possible issues of economic growth:
○ Is it keeping up with population growth?
○ Is it exceeding inflation (aka real growth)?
○ Is it in demerit goods (e.g. illegal drugs)?
○ Is it at the expense of the environment or through exploitation of the poor?
○ Are the benefits from growth evenly distributed, or is the gap between rich
and poor growing?

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○ Rapid growth may attract imports, worsening the balance of trade, rather
than benefiting domestic producers.
1.4 Inflation
● Goal: stable prices & low inflation
● Because:
○ Inflation causes uncertainty & stifles business investment
○ Not all incomes rise in line with inflation
○ Extreme inflation > function of money may break down > civil unrest
○ Distorts the working of the price mechanism (a market imperfection)
● High inflation’s effect on savings:
○ Erodes the future purchasing power of funds, so people may decide to save
less & spend money now
○ The real balance effect: higher prices reduce individuals’ real wealth, so they
spend less > higher savings
1.5 Unemployment
● Some unemployment is normal, e.g. ppl change jobs
● Mass unemployment:
○ Gov unemployment benefits paid out when tax receipts are low > gov may
have to raise taxes, borrow money, cut back on services
○ Rise in crime, poor health, breakdown in family relationships
○ Waste of human resources, restricts economic growth
○ Gives firms higher bargaining power > lower wages
1.6 Balance of payments

● Broad balance between the value of imports & exports
● A persistent surplus or deficit can have negative macroeconomic effects:
○ Long-term trade deficit has to be financed > major drain on the productive
capacity of the economy
○ Long-term trade surplus > significant inflationary pressures > loss in
international confidence in the economy & lack of international
competitiveness
1.7 Trade cycles

● Fluctuations in economic activity over time with an underlying trend of output
growth
● Is the role of gov to smooth out this pattern & avoid boom and bust years?

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● The Great Recession: 2007/8 worldwide economic downturn
1.8 The economic diamond / objectives of economic policy

● Price stability, low annual rate of inflation
● Full employment
● External balance implying no long-term tendency for balance of payments current
account deficits
● Economic growth (annual rise in GDP)
● The bigger the diamond, the better the performance of the economy, the more
successful the economic policy
● Constraints of the market economy on economic policy:
○ Previous policies (which can’t be abandoned or altered due to continuity &
stability)
○ Imperfect economic predictions
○ Time lags between design and implementation
○ Political limitations (what is possible & acceptable to the electorate)
● TEST1: not an objective of macroeconomic policy: C lower levels of taxation

● TEST2:
○ Economic growth benefits everyone equally FALSE
○ Economic growth can lead to an increase in imports TRUE
○ Inflation doesn’t affect those on fixed income as much FALSE

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○ Inflation encourages investment in a national economy FALSE

● TEST3: Boom and bust are extremes, steady growth without high risks would
be preferable. The main issue is the bust: job losses, losing homes, fall in
labour mobility, bankruptcy, low confidence, corporate failures, fall in profits,
excess capacity. In boom, ppl and orgs may be tempted to over-stretch
themselves. Possible inflation, the main problem w/ boom and bust.
2. Understanding national income: the circular flow model

● Y national income (YIELD lolol)
● Consumption
● Savings
● Investment
● Taxation
● Government expenditure
● eXports
● iMports
2.1 The circular flow model

● Without gov, international trade, private sector investment, no savings:
○ Income of households is equal to expenditure/demand

○ C = Y, total expenditure = consumption, so E = Y
○ Simple economy equilibrium (no growth or decrease)
● Real things (goods, services, work) go in one direction
● Payment for things (consumption expenditure, wages) goes in the other direction
2.2 Injections and withdrawals

● More realistically, circular flow can experience:
○ Injections: additions to expenditure from outside the circular flow (eXports,
Gov investments, private sector Investments)
○ Withdrawals/leakages: some element of income that is not passed on as
expenditure (iMports, Taxation, Savings)
● Exports: goods flow out of the country, money flows into the country
● Imports: goods flow into the country, money flows out of the country

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2.3 Equilibrium
● An economy making full use of its resources will be moving towards a state of
rest/equilibrium
● Planned injections = planned withdrawals
● Equilibrium in national income is where:
● J (injections) = W (withdrawals)
○ I + G + X = S + T + M
● J > W the level of national income will rise; further ongoing investment would be
required to sustain growth
● J < W the level of national income will fall; if national income falls, then savings will
fall, reducing the overall level of withdrawals & slowing the fall of income
2.4 More complex circular flow of funds

● Households save via financial institutions > that money goes to firms to finance
investment
● Govs tax incomes & may use these revenues to purchase goods/services from the
firms or provide support incomes for households
● International trade: exports represent additional spending on the firm sector, but
imports represent a diversion of spending away from the firm sector towards other
countries

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3. Understanding the components of the circular flow of funds
3.1 Consumption (C)

● Spending by people/households
● Most important determinant of the level of consumption is the level of income
● Marginal propensity to consume (MPC): the extent to which consumption changes
with income
● MPC = (change in consumption) / (change in income)
● E.g. $15/$20 = 0.75 = 75% of the increase in income has been converted to an
increase in consumption
● MPC usually positive, but likely to fall as income rises
● Factors affecting consumption / objective influences:
○ Income: C normally based on current income (sometimes previous income
OR expected future income)
○ Wealth:
■ for individuals an increase in wealth may raise MPC because less
saving is needed
■ in the ec as a whole a more equal wealth distribution would likely raise
consumption
■ Liquid wealth, such as savings under the bed, is likely to raise
consumption VS illiquid wealth will have little effect on C
○ Gov policy: influences the level and pattern of consumption by taxation &
public spending
■ Increase in direct taxations lowers disposable income, reduces
consumption
■ Higher gov spending raises incomes and stimulates consumption
○ The cost and availability of credit: low rate of interest (= low cost of credit)
& more availability > more consumption
○ Price expectations: when price rises are anticipated, consumption might be
brought forward, temporarily raising MPC
● Subjective influences which determine individual behaviour (e.g. some cultures
encourage high levels of savings)
● TEST4: least likely to result in a fall in consumption C increase in the rate of inflation
(cuz money will be worth less tomorrow, so better buy now)
3.2 Savings (S)

● The amount of income not spent
● Factors affecting savings (mirror image of those determining consumption):
○ Income: level of saving determined mainly by income
○ Interest rates: increase in interest rate will mean ppl need to save less to
achieve a target; however, ppl might want to save more
○ Inflation: real interest rate even more important than the money rate of
interest; customers might still save more when nominal interest rates are
high, even if inflation reduces the real rate due to ‘money illusion’

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○ Credit: when it’s easily available, consumers might acquire as much as they
are saving, so in effect no net saving
○ Contractual savings: most saving is contractual and regular (e.g. pensions)
● Most saving undertaken by households and companies, govs save when they run
budget surpluses & then dis-save when they run deficits
● Savings deficit in any one sector has to be financed by saving of the other sectors
(e.g. companies invest more than they’re saving, it’ll have to borrow)
3.3 Investment (I)

● Expenditure on investment covers:
○ Fixed capital formation (e.g. plant, machinery, roads, houses)
○ Value of the physical increase in stocks of raw materials, wip and
finished goods
● Public & private sector (firms & households r private s.)
● Enhances the capacity of the economy
● The capital stock of the economy is increased by the amount of net investment
undertaken each year
● Net investment = gross (total) investment - replacement investment (capital
consumption)
● Capital consumption accounts for the deterioration of the existing capital
equipment stock
● Assessing investments using discounted cash flows, main determinants of the level
of investment are:
○ Expectations about future cash flows (including anticipated revenue from
the output of investment compared with the anticipated costs of investment)
○ The business’s cost of capital (affected by availability and cost of finance,
inflation, perceived risks of the cash flows)
● Other factors:
○ The state of business confidence (optimistic/pessimistic)
○ Technological innovation (> capital becomes more productive > raises the
level of investment at any given rate of interest)
■ Marginal Efficiency of Capital (MEC): to calculate the return on
invested funds, must exceed the interest rate for an investment to be
worthwhile
○ Gov policy (uncertainty if inconsistent and varying; reductions in corp tax &
improved tax allowances will increase income stream & encourage
investment; also changes in interest rates influence the profitability of
investment)
● TEST5: FALSE (Brenda is saving more, not investing; however, you could argue that
the bank now has additional funds > increased lending > investment, but it’s not a
direct correlation & def not the exact number; also, a reduction in consumption
demand may result in a fall in investment levels LOL)
3.4 The government and external sectors

● U don’t get to know about this now, coming later

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3.5 Linkages between different elements of the circular flow

● The accelerator
○ When an economy starts to grow, this in itself can fuel further growth
○ I.e. national income rises > consumption demand increases > firms respond
by investing in new capital goods to meet extra demand > increases
aggregate demand further > increases pressure for more investment
○ The reverse is also true: a reduction in the size of an economy > cut in
investment > accelerating the decline further
● The multiplier
○ Changes in injections (gov expenditure, investment, exports) may cause
a more than proportional increase in national income
○ Planned injection into the circular flow increases while other injections &
withdrawals remain the same > national income > the use of more factors of
production whose earnings will be spent > adding to the income of others >
more spending, etc.
○ An initial injection of additional expenditure in the circular flow will lead to a
series of additional rounds of expenditure
○ Determinants of the multiplier in a simple economy
■ Increase in national income cause by successive rounds of spending
will not go on forever, since some extra income is lost through the
operation of withdrawals
■ E.g. marginal propensity to save 20%:
● Round 1: $100
● Round 2: $80
● Round 3: $64
● Round 4: $51.2
■ Simple economy: the obvious withdrawal is savings (no gov, no
external sector):
● K = 1/(1-MPC) = 1/MPS
● K = the value of the multiplier
● MPC = marginal propensity to consume
● MPS = marginal propensity to save
■ E.g. MPC = 0.8 (and therefore MPS = 0.2), then K = 5 & an increased
injection of $10m would increase total national income by $50m
● Trade cycles:
○ Boosted investment (e.g. innovation, war)
○ Triggers multiplier effect > rising incomes
○ Increased consumption & demand
○ Triggers accelerator effect as firms invest further to meet demand
○ Extra investment triggers multiplier again etc.
○ = strong upswing in the trade cycle
○ Eventually economy reaches full capacity (i.e. all factors are employed)
○ Investment tails off
○ Incomes start to fall > triggers a reverse multiplier
○ Consumption and demand fall

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○ Reduced investment etc.

○ = downward part of the trade cycle
● Governmental demand management policy (= using its levels of taxation and
expenditure to influence the level of aggregate demand & so national income) needs
a knowledge of the working of the multiplier and its value in the economy
○ The value of the multiplier can vary not only over time as savings rates and
the propensity to import changes, but also between gov policy instruments
○ Expenditure tends to have a higher multiplier value than tax cuts (Round
1: all expenditure is spent, but some tax cuts may be saved)
○ Some expenditure has immediate spending effects (e.g. increased
pensions) & some may only have their full effect over a period of years
(e.g. long-term investment projects)
○ Some economists argue that the multiplier value of gov expenditure is zero,
since an increase has to be financed via gov borrowing from the private
sector, which crowds out an equivalent amount of private expenditure
● TEST6: least likely to result in a fall in investment spending (A) an increase in gov
expenditure
● TEST7:
○ Name two withdrawals from the circular flow: imports, savings, taxes
○ An injection into the circular flow = any additional expenditure that does
not arise from the circular flow of income itself
○ Equilibrium: I = W
○ What does the consumption function show? The extent to which consumption
changes with income. (change in consumption) = (change in income) *
MPC
○ Major consumer of goods & services are households, firms & gov, overseas
consumers (via exports)
○ Net investment = gross (total) investment - replacement investment (capital
consumption). Net investment is the value of investment in capital goods
over and above that required to replace worn-out capital (depreciation).
○ What does the accelerator theory show: changes in consumption
expenditure may induce much larger proportional changes in
investment expenditure, and thereby contribute to the trade cycle
○ Multiplier: an increase in expenditure will cause a much larger increase in
total income and expenditure through successive rounds of spending
○ K = 1/(1-MPC) = 1/MPS
4. Aggregate supply and demand

● Twin problems of inflation and unemployment
● Much of gov econ policy is devoted to prevent either of those
● But first, let’s see how they arise :D
4.1 The aggregate demand and aggregate supply model

● Aggregate Demand (AD): made up of consumption, investment, gov expenditure &
net exports (exports - imports)

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● AD = C + I + G + (X - M)
● How the economy functions & why problems may occur is not just due to demand for
goods and services, we also need to know about:
● Aggregate Supply (AS): the ability of the economy to produce goods &
services
4.2 Aggregate demand (AD)

● Circular flow model: AD related to the level of national income & level of expenditure
● Aggregate demand and supply model: AD related to national income and price
level
● Made up of all components of expenditure in the economy
● Inversely related to prices, since a price fall > raises real wealth / purchasing power
> raises spending
● May shift it any one component (e.g. investment, exports) changes through the
multiplier effect
● The AD curve slopes down from left to right but may shift
4.3 Aggregate supply (AS)

● The willingness and ability of producers (largely the business sector) to
produce and offer goods/services for sale
● Collective result of decisions made by millions of business producers to produce &
sell goods/services
● Positively related to price level: rise in price level > sales more profitable >
businesses expand output
● Limited by availability of resources: at full employment, output can’t be increased
any further
● Can only shift in the long run as the result of a change in the costs of production
or in the availability of factors of production
● AS curve slopes upward from left to right & does not shift in the short run
4.4 Equilibrium
● National equilibrium = where AD curve intersects with AS curve
● Total demand for goods/services = total supply of goods/services in the economy
● This model demonstrates the effect of changes in either AD or AS on both the level
of national income & price level
● Level of employment in the short-medium run is a function of the level of national
income > the model can show how inflation and unemployment might arise in an
economy & how govs might respond

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4.5 Changes in AD
Example 1:
● Economy is in E at a level of national income (= national output) & employment
denoted by Y1
● AD raises from AD1 to AD2, new E is at Y2, national income rises from Y1 to Y2 &
unemployment falls, price level rises from P1 to P2
● Most of the effect of an increase in AD is felt in the form of rising income &
employment, there’s only a small inflationary impact (P1 to P2)
● If the gov wishes to reduce unemployment, an expansion of AD by reducing taxes or
raising gov expenditure would be good :D appropriate & effective
Example2:
● Initial E is at Y3
● Increase AD3 to AD4, new E is at Y4, national income rises Y3 to Y4, unemployment
falls, price level rises P3 to P4
● Increase of AD mostly felt as rise in price level, only a small effect in national income
& reducing unemployment > significant inflationary pressure for a small benefit
● More appropriate gov policy here is to restrain AD by raising taxes & reducing gov
expenditure, shifting AD4 to AD3
● At some point, the AS curve becomes very steep because the economy is
approaching full employment
● Shifts in the AD curve may occur for reasons other than gov policy:
● Recession (falling output and employment & reduced inflationary pressure) results
from a leftward movement in the AD curve caused by:
○ A fall in investment if business confidence is damaged
○ A fall in consumer expenditure if they lose confidence or reach the limits
of their ability to finance extra credit
○ A fall in exports if there is a major loss of competitiveness or if there’s a
recession in the country’s major trading partners
● Inversely, growth/boom (rising output & employment, increasing inflationary
pressures) results from a rightward movement in the AD curve caused by:

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○ Investment boom if business is confident and profitable

○ Rapid rise in consumer expenditure if confident & access to affordable credit
○ Rapid rise in exports if there is a major gain in competitiveness (e.g. from a
depreciation of the currency) or a boom in the country’s major trading
partners
4.5 Changes in AS
Example 1:
● Supply-side shocks: reduce the ability/willingness of productive businesses to
produce and sell
● AS shifts left AS1 to AS2, rise in the price level P1 to P2, fall in output Y1 to Y2
● Falling output & rising inflation = stagflation
● Such supply-side shocks might arise from:
○ Major rise in energy and/or raw material prices (e.g. oil price rises in
70s/80s)
○ Major rise in labour costs (haha EU social labour legislation rising the cost
of labour MAY HAVE CAUSED THE ISSUES FOR EU LARGE ECONOMIES
lehrprosihdpo)
○ Significant fall in productivity due to major tech problems (e.g. some fear
that attempting to deal with global warming by emissions controls may have
some of this effect)
Example 2:
● Rightward shift in the AS curve AS1 to AS3
● National income and employment expand Y1 to Y3, price level falls P1 to P3
● The opposite of stagflation
● Might arise from:
○ Favourable developments reducing costs (e.g. falling energy & raw
material prices, big productivity improvements from tech change)
○ Deliberate gov supply-side policies designed to shift the AS curve to the
right (e.g. privatisation, business tax reduction, labour market reforms)
● Supply side policies

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○ Monetary and fiscal policies primarily concerned with influencing the level
of aggregate monetary demand
○ In terms of AS/D, these policies are aimed to shift the AD curve to the right
when the problem is unemployment
○ And to the left when the problem is inflation
○ Concern over effectiveness has led to a shift of emphasis towards supply side
policies
○ Supply side policy wants to shift the AS curve to the right
○ In terms of AS/D, this would raise national income & lower unemployment
at the same time as reducing inflationary pressure
○ Supply side policies consist of a wide range of measures - most importantly:
■ Shifting taxation away from direct to indirect & reducing marginal rates
of taxation to encourage work and enterprise
■ Reducing social security payments & tailoring them to encourage the
unemployed to seek employment
■ Emphasis on vocational education & training to improve work skills
■ Reducing the power of trade unions & employee orgs to limit entry into
occupations & raise wages above E levels
■ Deregulation & privatisation to encourage enterprise and risk-taking
○ In the longer run, such policies appear to have been successful :puke:
○ UK & USA most widely adopted: unemployment & inflationary pressures fell
significantly in the 90s and onwards
○ LESS DESIRABLE CONSEQUENCES:
■ Making the taxation system much more regressive (UK poorest 20%
of the population pay more tax than riches 20%)
■ More unequal distribution of income
■ Greater degree of uncertainty for workers & less employment
protection
■ A fall in the relative (and sometimes absolute) standard of living for
many who are dependent on social security payments
● TEST8: AS curve shifted to the left - C national income would fall & the price level
would rise
● TEST9: would case a fall in the level of AD - A a decrease in gov expenditure
● TEST10: would cause AS curve to shift to the right - B increased investment in new
tech
● TEST11: would it affect AD or AS curve & in which direction
○ A fall in business confidence due to political scandals AD L
○ An increase in tariffs on imported goods AD R
○ A major increase in world oil prices AS L
○ An increase in trade union power & militancy AS L
○ An increase in interest rates AD L
○ New training initiatives for the unemployed AS R

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5. Trade cycles
5.1 The trade cycle and gov policy

● Trade cycle of recessions, recoveries & booms, followed by further recession
● Gov policy used to deal with these problems
● Recession (AD L)
○ Causes
■ Falling domestic AD from lower levels of
● Consumer spending
● Investments
● Exports
● Gov expenditure
■ World recession
○ Features:
■ Falling output/income
■ High and rising unemployment
■ Reduced inflationary pressure
■ Improving trade balance as imports fall
■ Public finance adversely affected (due to reduced tax income &
increased benefits payments)
○ Response:
■ Raise AD
● Reducing taxation
● Raising public expenditure
● Lowering interest rates
■ Note: this will further increase the need for gov borrowing

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● Stagflation (AS L)
○ Causes:
■ Supply-side shocks reducing AS
■ Low AD combined with imported cost-push inflation
○ Features:
■ Falling output, income, employment
■ Rising inflationary pressure
○ Response:
■ Supply-side policy to raise AS
● Recovery
○ Causes:
■ Returning confidence in business and consumer sectors
■ Effect of gov expansionary policy undertaken in recession
○ Features:
■ Output, income & employment begin to rise
■ Only moderate inflationary pressure
■ Improving public finances
○ Response:
■ Reduction in expansionary policy to prevent too strong a boom
● Boom
○ Causes:
■ High and rising AD from higher levels of:
● Consumer spending
● Investment exports
● Gov expenditure
○ Features:
■ High output and employment
■ Rising inflationary pressure
■ Deteriorating trade balance as imports rise
■ Higher net income for gov > repayment of debt
○ Response:
■ Reduce AD by
● Raising taxation
● Reducing public expenditure
● Higher interest rates
● A period of econ growth without undue inflationary pressure if AS continually
increases
○ At least partly the result of supply-side reforms blah blah blah capitalism
5.2 Implications for businesses

● Impact on likely demand for the firm’s products
○ Staple goods (e.g. milk, bread) will be less affected
○ Capital goods (e.g. machinery) will see a major downturn in demand in
recession, but a large upswing in a boom

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○ A firm that supplies to the public sector will be concerned with gov
spending plans (e.g. in recession gov spending by building new roads and
schools, this would be major opportunities for building contractors)
○ Consider the portfolio of products to reduce the risk associated with trade
cycles, e.g. diversifying geographically
○ Some firms produce/provide counter-cyclical goods/services: items that
sell well in a recession, e.g. discount retailers (Lidl, Poundland) and auto
repair businesses (car owners more likely to repair than buy new)
● During downturn, unemployment is higher, so firms have more bargaining power
over employees (lower wages)
● Success may also be influenced by being able to determine when best to act, e.g.
increasing production in response to an anticipated upturn
● If gov adjusts interest rates as part of its policies, this will affect the firm’s cost of
borrowing
6. Fiscal and monetary policy options
6.1 Fiscal policy options

● Gov taxation & spending plans
● Demand side policies, known as Keynesian economics
● Government budget
○ Medium - to long-term aim is to achieve a balanced budget =
income=expenditure
○ Deficit = income < expenditure
○ Surplus = income > expenditure
○ Don’t confuse a balanced budget with the balance of payments! Balance of
payments refers to the flow of funds into and out of the country.
● Running a budget deficit
○ Gov injecting more than taking out of the economy
○ Financed through borrowing: Public Sector Net Borrowing (PSNB)
○ This is known as expansionary policy: used to promote economic growth &
reduce unemployment by closing a deflationary gap
○ Deflationary gap: AD is less than that required to ensure full employment, so
national income is too low to provide employment opportunities

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○ Criticism: higher public spending will crowd out private expenditure

(e.g. higher public borrowing may increase interest rates & make private
sector borrowing more expensive)
● Running a budget surplus
○ Inflationary gap: AD above the level necessary to generate full employment,
can lead to inflation (too much money chasing too few goods)
○ Fiscal policy can also be used to control inflation
○ Contractionary policy: gov can seek to reduce AD by running a budget
surplus, effectively taking money out of the economy
6.2 Monetary policy options

● Monetary policy = management of the money supply in the economy
● Usually understood within the context of monetarism
● Monetarist economists believe in using monetary policy rather than fiscal policy to
control the economy
● It can involve changing interest rates:
○ Directly
○ Indirectly, through open market operations and setting reserve requirements
for banks
● Expansionary policy: increases the total supply of money in the economy
○ Used to combat unemployment in a recession by lowering interest rates
● Contractionary policy: decreases …
○ Raising interest rates to combat inflation
● Money supply: the total amount of money in the economy
○ Many measures of the money supply, including:
■ M0 Notes and coins in circulation & balances at the country’s Central
Bank
■ M4 Notes and coins & all private sector sterling bank/building society
deposits (96% of which are deposits)
● Reserve requirements
○ Fractional reserve system: only a part of the deposits in the bank is kept in
cash
○ Reserve asset ratio / liquid ratio = the proportion of deposits retained in
cash
● Open market operations
○ Gov exerts some control over the money supply by buying and selling its
own bonds
○ E.g. buying back its own bonds will release more cash into circulation VS
selling bonds reduces the amount of money (because gov gets the cash in
return) and restricts the ability of banks to lend
● Interest rates
○ High interest rates suppress demand for money because borrowing is more
expensive
○ Over a period of time, the money supply will then react to this reduced
demand for money by contracting
○ Key control over inflation

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○ Setting of interest rates may be done by the Central Bank (India, Singapore,
Japan, UK) or a gov minister
6.3 The problem of gov borrowing

● Cyclical deficit: a result of the downswing phase in the trade cycle, will decrease or
turn into a surplus in the upswing
● Structural deficit: long-term / permanent imbalance between expenditure and
taxation, not affected by the trade cycle
○ Implies continuous borrowing by gov & an increasing total/national debt
○ Pressures to increase spending long-term:
■ Ageing population - increased public spending on health care &
state pensions
■ Inflation in the prices of public sector goods/services which are
mainly labour intensive & thus tend to show the fastest rate of inflation
■ Spending commitments for public & merit goods (esp social welfare,
education, health), which are difficult to decrease in the face of voter
opposition
■ Tax changes as it’s always politically much easier to reduce taxes
than to raise them
● Financing budget deficits:
○ Who does the gov borrow from: might be non-bank private sector, e/g.
pension funds or individual households
○ The type of liability the gov issues: main distinction is between different
degrees of liquidity of those liabilities
■ Long-term gov securities (gilts in the UK) are the principal liabilities of
govs
● PSNB arising from the budget deficit is usually mainly financed by the sale of
long-term gov debt to the private (non-bank) sector of the econ
● Effects of above on the economy:
○ Some believe the effects are real & the deficit financed in this way will affect
real variables in the economy, raising output and employment via the effect of
the deficit on AD
○ Monetarists & new classical economists believe that effects are
monetary: the gov injects liquid assets into the economy, thus boosting the
money supply and causing inflation
■ May also push up interest rates, reducing private spending, which will
offset the gov expenditure (crowding out)
● Gov also has to pay interest on the national debt
● Policies designed to control the level of gov borrowing (e.g. austerity measures
in the UK, stability pact in the EU)
○ UK ‘golden rule’: over the economic cycle, the gov will borrow only to invest &
not to fund current spending, overall burden of public debt not above 40% of
GDP > 2008 recession forced the gov to effectively abandon this rule
● TEST12: supply-side economics: most likely to reduce unemployment - A increasing

labour retraining schemes

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7. Interest rate management

● Monetary policy changes interest rates since they are the price of credit, which
influences the decisions of consumers, investors, businesses
7.1 The effects of interest rate changes

Main effects of an increase in interest rates:
● Borrowing falls & saving rises
● Spending falls: consumers spend less because the cost of credit is high, e.g. if
incomes are fairly stable in the short term, higher interest payments on credit cards,
mortgages, etc. leave less income to spend
○ Lowers the demand for individual goods/services
○ And also lowers overall aggregate demand
● Gov borrowing becomes more expensive & gov expenditure falls
● Investment falls: interest rates rise reduces the net return to investment &
discourages business from undertaking new investment projects
● Asset values fall: the market value of financial assets (e.g. bonds) drops, because
of the inverse relationship between bond prices & the rate of interest > reduces many
ppl’s wealth > they may wanna save more, further reducing expenditure
● Consumer spending & investment falling > AD falls, curve shifts to the left > lower
inflationary pressures, but at the cost of reducing the level of econ activity & higher
unemployment
● External effects:
○ Foreign funds are attracted into the country: overseas fin businesses
deposit money in domestic banking institutions
○ The exchange rate rises, at least in the short term: inflow of foreign funds
raises demand for the currency > pushes up the exchange rate
■ In the longer term, high interest rates can stifle econ growth,
potentially making domestic firms less competitive globally > reduces
export demand > fall in exchange rates
● Overall, a rise in interest rates reduces inflationary pressures in the economy
7.2 The impact on businesses

● Costs: e.g. the cost of credit, stockholding are directly determined by the rate of
interest the business has to pay
● Investment decisions: the rate of interest is the cost of acquiring external
investment funds, or the opportunity cost of using internal funds > a change in
interest rates will therefore affect the profitability of investment projects
○ Cost of debt, tho at least the interest is tax-deductible
○ Opportunity cost: the return the business is giving up by not investing (when
interest rates rise, the return the business could’ve earned if they had
invested the money rather than used it, e.g. to finance an expansion)
○ Equity finance from outside investors, who will expect a comparable ROI: so
the cost of equity finance is not just an opportunity cost, it’s the return
outside investors expect to receive as well

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● Sales revenue: the volume of sales will decrease if interest rates rise
○ Deflationary pressure in the economy
○ And some sales are based on credit (e.g. consumer durable goods)
7.3 UK interest rate policy

● Monetary Policy Committee at the Bank of England (est 1997), 7 members (incl 5
external experts) decides the centra rate of interest in the UK
● Target rate of inflation is 2%
● Eurozone (EU): European Central Bank
● TEST13: if interest rates in Japan were cut, which of the following would NOT occur -
C decrease in the value of corporate bonds
● TEST14: increase in the money supply will cause - D interest rates fall, investment
spending rises, aggregate demand rises
7.4 Managing interest rate risk

● Financial managers face risk arising from changes in interest rates, i.e. lack of
certainty about the amounts or timings of cash payments and receipts
● Companies face the risk that interest rates might change between the decision to
borrow/invest & the actual date when they enter into the transaction
● U gotta manage and reduce these risks
● TEST15: borrow $10m in 3 months’ time, what’s the interest rate risk - D the risk to
profit, cash flow, or a company’s valuation from changes in interest rates
● Forward Rate Agreement (FRA): locks the company into a target interest rate,
hedges both adverse and favourable interest rate movements
○ Company enters into a normal loan, but independently organises a FRA with
a bank:
○ Interest is paid on the loan in the normal way
○ If the interest is greater than the agreed forward rate, the bank pays the
difference to the company
○ If the interest is less, the company pays the difference to the bank
● TEST16: FRA to borrow $5m in 6 months’ time at 5% > borrowing rate then is 6%: D
1% from the FRA bank to the company
● Interest Rate Guarantee (IRG): an option on an FRA
○ Company has a period of time during which it can buy an FRA at a set price
○ IRGs protect the company from adverse movements & allow it to take
advantage of favourable movements (so if the movement is favourable, just
allow the option to lapse)
○ More expensive than FRAs, obv
● If the company treasurer believes interest rates will rise, they’ll use an FRA as it’s
cheaper against the potential adverse movement
● If they’re unsure which way interest will move, they may be willing to use the more
expensive IRG to benefit from a potential fall
● Interest rate futures provide an offsetting contractual position to a move in interest
rates. The result of a future is to:

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○ Lock the company into an effective interest rate

○ Hedge both adverse & favourable i.r. Movements
● Futures fix the rate on loans and investments
● Borrowers may additionally buy options on futures contracts, so they can enter
into the future if needed, but let it laps if the market rates move in their favour
8. Taxation
8.1 Taxes can be used to

● Change markets: demerit goods may be heavily taxed to reduce consumption
levels; also petrol to deter consumption
● Influence the level of aggregate monetary demand: AD can be reduced by raising
taxation, and raised by reducing taxation
● Finance the provision of public and merit goods: paid from taxation revenue, free
for everyone
● Change the distribution of income and wealth: direct taxes, esp progressive direct
taxes, fall most heavily on upper groups, while indirect and regressive taxes in
general fall most heavily on lower income groups - changing the balance between
different taxes can thus alter income distribution
8.2 Types of taxation

● Classified by what is taxed:
○ Income = income tax, corporation tax, social security taxes (e.g. NI)
○ Expenditure = VAT, excise duties, customs duties
○ Capital = inheritance tax, capital gains tax
○ However, there are also taxes on
■ property ownership (council tax),
■ car use (motor vehicle licence duty),
■ payroll (employers’ social security) and
■ oil royalties (petroleum revenue tax).
● Who is levying the tax:
○ Central government: most taxes
○ Local government authorities
● Who is paying the tax:
○ Direct taxes: the person receiving the income pays the tax (e.g. income tax)
○ Indirect taxes: most taxes on expenditure, the purchaser who benefits from
the consumption is charged; but the actual tax revenue is remitted by the
seller to the authorities
● What percentage of income is paid in tax:
○ Progressive: a larger percentage of income is paid in tax as income rises
(e.g. income tax)
○ Regressive: a smaller percentage of income is paid in tax as income rises
(e.g. VAT)
○ Proportional: the same percentage of income is paid in tax at all income
levels

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○ So the average rate of tax rises/falls/is constant.

○ The marginal rate (percentage of extra $1 income paid in tax) also varies
between these different types: higher than the average rate with progressive
tax, lower with a regressive tax as income rises. The two rates are equal for a
proportional tax.
● TEST17: progressive tax on income - tax payment (D) rises at a faster rate than
income increases
○ B falls as income increases = regressive tax
○ C is a constant proportion of income = proportional tax
○ A rises as income increases = insufficient, since the tax payment could rise
with regressive and proportional taxes
● TEST18:
○ (a) direct or indirect tax:

■ (i) income tax - direct
■ (ii) corp tax - direct
■ (iii) VAT - indirect
■ (iv) excise duties - indirect
■ (v) social security taxes - direct
○ (b) true or false:
■ (i) between 200x and 200y, the burden of taxation in this economy
shifted from indirect towards direct taxation - FALSE
■ (ii) retailers cannot pass all of an indirect tax onto the customer -
TRUE (can pass all only if the demand for the good is perfectly price
inelastic)
■ (iii) most tax revenue is gained when indirect taxes are levied on
goods with high price elasticity of demand - FALSE (most revenue is
gained from taxing goods with very low price elasticity, since
consumers continue to buy them even when the price has risen)
■ (iv) indirect taxes are likely to be more regressive than direct taxes -
TRUE (indirect taxes are unrelated to income, so tend to be strongly
regressive)

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9. Achieving policy objectives

Policy options can be blended to achieve economic objectives as follows.
9.1 Engineering a recovery from a recession

● Cutting interest rates: as part of Keynesian demand management (cutting interest
rates should boost AD) or monetarism (to boost the money supply)
● Running a budget deficit: classic Keynesian, monetarists would argue that the way
the gov finances the increase will have a negative effect elsewhere (e.g. higher
taxation), thus reducing its effectiveness
9.2 Enabling long term growth

● Supply-side policies: to increase the total quantity of factors of production,
especially capital, as well as raise levels of productivity, e.g.:
○ Increase the availability and quantity of skilled labour:
■ Training schemes to increase skills
■ Childcare vouchers to encourage single parents to work
■ Using income tax and benefits system to encourage workers to
work harder & longer hours
○ Encourage research and development (e.g. gov sponsorship of uni
research)
○ Modernise the transport system to enhance the distribution networks of
firms
○ Provide smaller firms with assistance in the form of market info, advice on
exporting, management training, tech assistance, tax concessions
○ Deregulation of markets
● Other:
○ Regional development grants and tax incentives to boost investment
○ Protectionist measures to reduce imports (e.g. quotas)
○ Creating a stable econ to boost confidence (e.g. low inflation)
● Factors influencing econ growth:
○ Growth potential dependent on:
■ Amount of economic resources (the more factors of production
there are (land, labour, enterprise, capital), the greater the potential for
growth)
■ The productivity of these factors of production
○ Improvements in productivity increase output from a given stock of factors
of production & lower costs & improve the competitiveness of an economy
○ Capital:
■ The greater the capital/output ratio, the higher the productivity of
labour
■ The greater the levels of investment, the faster the growth in the
capital stock
■ The higher the quality of capital, the more advanced the tech
progress (update machinery, invest in research & development)

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○ Labor quality/quantity:
■ The size and gender/age composition of the population determine
the size of the workforce. Participation rate measures the proportion
of any age group which makes itself available for work
■ Education & training make the workforce more adaptable and
enterprising > improves mobility of labour & raises productivity
● Policies to promote econ growth
○ Econ growth helps raise the standards of living
○ Necessary condition: levels of aggregate monetary demand are kept
sufficiently high that existing productive capacity is fully used & firms
encouraged to expand by further investment
■ Govs can use fiscal & monetary policy to keep AMD close to its full
employment level
■ Tax rates can be cut and interest rates lowered to encourage
spending
○ Also seek to encourage aggregate supply in order to expand production -
supply-side policies
■ Increase the total quantity of factors of production, esp capital
■ Raise levels of productivity
■ Can be market driven (create a free market) or interventionist in
nature: reduce the role of gov in the economy
■ Seek to offer greater incentives in the economy
● Marginal rates of taxation can be cut for workers and firms
● This encourages workers to work harder & longer hours as
they will retain a greater amount of their earnings
● Also encourage previously inactive persons to enter the labour
market
● So the amount of labour & productivity goes up as income tax
rates are reduced, raising the econ growth
● Cuts in business tax would raise the level of retained profits,
providing more funds for firms to reinvest > raising the capital
stock in the economy
○ Market driven policies will seek to reduce the amount of controls, which could
involve regulations which include unnecessary restrictions on business
activity, e.g. licensing laws, or bureaucracy
○ Not all firms & entrepreneurs thrive in a free market, so supply-side policies r
often interventionist in order to promote further growth
○ In most developed economies, govs support the infrastructure to give firms a
stronger foundation from which to conduct their business:
■ Modernisation of the transport system
■ Education & training upgraded
■ Gov may sponsor research and development in unis
9.3 Unemployment
● May have a variety of causes, which may require different and incompatible solutions
● Cyclical / demand-deficient / persistent / Keynesian unemployment

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○ Caused by AD too small to create employment for everyone

○ Keynesian economists see it as a deflationary gap & seek to remove it by
boosting AD
○ Monetarists seek to reduce it by supply-side measures, as they would argue
that cyclical unemployment doesn’t rly exist
● Frictional unemployment
○ Short-term unemployment while moving from one job to another
○ Not rly a problem, but can be reduced by the provision of better info through
job centres & other supply-side policies
● Structural and technological unemployment
○ Caused by structural change in the economy, leading to a change in skills
required & the location of econ activity
○ Boosting AD (a demand-side policy) is likely to have little impact
○ Supply-side policies:
■ Gov funded retraining schemes
■ Tax breaks for redevelopment of old industrial sites
■ Grant aid to encourage relocation of industry
■ Business start-up advice and soft loans
■ Help with worker relocation costs
■ Improved info on available employment opportunities
● Seasonal unemployment
○ Seasonal demand for goods/services (e.g. fruit pickers)
○ This can create regional econ problems
● Real wage unemployment
○ In industries that are highly unionised
○ Keeping wages artificially high by the threat of strike action & closed shops,
the number of ppl employed in the industry is reduced
○ Monetarists would see this as a prime example of a market imperfection &
would address it by reducing union powers & abolishing min wage
agreements
● TEST19:
○ A new tech unemployment - structural
○ B recession - cyclical
○ C rise in min wage - real wage
○ D new job - frictional
○ E holiday resort - seasonal
● TEST20: Skilled workers left A to work in B cuz lower tax. Decrease in supply of
skilled labour in A is likely to lead to - C a higher E wage & lower quantity of labour
employed (labour supply curve shifts left, which results in the E moving)
9.4 Inflation
● Demand-pull inflation
○ Demand growing faster than supply, prices increase
○ Demand-side policies would focus on reducing AD through tax rises, cuts
in gov spending, higher interest rates
○ One type of d-p inflation is due to excessive growth in the money supply

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○ Monetarists argue it’s from an over expansion of the money supply >
increasing purchasing power, boosting demand
■ Expansion faster than expansion in supply
■ Solution: reduce the growth in the money supply through higher
interest rates
● Cost-push inflation
○ Underlying cost of factors of production increases, output prices increase as
firms seek to maintain their profit margins
○ Reasons for cost increases include rising factor prices, rising import prices,
increases in indirect taxes
○ E.g. where imports r significant, weakening of the currency increases the cost
of imports & leads to domestic inflation - reduced by policies to strengthen the
national currency
● Expectations effect
○ If anticipated levels of inflation are built into wage negotiations & pricing
decisions, then it’s likely that this will come true
○ It’s not the root cause of inflation, but it can contribute significantly to an
inflationary spiral
○ Managed by a ‘prices and income’ policy where manufacturers agree to limit
price rises in response to union agreements to limit wage claims
○ 1970s UK gov set ceiling prices for basic goods/services & wage increases
● TEST21:
○ Underlying causes of demand-pull inflation: principal cause is the AMD
exceeding the supply of goods/services at current prices. Could result
from increases in injections into the circular flow when the economy is
at or near full employment
○ In cost-push inflation, cost rises are exogenous = those that occur from the
outside of the econ system & are not the result of excessive AD, e.g.
increase in import prices or wage increases due to trade union pressure
rather than the demand for labour
○ Suggest 4 effects of inflation:
■ Reduce the international competitiveness of the trade sector
■ Shift wealth from the holders of fin assets to the holders of debt
■ Discourage savings
■ Distort consumer expenditure as consumers attempt to anticipate
price changes
○ List three important types of unemployment: seasonal, frictional, structural,
real wage, cyclical, voluntary
○ Specify three costs of unemployment:
■ Loss of output
■ Loss of tax income for the gov
■ Loss of income to the unemployed
■ Damage to the unemployed’s skills & health
● TEST22:

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● (a) id 2 years of recession & state whether in a recession: 2004, 2005, 2015, 2016
○ (i) gov borrowing increases or decreases: increases
○ (ii) the current account of the balance of payments moves towards deficit or
surplus: surplus
● (b) increase or decrease the level of gov borrowing (the PSNB) or have no effect:
○ (i) a rise in exports: no direct effect on the gov budget & borrowing
○ (ii) a fall in unemployment: lower borrowing, as expenditure on unemployment
pay fell and tax receipts rose
● (c) true or false
○ (i) current account deficit must be financed by a surplus on the capital and
financial accounts: TRUE
○ (ii) gov has a budget deficit, it must borrow from abroad: FALSE
○ (iii) national debt is the amount of money owed by the gov to other countries:
FALSE
○ (iv) gov budget acts as an automatic stabiliser in the trade cycle: TRUE
9.5 The Phillips Curve

● Unemployment and inflation are linked
● Phillips correlated changes in the UK money wages & the level of unemployment
● When unemployment was 2.5%, the rate of change in money wages would be
non-inflationary
● As wages accounted for 70% of production costs & it was assumed that cost-plus
pricing was adopted, it was concluded that prices & unemp. were correlated
● If econ is run at 2.5% level of unemployment, the general price level would be
established
● Thuse the Phillips curve = relationship between the level of unemp. and the rate of
inflation
● A stable relationship between inflation & unemployment:
○ The lower the rate of unemp, the higher the rate of infl & vice versa
○ A trade-off between employment and price stability

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○ Govs could not simultaneously achieve price stability & full employment

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Ch 5 - Macroeconomic and Institutional Context II:

The International Economy
1. Introduction
● Balance of payments - how should we manage our relationship and trade with other
countries?
2. International trade
2.1 The benefits of international trade

● Specialisation
● Economies of scale
● Competition
● Lower prices & greater choice for consumers
● Limitations:
○ Factor immobility
○ Transport costs, though they are falling
○ The size of the market (specialisation & the resultant possible economies of
scale are only justified if the production can be sold)
○ Government policies: barriers to trade for political, econ, social reasons
● TEST1: international trade exists cuz C opportunity costs vary from one country to
another
○ Opportunity cost = the value lost from using resources in one area instead
of another (so it’s better to buy international than make yourself & give up
those resources that could be used for another good/service)
● TEST2: NOT a benefit of free trade for a country - D more jobs created across all
industries in that country
2.2 Protectionism

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● Domestic producers want protection from imports to make higher profits at the
expense of consumers
● Justifications:
○ To protect employment: possible redundancies if an industry is replaced by
overseas products
○ To protect infant/sunrise industries from competition with fully developed
foreign competitors
○ To protect declining industries to buy time for structural readjustment
○ To prevent unfair competition, e.g. fake British goods sold in Britain - break
the copyright and patent laws
○ To protect the balance of payments: using import controls to remedy a
persistent balance of payments deficit
■ High marginal propensity to import: imports grow more than
proportionately as the domestic economy expands
○ To raise revenue: protective tariffs will raise revenue for the gov if such
duties are levied on goods with inelastic demand
○ To maintain security: essential products, such as defence equipment
● Arguments against:
○ Inefficiency is encouraged: essentially you’re removing possible competition,
so domestic firms may ‘settle’ blah di blah
○ Resources are misallocated: resources don’t move from protected declining
industries to expanding ones
○ Cost of living is raised: domestic consumers have to pay higher prices for
the taxed imported goods OR the protected domestic goods
○ Retaliation may occur: if one nation has protections in place, its trading
partners may take similar action, this will reduce the volume of world trade
(unilateral gov action is apparently bad for internationally accepted rules of
trading)
● Methods of protection:
○ Tariffs: tax on imports (cool for imports with an elastic demand if the objective
is to reduce the volume of imports; if it’s to raise revenue, then goods with
inelastic demand should be chosen)
■ Ad valorem: a given percentage of the import price
■ Specific: a set amount per item
○ Non-tariff barriers (NTBs):
■ Quotas: restrictions on the quantity of imports
● Voluntary Export Restraint Agreement (VERA)
■ Hidden restrictions: used to subtly undermine foreign competition
● Complicated forms
● Special testing regulation and safety certification
● Unusual product specification
● Public procurement (govs deliberately buy domestic goods)
● Specialisation of customs posts, etc.
■ Subsidies: encourage exports
● Outlawed by the WTO, so done in more subtle ways nowadays

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● E.g. sales tax on exports is refunded by the British Gov to the

producers, German gov gives subsidies on electricity to
domestic manufacturers
● International friction has increased because of the expansion of protectionism
○ Between countries of the EU over beef and livestock movements
○ Between govs and trading blocs
● TEST3: not an example of protectionism - B fixed exchange rate
● TEST4: not an argument in favour - B to reduce inflationary pressure // if anything, it
would lead to higher inflation:
○ Imported goods more expensive due to tariffs
○ Lack of competition > domestic goods more expensive
○ Increase in AD may result in inflationary pressure
3. Trade agreements
● World Trade Org (WTO) is opposed to trading blocs & customs unions (e.g. the EU)
because they encourage trade between members, but often have high trade barriers
for non-members
● Different types of agreements:
3.1 Bi-lateral and multi-lateral trade agreements

● Agreements between two or more countries to eliminate quotes and tariffs on
the trade of most (if not all) goods between them
● E.g. Closer Economic Relations (CER) Australia/NZ
3.2 Free trade areas

● Members of a multi-lateral free trade agreement all in the same geographical area
● E.g. North American Free Trade Agreement (NAFTA) Canada/US/Mexico, due to be
replaced by the USMCA,
● Association of Southeast Asian Nations (ASEAN) Free Trade Area (AFTA)
● South Korea/EU entered into 2015
3.3 Customs unions

● A free trade area with a common external tariff
● Members set up common external trade policies, but sometimes use different import
quotas
● E.g. Mercosur Brazil/Argentina/Uruguay/Paraguay/Venezuela/South Am

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● Countries may choose to move from a FTA to a CU to eliminate trade distortions of

FTAs where different member countries have different export rules to the same target
country
● To avoid local regulations, producers may sell to a partner in another member
country, which then sells to the target country > the need for rules to determine the
origin of goods
3.4 Single markets (economic communities)

● A customs union with
○ Common policies on product regulation,
○ Free movement of goods and services
○ Free movement of factors of production, notably capital and labour
● E.g. Economic Community of West African States (ECOWAS), the Comprehensive
and Progressive Agreement for Trans-Pacific Partnership (which USA abandoned
cuz Trump)
3.5 Economic unions

● A single market with a common currency
● E.g. Eurozone (EU member states that have adopted the Euro)
● Regional trading blocs:

○ Pro: encourage trade creation by harmonising policies & standards &
reducing prices
○ Con: trade diversion, member countries buy within when cheaper sources are
available outside & regional fortress mentality which can lead to conflicts
○ Could lead to development of protectionism worldwide at a time when the
WTO is seeking to create free trade
● TEST5: necessary characteristics of a single market: C (i) (ii) (iii)
○ (i) a multi-lateral trade agreement between nearby countries
○ (ii) a common external tariff
○ (iii) free movement of factors of production
○ BUT NOT: (iv) a single currency
4. The balance of payments
4.1 Balance of payments

● An account showing the financial transactions of one nation with the rest of
the world over a period of time
● Split into three parts:
○ Current account (goods and services)
○ Capital account (acquisition and disposal of fixed assets)
○ Financial account (e.g. cash flows)
● The accounts as a whole will always balance to zero
○ However, there may be deficits or surpluses on each of the 3 accounts

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4.2 The current account

● Two parts:
○ Visible trade (goods)
○ Invisible trade (services, investment income, transfers of money between
individuals and national bodies)
● Current account balance
○ Combines the visible & invisible trade
○ Surplus = good
○ Deficit means a decrease in spending power & net withdrawal from the
circular flow, which is deflationary
○ Balanced by combined capital & financial accounts
4.3 The capital and financial accounts

● Transactions in country’s external assets and liabilities
● Records capital and financial movements by firms, individuals, govs
● Also includes the balancing item:
○ Positive balancing item indicates unrecorded net exports
○ Negative balancing item indicates unrecorded net imports
○ Arises because of the errors and omissions which occur in the collection of
such detailed and numerous statistics based on enormous numbers of
international transactions
● Types of flow include:
○ Real foreign direct investment, e.g. UK firm establishing a manufacturing
facility in China
■ Direct investment: investment in an enterprise where owners or
shareholders have some element of control over the business
○ Portfolio investment: e.g. UK investor buying shares in an existing business
abroad (no control over the enterprise)
○ Financial derivatives: any financial instruments whose underlying value is
based on another asset (e.g. foreign currency, interest rates, commodities,
indices)
○ Reserve assets: foreign financial assets that are controlled by monetary
authorities (Central Banks), used to finance deficits and deal with imbalances
■ Include gold and foreign exchange held by Central Banks
4.4 Equilibrium and disequilibrium

● Balance of payments accounts always balance for technical reasons:
● Current account + capital account + financial account + balancing items = 0
● However, economists are concerned with the component parts - persistent
imbalances in certain sections, such as visible trade and the current account, indicate
fundamental disequilibrium
● E.g. countries with persistent deficits on their current accounts (USA, UK, Spain,
Italy, France); countries with persistent surpluses on their current accounts (China,
Japan, Germany)

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● Will induce govs to undertake policy action to create/restore equilibrium

● E.g. a persistent balance of payments current account deficit may be covered by
○ substantial capital inflows (achieved by higher interest rates for a short period
of time), or
○ by a decrease in official reserves (also can’t be undertaken indefinitely)
● This temporary expediency may have damaging consequences for the economy,
e.g. higher debt repayments, lower investment, higher exchange rate
● Remedial action to deal with a balance of payments may constrain policies which are
designed to achieve other econ objectives, such as econ growth via lower interest
rates
4.5 Causes for structural deficit/surplus in the balance of payments current account
● Deficit usually due to high demand for imports + a weak export performance
● Import penetration can arise from
○ Imports taking larger shares of static markets OR
○ Maintaining their shares of expanding markets.
○ Has increased for many reasons:
■ Growth in consumer spending is often largely supported by imports
■ More competitive than domestic substitutes
■ Domestic currencies may be overvalued
■ Foreign currencies may be undervalued (e.g. Chinese Yuan)
■ Domestic producers have lacked competitiveness in non-price factors,
e.g. design, reliability, delivery, pre- and after-sales service
● Export performance can arise from
○ The willingness and ability of domestic producers to supply abroad (e.g. a
growing home market & a lack of surplus capacity will inhibit exporting and
lead to concentration on home sales)
○ The price competitiveness of exports
○ Firms in some countries tend to have more surplus capacity, which can be
quickly utilised to raise output for domestic consumption when incomes rise
4.6 Policies
● Do nothing
○ A floating exchange rate is claimed to lead to automatic correction of a
balance of payments disequilibrium
○ E.g. imports exceed exports > balance of payments deficit
○ More sterling is being sold to buy imports than is being bought to purchase
exports
○ Excess of supply of sterling over demand will lead to a weakening of sterling
against other currencies
○ Makes imports into UK more expensive, exports cheaper
○ Import/export volumes should start to switch, gradually removing the deficit
● Deliberate depreciation/devaluation of the exchange rate
○ To induce expenditure-switching by consumers
■ Dearer imports lead to buying domestic goods instead

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■ Cheaper exports cause foreign customers to buy the exports

○ Dirty floating exchange rate system: intervention to change the exchange
rate through the central bank buying or selling currency onto markets
○ Will not immediately benefit a balance of payments in practice
■ Initial worsening of the current account because volumes are fixed &
prices adjust automatically. Eventually demand and supply become
more elastic & consumption and production patterns change, creating
an improvement in accounts
■ Following a depreciation, exporters maintain their foreign exchange
price (i.e. raise their prices measured in the domestic currency) rather
than lowering them, which raises their short-run profits at the expense
of long-term sales growth
● Deflation
○ Effective but generally undesirable
○ Domestic deflation to induce expenditure-reduction by consumers
○ Gov curbs demand at home (through tight fiscal or restrictive monetary policy)
○ The growth of import demand is weakened and domestic suppliers might
switch resources towards export markets
○ Additional gains can be to weaken trade union bargaining power through the
fear of unemployment & by restraining production costs to help reduce
inflation
○ Unfortunate costs for the economy:
■ Tightening of fiscal policy, either by tax increases or expenditure cuts,
and the restrictions on money supply > both reduce the demand for
goods
■ Less demand means less supply > more unemployment
■ In general, by depressing business optimism, lowering investment &
under-utilising resources > constrains the rate of economic growth
○ Often used in conjunction with depreciation of the currency
● Import controls
○ Cause expenditure switching
○ Quotas prevent the purchase of imports, tariffs raise import prices & possibly
lower outgoings (assuming elastic demand for imports)
○ Advantages likely only temporary, because the basic weakness of price
uncompetitiveness has not been changed
● Supply-side policies
○ Attempt to improve the efficiency of the supply base of the economy
○ By freeing up markets, increasing incentives, deregulating & removing the
dead hand of the state from economic activity > claimed that econ can be
revitalised & achieve noninflationary growth
○ Intention is to transform attitudes and behaviour so that British
competitiveness re-emerges
○ Sustained econ growth 1995-2007 in the UK, but little evidence that this has
brought about any permanent improvement in the balance of payments

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● TEST6: causes a country’s exports to fall - propensity to import in the country’s

trading partners
○ Fall in exchange rate or a fall in barriers to trade will likely lead to increases in
a country’s exports
○ A rise in imports will have no direct effect on its exports, but may indirectly
raise them, since it will have increased the level of incomes in trading
partners
● TEST7: floating exchange rate, which will lead to a fall in the exchange rate - C an
increase in the country’s imports
● TEST8: normally result from an increase in exchange rate - C (i) a fall in the country’s
rate of inflation (import prices fall, dampening domestic inflation)
● TEST9: floating exchange rate system advantage - B provides automatic correction
of balance of payments deficits
5. Globalisation
5.1 The nature of globalisation

● Globalisation = the growing economic interdependence of countries worldwide,
through increasing volume and variety of cross-border transactions in
goods/services, free international capital flows & more rapid widespread diffusion of
tech
● Internationalisation: increasing spread of econ activities across geographical
boundaries (e.g. selling to other countries online, production facilities overseas)
● Globalisation: a more complex form of internationalisation where much greater
integration is seen (e.g. erosion of trade barriers is creating a single global market,
homogenising of tastes across geographies, firms selling the same product
everywhere instead of tailoring, greater harmonisation of laws in different countries,
dilution of traditional cultures)
5.2 The factors driving globalisation

● Improved communications: advances in ICT (info and comms tech), internet and
mobile phones
● Political realignments: more trade agreements > single markets, the huge markets
of China (1979) and the old Soviet Union (1989) opened, both of which used to be
closed to Western firms
● Growth of global industries and firms: global firms put pressure on local cultures
to accept Western tastes and values, influence govs, encourage political links
between countries
● Cost differentials: manufacture cheaper in developing countries (cheap labour
costs)
● Trade liberalisation: WTO working towards the removal of trade barriers
● Liberalisation of international capital markets: liberalisation of capital controls >
greater freedom in international capital flows; specifically, developing countries have
much greater access to capital for funding growth

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5.3 The impacts of globalisation

● Industrial relocation/offshoring: manufacturing bases in countries w/ lower labour
costs / more favourable econ conditions
○ Moving product manufacturing, service centres or operations
○ Can also be to avoid import quotas and tariffs, to take advantage of regional
expertise
● Emergence of growth markets: previously closed markets & more homogeneous
tastes
● Access to markets and enhanced competition: increased competition DUE to new
access (less barriers, global expansions)
○ Greater pressure on firms’ cost bases with factories being relocated to even
cheaper areas
○ Greater calls for protectionism
● Cross-national business alliances and mergers: to obtain expertise & greater
economies of scale (in 2010 Kraft Foods US acquired Cadbury)
● Widening economic divisions between countries: creating new gaps between rich
and poor, digital divide, pressure to focus on exports rather than public services at
home so they can repay foreign debt
5.4 Impacts of ICT on international trade and patterns of development

● Accelerated globalisation and the number of global firms
● Easier to control long, geo diverse supply chains
● TEST10: Which would HINDER rather than drive globalisation? D Protectionism
6. Institutions encouraging free trade

6.1 WTO and the 1948 General Agreements on Tariffs and Trade (GATT)
● 1995 WTO based in Geneva replaced GATT
● WTO’s roles:
○ To ensure compliance of member countries with previous GATT agreements
○ To negotiate future trade liberalisation agreements
○ To resolve trading disputes between nations
● Much greater authority than GATT
○ Power to police and enforce trade agreements
● Opposed to development of trading blocs and customs unions such as the EU and
NAFTA
● WTO activities:
○ Reviewing members’ trade policies: regular reviews (EU, Japan, US,
Canada reviewed every 2 yrs, the next 16 countries every 4 yrs, then 6 yrs)
○ Anti-dumping rules: dumping = exporting at a price lower than what the firm
would charge on the home market; WTO doesn’t give a shit whether this is
unfair competition, just wants to dictate how govs can/can’t react to dumping
■ Disciplines anti-dumping actions

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6.2 The EU
● Single market & Eurozone economic union
● Treaty of Rome 1957
● Imports/exports, common external policy, free movement, common policies on
transport & agriculture, fair business practices, association of overseas countries to
increase trade and dev
● Challenges:
○ Managing the ongoing economic crisis
○ Enlargement/exit
○ Ongoing reform of the Common Agricultural Policy (CAP): a system of
agricultural subsidies (min price to producers & subsidy for crops planted)
○ Migration
6.3 The Group of Seven (G7)

● Canada, France, Germany, Italy, Japan, UK, US & Russia until 2014
● About 65% of the world econ
● It’s a forum for them to discuss shit, no formal resources or powers
● G7 summit:
○ Macroecon management
○ International trade
○ Energy issues & climate change
○ Dev issues and relationships w/dev countries
○ Issues of international concern, e.g. terrorism and organised crime
● G20 (1999): international forum for the govs and central bank governors from the 20
major econs
○ Argentina, Australia, Brazil, Canada, China, France, Germany, India,
Indonesia, Italy, Japan, South Korea, Mexico, Russia, Saudi Arabia, South
Africa, Turkey, UK, US, EU
● TEST11: main objective of the WTO is (B) to minimise barriers to international trade
● TEST12:
○ Why are exchange rates important? Facilitate pricing & this enables
international comparisons to be made.
○ What factors inhibit international trade? Transport costs, immobility of factors,
market size, protective policies.
○ Give three arguments for trade protection policies: to protect employment,
help infant industries, prevent unfair competition, help balance of payments,
protect dying industries while structural shift happens.
○ What is a VERA? Voluntary Export Restraint Agreement - restriction on the
quantity of exports.
○ What does the WTO attempt to do? Reduce tariff barriers and other protective
measures.
○ Why have some companies become multinational in structure? To reduce
costs and expand markets and sales.

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○ How can multinational companies benefit national economies? Direct foreign

investment can boost domestic capital fund, tech transfer, improvement in
production processes and org structures, employment gains.
● TEST13:
○ Invisible earning: a dividend from an overseas share
○ What do the capital and financial accounts show? Transactions in external
assets & liabilities.
○ What is ‘hot money’? Short-term capital movements of currencies by
international financiers/speculators.
○ What has caused Britain’s balance of payments current account deficit? Lack
of competitiveness in trade.
○ What is the difference between devaluation and depreciation of the ex rate?
Devaluation is when a fixed exchange rate is lowered, depreciation is when
a floating exchange rate moves downwards.
○ How could a fall in the exchange rate help an economy? Raises exports by
reducing their price, leading to increase employment and greater export
earnings (if demand is price elastic)
○ How can deflation help the balance of payments deficit? By suppressing
domestic demand for imports and releasing goods for export (if home sales
are stagnant).
● TEST14:
○ (a) following raise/lower the exchange rate for a currency or unaffected
■ (i) a rise in interest rates: raise
■ (ii) a rise in the rate of inflation: lower
■ (iii) a surplus on the current account balance: raise
■ (iv) gov budget deficit: no effect
■ (v) an increase in the export of capital: lower
○ (b) true or false - rise in exc rate:
■ (i) reduces the domestic rate of inflation T (cuz it reduces the domestic
price of imports)
■ (ii) reduces domestic unempl F (reduces exports)
■ (iii) worsens the terms of trade F (terms of trade = a measure of the
relative prices of imports and exports; a rising ex r raises export
prices and reduces import prices)
■ (iv) worsens the balance of trade T (export prices rise, total exports
fall, opposite for imports, thus worsening the trade balance)
■ (v) raise domestic living standards T (reduces import prices, raises
purchasing power)
7. External analysis of the macro environment

● Looks at the environment within which the org operates
● Environment factors: threats or opportunities & competition
7.1 PESTEL analysis

● Macro environment = factors that can’t be directly influenced by the org itself

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● Respond to rather than control

● PESTEL analyses:
○ Political influences and events: legislation, gov policies, changes to
competition policy or import duties, etc.
○ Economic influences: either international or domestic, e.g. changes in the
gross domestic product, changes in consumers’ income and expenditure,
population growth
○ Social influences: social, cultural, demographic factors, e.g. population
shifts, age profiles
■ Attitudes, values, beliefs held by ppl
■ Changes in lifestyle, education, health, etc.
○ Tech influences: changes in material supply, processing methods, new
production development
○ Ecological/environmental influences: impact the org has on its external
environment, e.g. pollution
○ Legal influences: changes in laws and regulations affecting, e.g.,
competition, patents, sale of goods, pollution, working regulations, industrial
standards
● TEST15: DM - largest and best-known food service retailing group PESTEL analysis
● TEST16: aging of Europe population - (B) Social influences

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Ch 6 - Financial Context of Business II:

International aspects
2. International money markets
2.1 International capital markets

● Eurocurrency: short-term capital, borrowed mainly for working capital
● Eurocredit: medium-term, borrowed for working capital & investment purposes
● Eurobonds: long-term, borrowed for investment purposes & financing mergers and
acquisitions
○ Issued by very large companies, banks, govs, and supranational institutions
(e.g. European Commission)
○ Typically 5 years and over
○ Denominated in a currency other than that of the borrower (often USD)
○ Bought & traded by investment institutions and banks
● Used by business borrowers & gov borrowers, and provides a market for lending
funds for businesses with surplus cash
● Dominated by Europe & USA, especially London
2.2 Foreign exchange markets

● Purchase and sale of foreign exchange for 4 reasons:
○ To finance international trade
○ Portfolio of currencies as part of the financial asset management function of
companies
○ Financial institutions dealing in foreign exchange on behalf of their
customers to benefit from changes in exchange rate
○ To manage risks associated with exchange rates movements
● London is the world’s largest foreign exchange centre ($2 trillion daily)
● Spot transactions: undertaken almost immediately & settled within 2 days
● Forward transactions: future delivery date from 3 months onwards
○ Banks and brokers operate in the forward market to mitigate the risk of
adverse exchange rate movements
○ Risk arises when prices of imports/exports are fixed in foreign currency terms
& there is movement in the exchange rate between when the price is agreed
& when the cash is paid or received
○ The forward price of currency is normally higher (at a premium) or lower (at
a discount) than the spot rate - reflect interest rate differentials between
currencies & expectations of depreciations and appreciations
● The price of currency (the exchange rate) is determined by the operation of currency
transactions undertaken in the foreign exchange markets (i.e. demand & supply
determine price)

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3. Foreign exchange risks

Firms dealing with more than 1 currency face:
● Economic risk: long-term movements in exchange rates can undermine a firm’s
competitive advantage (e.g. exports being more expensive if currency strengthens,
manage the risk by setting up production facilities in the target market)
● Transaction risk: exchange rate movement in the time between agreeing to the
order and payment, manage the risk by
○ Forward exchange contracts: purchase/sale of currencies at a fixed rate for
a specified period of time
○ Using derivatives, e.g.:
■ Futures: like a forward contract in that fixed exchange rate & it’s a
binding contract, but
● can be traded on futures exchanges
● Settlement takes place in three-monthly cycles (Mar, Jun, Sep,
or Dec), i.e. a company can buy or sell Sep futures, December
futures etc.
● Futures are standardised contracts for standardised amounts
(e.g. CME trades £62,500 multiples)
● They rarely cover the exact exposure (cuz of the above - fixed
amount and maturity date)
■ Currency options: similar to future contracts, but they give the right
but not the obligation to buy or sell currency, so u can either exercise
the option or let it lapse (if the spot rate is more favourable or you
don’t need the currency anymore)
● Translation risk: foreig assets denoted in another currency > their value in the home
currency depends on the exchange rate, but the risk is not realised unless the asset
is sold
○ The change in local value, however, could lead to a breach in a debt
covenant or a change in the viewpoint of the shareholders, which could then
affect the share price, and return on capital employed could decrease if asset
value increases, which can also affect the viewpoint of the investors
● TEST1: purpose of hedging - C to reduce or eliminate exposure to risk

● TEST2: forward exchange contract is:
○ 1 an immediately firm and binding contract YES
○ 2 for the purchase/sale of a specified quantity of a stated foreign currency
YES
○ 3 at the rate of exchange fixed at the time the contract is made YES
○ 4 for performance at a future agreed upon time YES
○ D all of the above
● TEST3: Eurozone company sells a product $1,200, exchange rate 1EUR = $1.2 >
1EUR = $1.25
○ 1200/1.2 = 1000EUR
○ 1200/1.25 = 960EUR

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○ B loss 40EUR
● TEST4: UK company raises a USD invoice. If the dollar strengthens against sterling
before the funds are received, this will lead to an exchange gain. TRUE (cuz the UK
company will be receiving dollars, which will be more valuable now)
● TEST5: US company struggling to compete against imports because of the strong
dollar. What type of risk? A economic risk
4. Exchange rate systems
4.1 Exchange rates

● Exchange rate of a currency is a price / external value of a currency expressed in
another currency
4.2 Exchange rate systems - floating exchange rates

● Fluctuate in the light of changes in demand and supply
● Examples of nearly perfect markets
● Demand
○ Exports
○ Overseas investors
○ Speculators - aka ppl who buy when they think the price will go up
○ Government / central bank - to manipulate the exchange rate
○ Demand for it to be held as an international medium of exchange: USD
● Supply
○ Imports (e.g. UK residents selling sterling to buy foreign currency to buy
imports)
○ Overseas investments in the other direction
○ Speculators if value is about to depreciate
○ Gov / central bank - sell currency on international markets to weaken the
currency to improve export performance
● Impact of factors on the exchange rate
○ High inflation will weaken a currency (it makes goods more expensive, lower
export demand, reducing the demand for the currency)
○ Increase in interest rates:
■ Short run: “hot money” attracted to UK for deposits, increasing
demand, rise in exchange rate
■ Long run: high interest rates erode competitiveness of UK businesses,
reducing supply of and demand of UK goods, reducing demand of
sterling, reducing the exchange rate
○ A trade deficit will result in the demand for £ to buy exports being lower than
the supply of sterling to buy imports > downward pressure on the exchange
rate
○ Speculation can influence it up or down, usually short-term
○ Demand/supply of a currency for trade purposes is a tiny fraction of all
demand/supply for a currency, so current account deficits/surpluses are
unlikely to have much effect on the exchange rate

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● TEST6: imports demand is price inelastic, sterling depreciates: C imports more

expensive in £, total spending by the UK on imports would rise
4.3 Exchange rate systems - dirty floating

● Govs often intervene in the foreign exchange markets to maintain or achieve an
exchange rate target
● Usually to make exports more competitive or to assist in the control of inflation
● Central bank will be instructed to:
○ Buy or sell the currency to raise or lower the exchange rate
○ Alter interest rates to encourage buying/selling of the currency (e.g. raising
interest rates encourages speculators to deposit more funds in the country,
rise in demand causes a rise in the exchange rate)
● Hot money
○ Deposits of money transferred from one currency to another at short notice
○ Factors influencing such transfers:
■ Relative interest rates (money flows to high interest rates)
■ Expectations (money flows to currency they expect to appreciate)
■ Inflation (countries w high rates will find their currency less attractive
to depositors because its value is depreciating more than that of other
countries)
● TEST7: floating exc rate, what would lead to depreciation - C an increase in the
country’s imports (raises supply, depressing the exchange rate)
● TEST8: would result in a rise in the value of £ against Euro - A a rise in interest rates
in the UK (attracts foreign money to invest, £ are demanded in exchange for the
foreign currencies in order to invest, so the price of £ rises)
● TEST9: does NOT lead to a rise in the exchange rate - D an increase in the export of
capital from the country (capital leaving the country would increase the supply of the
currency & reduce the exchange rate)
● TEST10: $1 = K10 > $1 = K12. Forward contract to sell 1bn K at $1 = K10, what’s the
profit?
○ Speculator will by 1bn K at the new exchange rate, which costs $0.083bn
○ These can then be used to deliver on the forward contract, sold at $1 = K10,
so $0.100bn

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○ Net profit = $0.100bn - $0.083bn = $0.017bn
4.4 Exchange rate systems - fixed

● Fixing the value of currency against the value of another currency or to another
measure of value, e.g. gold
● Can stabilise the value of the currency, making international trade easier
4.5 Currency substitution

● Allowing the use of a foreign currency in addition to the domestic currency
● Dollarisation: when the foreign currency used is USD
● E.g. when the domestic currency is subject to significant fluctuation, so using the
stable foreign currency stabilises the value of day to day transactions
5. Single currency zones

● To avoid exchange rate risk
● Economic and Monetary Union (EMU) within the EU
● The Euro
○ Launched 1/1/99 (national currencies retained until 2002)
○ Performance of the Euro against other major world currencies has been
patchy
● The European Central Bank (ECB)
○ May 1998 in Frankfurt
○ Issue currency, draft monetary policy, set interest rates in the Euro-zone
○ Principal duty of price stability > power to set short-term interest rates
○ Main focus of activities has been on interest rate policy, rather than exchange
rate policy
● TEST11: not a benefit of single currency for all countries - C lower interest rates
● TEST12: not a benefit of countries forming a monetary union - D it allows each
country to adopt an independent monetary policy

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Ch 7 - Financial Context of Business III:

Discounting and Investment Appraisal
1. Introduction
● Various techniques of investment appraisal
2. The investment decision-making process

● Origination of proposals: different alternatives introduced and discussed
● Project screening: the ‘sensible’ projects looked at with the company’s long-term
aims in mind
● Analysis and acceptance: investment appraisal techniques/financial analysis
undertaken, and qualitative issues discussed
● Monitor and review: monitor progress, compare to capital expenditure budgets,
review timing
● Focus on ANALYSIS in this chapter
3. The time value of money

● Money received today is worth more than the same sum received in the future, i.e. it
has a time value because:
○ Potential for earning interest / cost of finance
○ Impact of inflation: most years prices rise as a result of inflation, so funds
lose purchasing power over time
○ Effect of risk: the earlier cash flows are due to be received, the more certain
they are
● Discounted Cash Flow (DCF) techniques take account of this time value of money
when appraising investments
4. Interest
4.1 Simple interest

● Interest is paid only on the original principal, not on the interest accrued
● E.g. $200 invested for 3 years with annual simple interest rate of 5% = 200*5% = $10
* 3 = $30, so final sum is $230
● V(total) = P(primary sum) + r(fixed rate of interest per annum) * P * n(years)
● V = P(1+r*n)
● Can be applied to non-annual time periods as long as an interest rate is used to
match the timescales
● E.g. $2000 paying 0.1% per month for 2 years
○ P = 2,000
○ r = 0.001
○ n = 24

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○ V = P(1+r*n) = 2000 * (1 + 0.001 * 24) = 2000 * 1.024 = $2,048

● TEST1: $5,000 at 8% per annum, 5 years simple interest added once at the end of
the period
○ V = P(1+r*n) = 5,000 * (1 + 0.08*5) = 5,000 * 1.4 = 7,000
● TEST2:
○ A: $20k 5 years 5% annum > V = 20,000 * (1 + 0.05*5) = 25,000
○ B: $50k 3 years 6% annum > V = 50,000 * (1 + 0.06*3) = 59,000
○ C: $30k 6 years 1% quarter > V = 30,000 * (1 + 0.01*24) = 37,200
4.2 Compound interest

● Interest paid on both the original principal + any interest accrued
● $200, 3yrs, 5% compound interest
○ Yr 1: 5% * $200 = $10
○ Yr 2: 5% * $210 = $10.50
○ Yr 3: 5% * $220.50 = $11.025
○ Total sum = $231.525
● V = P*(1+r)n
● TEST3: $5000 8% annum, 5 years:
○ Interest compounded annually: V = 5000 * 1.085 = 7,346.64
○ Compounded every 6 months: V = 5000 * 1.0410 = 7,401.22
● TEST4:
○ $20k 5yrs 5% annum > V = 20,000 * 1.055 = 25,525.63
○ $50k 3yrs 6% annum > V = 50,000 * 1.063 = 59,550.80
○ $30k 6yrs 1% quarter > V = 30,000 * 1.0124 = 38,092.04
4.3 Equivalent rates of interest

● E.g. 8% annum paid every 6 months = 4% every 6 months
● Effective annual rate of interest: consider the impact of two 4% increases on an
initial value of $1:
○ Yr 1: $1*1.04*1.04 = $1.0816
○ The effective annual rate of interest is %8.16
● Annual Percentage Rate (APR) or Annual Equivalent Rate (AER)
● APR = (1+r)^n
● TEST5: $20k 10yrs:
○ A: 1.5% compounded every 3 months > n = 10*4 = 40, r = 0.015 > V =
20,000 (1+0.015)^40 = 36,280.37
○ B: 3.2% compounded every 6 months > n = 10*2 = 20, r = 0.032 > V = 20,000
(1.032)^20 = 37,551.21
○ B is better
● TEST6: find the APR
○ 3% every 6 months > 1.03^2 = 1.069, so annual rate 6.09%
○ 2% per quarter > 1.02^4 = 1.0824 = 8.24%
○ 1% per month > 1.01^12 = 1.1268 = 12.68%
● TEST7: $1,000 cost of bond, 5yrs increases to $1,250
○ APR =

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○ V = P(1+r)^n
○ 1,250 = 1000 * (1+r)^5 .. /1,000
○ 1.25 = (1+r)^5 … ^1/5
○ 1.25^⅕ = 1+r = 1.0456
○ r = 4.56%
● TEST8: house prices rise by 20% per annum
○ Equivalent percentage rise per month
■ APR = (1+r)^n
■ 1.2 = (1+r)^12 … ^1/12
■ 1.2^1/12 = 1.0153
■ 1.53%
○ Percentage rise over 9 months
■ APR = 1*(1+r)^n
■ 1.2^9/12 = 1.1465
■ 14.65%
5. Investment appraisal
5.1 Introduction
● Looking at forecast cash flows many years into the future
● E.g. invest $10k now for a $11k return
○ When do you get the $11k? What else could you do with the $10k now?
○ If you receive the $11k in 2 years (t2) & you could instead invest $10k in a
deposit account at 6% interest per annum > 10k & 1.06^2 = $11,236
○ So $10k now (t0) is worth more than $11k in two years (t2) > time value!
5.2 The time value of money

● Three reasons:
○ Potential for earning interest / cost of finance
○ Impact of inflation
○ Effect of risk
● The time value of money can be expressed as an annual interest rate for
calculation purposes, i.e.:
○ Discount rate
○ Required return
○ Cost of capital
● E.g. cost of capital 10% per annum
○ Deposit rate at a bank $100 & 1.1 = $110 in a year’s time
○ $100 now & $110 in a year’s time have the same value to us for decision
making purposes
○ I.e. the offer of $110 in a year’s time is only worth $110/1.1 = $100 in today’s
terms (or 90.9% of its actual value)

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5.3 Discounted cash flows

● Cash flows must be converted to a common point in time, usually the present day,
i.e. the cash flows are discounted
● Effectively the opposite of compounding interest

● E.g. (A) $200 payable in 2 years’ time, investment rate of 7%/annum, compounded
annually is available & (B) $350 in 3 years’ time at 6%
○ V = P(1+r)^n
○ (A): $200 = P(1+0.07)^2
■ P = $200/1.1449 = $174.69 - this is the present value of $200 with an
interest rate of 7%
○ (B): $350 = P(1+0.06)^3
■ P = $350/1.191016 = $293.87 - present value
● PV = present value is the cash equivalent now of money receivable/payable at
some future date
● P = V / (1+r)^n = V * (1+r)^(-n) = V*DF
● (1+r)^(-n) is the discount factor (DF)
● E.g. r = 10% n = 5
○ Formula: DF = 1.1^(-5) = 0.621
○ Or tables (give in examination): find the DF from the PV table by locating the
DF at 10% column & the 5-year row
● TEST9: calculate PV
○ $12k 6yrs 9%: DF = 1.09^-6 = 0.596, PV = 12,000*0.596 = $7,152
○ $90k 8yrs 14%: DF = 1.14^-8 = 0.351 PV = 90,000*0.351 = $31,590
○ $80k 5yrs 6.3%: DF = 1.063^-5 = 0.737 PV = 80,000*0.737 = $58,960
○ $50k 4y3m 10%: DF = 1.1^-4.25 = 0.667 PV = 50,000*0.667 = $33,350
6. Net present value (NPV)

● NPV is the total of the individual present values, after discounting each
● NPV represents the net gain/loss on the project, after taking into account the timing
of cash flows & the time value of money
○ NPV positive - the project is financially viable
○ NPV = 0 - the project breaks even
○ NPV negative - the project is not financially viable
● Choose the project with the highest NPV
● NPV gives the impact of the project on shareholder wealth

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● E.g. $10k machine purchase, contribute $2.5k per annum for 5 years, then scrapped
for $500 - interest rate for the period assumed 5%
○ NPV of the machine?
● TEST10: cost of capital 6%
Discount factor (6%) Present Value ($)

1.000 -25,000
1.06^-1 = 0.943 5,658
0.890 8,900
0.840 6,720
0.792 5,544
--------------------
1,822
● TEST11: evaluate NPV of the potential purchases below
Year Cashflow Discount factor PV NPV
0 (35) / (55) 1/1 (35k) / (55k)
1 (10) / 0 0.943 / 0.926 (9,430) / 0
2 20 / 15 0.890 / 0.857 17,899 / 12,855
3 30 / 25 0.840 / 0.794 25,200 / 19,850
4 40 / 35 0.792 / 0.735 31,680 / 25,725 30,349 / 3,430

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6.1 Using NPV in practice

● Estimation of the interest rates / cost of capital used - especially future
● Estimation of annual cash flows - again, the further into future u go, the more
difficult it is & u can’t take into account the attachment of probabilities to different
estimates
● Assuming all cash flows occur at the end of the year, which is how this usually
works with this method, but obviously that might not be true
● Some of the issues above can be lessened, since COMPUTERS - a whole range of
NPVs (worst-case, best-case, expected scenarios)
● TEST12: cost of capital 8%, PV $450k, excluding the initial investment > C $450k is
the max amount the company should invest today into the project, for it to be
worthwhile
7. Annuities
● A person receives a series of constant annual amounts
● Can be until death of the recipient or for a guaranteed min term of years (irrespective
of whether the annuitant is alive or not)
● Can also be deferred until sometime in the future
● Comparing annuities:
○ Can cover different time periods, so their net present values become relevant
● Annuity factor = (1-(1+r)^-n)/r
○ NPV of a $1 annuity over n years at interest year r, with first payment 1yr after
purchase
● Present Value of an annuity cash flow
○ PV = future cash flow * annuity factor
● Cumulative PV tables can also be used to determine the annuity factor
● E.g. purchase of a machine for $10k, contributes $2.5k per annum for 5 years, then
scrapped for $500, interest rate 5%
○ W = (1-1.05^-5)/0.05 = 4.329
● Aside from the NPVs, also consider other factors: e.g. some people may prefer more
income up front, during their lifetime, assuming payments after the investor’s death
would go to their estate

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● TEST13: $3,600/year for 7yrs, 8%

○ PV = future cash flow & annuity factor
○ AF = (1-(1+r)^-n)/r = (1-1.08^-7)/0.08 = 5.206
○ PV = 3,600 * 5.20637005922 = $18,743
● TEST14: $11,400 13yrs 5%
○ AF = (1-1.05^-13)/0.05 = 9.394
○ PV = 11,400 * 9.394 = $107,091.6
● TEST15: $12k until death 6%
○ 10 years: PV = 12,000 * (1-1.06^-10)/0.06 = 88,321
○ 20 years: PV = 12,000 * (1-1.06^-20)/0.06 = 137,639
● TEST16:
○ A: $2,000 5 yrs 10%
■ PV = 2,000 * AF = $7,582
○ B: $1,000 1yr, $1,500 2yr, keeps growing by $500/yr until the final payment of
$3,000 at the end of the fifth year // PV = $7,220.50
○ C: $4,000 1, $3,000 2, $2,000 3 // PV = $7,616
Yr PV factor B inflow PV C inflow PV
1 1.1^-1 = 0.909 1,000 909 4,000 3,636
2 0.826 1,500 1,239 3,000 2,478
3 0.751 2,000 1,502 2,000 1,502
4 0.683 2,500 1,707.5 0 0
5 0.621 3,000 1,863 0 0
○ 10% interest for the next 5 years, AF = (1-1.1^-5)/0.1 = 3.79078676940 =

3.791
○ Which one to choose? C
● TEST17: $15k r = 11%
PV factor
0.901
0.812
0.731
0.659
0.593
0.535
○ And then you just calculate the present values & subtract the initial outlay
○ PVs:
■ A = 14.590
■ B = 7 * (1-1.11^-6)/0.06 = 7,000 & 4.231 = 29.617 - 14 = 15.617
■ C = 16.096

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○ C costs the least initially & has the highest NPV, so go for that
8. Perpetuities
● Same as annuity, except the payments go on forever
● Constant payments tend to have ever-decreasing value due to inflation
● PV = future cash flow * perpetuity factor
● PF = 1/r
● TEST18: $12k/annum r = 6% lives forever
○ PV = 12,000 * 1/0.06 = $200,000
8.1 Advanced annuities and perpetuities

● The cash flows start immediately (in year 0)
● Advanced annuity
○ E.g. $600 5yrs 10%
■ PV = T0 + T1-4 = 600 + (600*3.17) = $2,502
■ PV = 600 * (1 + 3.170) = 600 * 4.17 = $2,502
○ So either you add the T0 payment separately, or you add 1 to the Annuity
Factor (DF for year 0 is 1)
○ PV = V * (1+AF)
● Advanced perpetuity
○ E.g. $2,000 9%
■ PV = 2000 + (2000 * 9% PF) = $24,222
■ PV = 2,000 * (1+ 1/0.09) = 2,000 * 12,11 = $24,222
■ Again, add 1 to the Perpetuity Factor
■ PV = V * (1+PF)
8.2 Delayed annuities and perpetuities

● Cash flows are delayed and start later than T1
● Delayed annuity
○ $200 4 years, starting in 3 years’ time, 5%
○ So the cash flow starts in T3 until T6
○ We can first discount the cash flows to T2 & then discount for a further
2 years to get to T0
○ As it’s a single figure once you get to T2, use the Discount Factor (rather than
the annuity factor)
○ PV = 200 * (4 year annuity factor at 5%) 3.546 * (2 year discount factor at
5%) 0.907 = $643
○ PV = V * AF * DF
● Delayed perpetuity
○ $300 commence in T2 6%
○ Perpetuity Factor = 1/r = 1/0.06
○ Discount Factor = 1.06^-1 = 0.943
○ PV = $300 * 1/0.06 * 0.943 = $4,715
○ PV = V * PF * DF
● TEST19: $3,600 8% annuity

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○ (a) 7 payments, starting immediately: PV = 3,600 * (1 + (1-1.08^-6)/0.08) =

3,600 * 5.623 = $20,243
○ (b) 7 payments first in T5: PV = V * 7 year AF * 4 year DF = 3,600 *
(1-1.08^-7)/0.08 * 1.08^-4 = 3,600 * 5.206 * 0.735 = $13,775.08
○ (c) perpetuity starting T0: PV = V * 1+PF = 3,600 * (1+1/0.08) = 3,600 * 13.5 =
$48,600
○ (d) perpetuity starting T3: PV = V * PF * 2 year DF = 3,600 * 1/0.08 * 1.08^-2
= 3,600 * 12.5 * 0.857 = $38,565
9. Internal rate of return

● For most projects the NPV falls as the discount rate increases
● IRR: the discount rate at which the NPV is zero
● Two ways of appraising an investment:
○ NPV > 0 means the project will increase shareholder wealth
○ Actual discount rate < project IRR (which means we should have a positive
NPV)
9.1 Calculating IRR

● Trial & error method:
○ Find a discount rate at which the NPV is small and positive
○ Find another larger discount rate at which the NPV is small and negative
○ Use linear interpolation between the two to find the point at which the NPV
=0
● E.g. find the IRR for this project:
○ Randomly select 5% & see - gives a positive NPV

○ Then go for 10% hoping we’ll get a negative NPV
PV (5%) PV (10%)
(80) (80)
38.095 36.364
27.211 24.793
17.277 15.026
4.114 3.415
NPV: 6.697 (0.402)
● Graphical method:

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● Calculation method, using proportions:

○ NPV drops from 6.697 to -0.402
○ Drop of 7.099 when the discount rate increases by 5 percentage points
○ NPV will therefore drop by 1 when the discount rate increases by 5/7.099 =
0.7043 percentage points
○ NPV will reach zero if, starting at its 5% level, it drops by 6.697
○ So an increase of 6.697 * 0.7043 = 4.7 percentage points in the discount rate
○ So IRR = 5 + 4.7 = 9.7%
● Calculation method, using formula:
○ IRR = R1 + (R2-R1) * (NPV1)/(NPV1-NPV2)
○ This works whether or not one of the NPVs is positive and one negative, so
you can just work with two guesses regardless of their results
○ If either of the NPVs IS negative, then be careful:
■ R1 = 0.05 NPV1 = 6.697
■ R2 = 0.10 NPV2 = -0.402
■ IRR = 0.05 + (0.1 - 0.05) * 6.697/(6.697 + 0.402)
■ IRR = 9.7% as before
● TEST20: estimate IRR both with the graphical & calculation methods for the following
project:
PV (5%) PV (10%)
(100) (100)
47.619 45.455
45.351 41.322
17.277 15.026
NPV = 10.247 1.803
○ NPV drops by 10.247 - 1.803 = 8.444 when R increases by 5

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○ NPV will drop by 1 when discount rate increases by 5/8.444 = 0.59214

percentage points
○ For IRR, NPV must drop by 10.247, which requires an increase in the
discount rate of 10.247 * 0.59214 = 6.0677 percentage points
○ IRR = 5 + 6.07 = 11.07%
IRR = R1 + (R2-R1) * NPV1/(NPV1-NPV2)
IRR = 0.05 + (0.1 - 0.05) * 10.247 / (10.247 - 1.803) = 0.05 + 0.05 * 10.247 / 8.444 = 0.05 +
0.05 * 1.214 = 0.05 + 0.0607 = 0.1107 = 11.07%
10. Terminal values and sinking funds

● Terminal value is when you compound all the cash flows to the end & then add
them up
● E.g. $3k investment T0 & $1.8k T1, T2, T3 & $600 T4, 6.5% annual, find value at end
of year 5
○ T0 = 3,000 * 1.065^5 = $4,110.26
○ T1-3 = 1,800 * (1.065^4 + 1.065^3 + 1.065^2) = $6,531.55
○ T4 = 600 * 1.065 = $639
○ Terminal Value = $4,100.26 + $6,531.55 + $639 = $11,280.81
● Sinking fund is an investment in which a constant amount is invested each
year, usually aiming to reach a specified value at a given point in future
● E.g. replace a machine costing $50k in 6 years’ time. To achieve this, make 6 annual
investments starting immediately at 5.5%. Find the value of the annual payment.
○ T0-T5 = 6 investments
○ T6 = 50k
○ So, first investment FV = P*(1.055)^6
○ 2nd = P(1.055)^5 etc. 6th = P*(1.055)^1
○ 50k = P(1.055)^6 + P(1.055)^5 … + P(1.055)
○ 50k = P(1.055^6 + 1.055^5 + … + 1.055)
○ 50k = P * 7.267
○ P = 50,000/7.267 = $6,800 per annum
● TEST21: three annual instalments of $500 starting immediately at 4.9%
○ Value of the investment immediately after the third instalment?
○ T0 = $500 // FV = 500 * 1.049^2
○ T1 = $500 // FV = 500 * 1.049^1
○ T2 = $500 // FV = 500
○ FV = 500 * (1.049^2 + 1.049 + 1) = 500 * 3.149 = $1,575

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Ch 8 - Informational Context of Business I:

Summarising and Analysing Data
1. Introduction
● How can raw data be collated into more meaningful formats
2. Data and information

● Data becomes information after it has been sorted and analysed
● Data = facts which have been recorded, but not yet processed into a form suitable for
making decisions
● Information = data which has been processed & has meaning to the person who
receives it
● TEST1: What’s the difference between data & info? C info results from sorting and
analysing data
3. Characteristics of good information

● ACCURATE
● Accurate: degree of accuracy depends on why the info is needed
● Complete: all the info they need, but not excessive
● Cost effective: value of info should exceed the cost of producing it
● Understandable: limit jargon & technical language
● Relevant: relevant to its purpose & presented to the right person
● Authoritative: from a reliable source
● Timely: in time to make decisions based on the info
● Easy to use: accessible via appropriate channels of communication
● TEST2: NOT a char of good info for a product price list - C prices rounded to the
nearest $100
4. Bar charts
● Distances against the vertical axis are measurements & represent numerical data
● Horizontal distances have no meaning / there is no horizontal axis or scale, just
labels
● Useful for making comparisons between different data items/sets
● Multiple bar chart (one next to the other, e.g. comparing two companies revenue in
the same countries)
● Compound (component/stacked) bar chart (literally stack em)
● TEST5: A
● TEST6: A multiple
● TEST7: B

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5. Scatter diagrams
● A visual way of determining if there might be a relationship between two
variables
● Correlated: if they are related to one another / if changes in the value of one tend to
accompany changes in the other
● Y = dependent variable
● X = independent variable
● E.g. how does advertising affect sales > sales = y, advertising = x
● Examples:
○ costs probably have a strong positive correlation with the number of units
produced
○ number of deaths on the roads probably has a middling positive correlation
with traffic levels
○ street crime is often thought to relate to visible policing, so the correlation
would be negative but probably not strong
○ strong negative correlation: almost any measure of bodily function, e.g.
condition of the heart with age in adults
6. Histograms and ogives

● Diagrammatic representations of frequency and cumulative frequency distributions

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6.1 Histograms
● In bar charts, frequency is represented by the height of a block
● In histograms, frequency is represented by the area of a block or rectangle
● A diagram consisting of rectangles whose area is proportional to the frequency
of a variable & whose width is equal to the class interval
● X: variable being measured
● Y: corresponding frequency
● Frequency distribution: obtained by tallying the number of values in a certain
range/class
● Classes r somewhat arbitrary, but should be neither too narrow (where most
frequencies would be zero) nor too wide (would produce only a small number of
classes & tell us little) - between 4 & 12 groups are often used
6.2 Ogives
● A graph of cumulative frequency distributions
● Cumulative frequencies: the number of data values up to (or up to and including) a
certain point
● Can be compiled as running totals from the corresponding frequency distribution

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● TEST10:
○ A: 155
○ B: 50
○ C: 30
● TEST11: K = 10, L = 15, P = 7, M = 20, Q = 23, N = 25, R = 36, O = 30, S = 40
● TEST12: 23/40 = 57.5% C

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Ch 9 - Macroeconomic and Institutional Context III:

Index Numbers
1. Introduction
● Index numbers measure how a group of related commercial quantities vary,
usually over time
● E.g. Stock Exchange indices like the Financial Times 100 shares index (FTSE 100)
fo the 100 largest companies listed on the UK Stock Exchange
● Most well-known index numbers are averages & relate the quantities to a fixed point
or base period
2. Definitions
● Index number: a series of values relating to different times, expressed as a
percentage of the value for a particular time
● Index number = (value in any given year) / (value in base year) * 100
● Usually years, but sometimes monthly data, so u could say ‘time point’ instead of
year
● The index number for the base year is always 100
3. Interpretation of index numbers

● E.g. 113 means a 13% increase since the base year
● It’s not possible to derive the percentage increase from one year (NOT the base
year) to the next by subtracting index numbers
● Instead: 2014 = 150, 2015 = 161
○ Percentage increase from 2014 - 2015 is 161/150*100 = 107.3, so 7.3%
increase
● (year B index number) / (year A index number) * 100 - 100 = percentage
increase from one year to the next
● Index number less than 100 means a decline (94-100 = -6)
● Two ways to interpret index numbers:
○ Subtracting 100 gives the percentage increase since the base year

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○ Dividing by 100 gives the ratio of current values to base-year values (this
one is better to use for big index numbers, e.g. 6,000 means 5,900%, but 60*
what the share prices were in the base year is much clearer)
● TEST1:
○ A(i) base 2009 index: 100 125 150 158 133 125 142
○ A(ii) base 2012 index: 63 79 95 100 84 79 89
○ (B) 2013: 133 = 33% increase from 2009, 84 = 16% decrease compared to
2012
○ (C) Percentage increase from 2014 to 2015: 142/125 * 100 = 113.6 = 13.6%
○ (D) index number 2,500 with 2007 = 100; 25 * as high as in 2007
● TEST2: answer = A 95
4. Choice of base year

● A base becomes less meaningful as time passes & it’s eventually necessary to shift
to a new base = rebasing
● Suitable base:
○ Fairly typical year
○ Sufficiently recent for comparisons with it to be meaningful
5. Change of base year

● Return to the orig data & recalculate the index numbers with the new base year
● If only the index numbers are available, they can be indexed as if they were the
original data
○ Rounding errors may build up, but not always
● TEST3:
2012 = 100 129/140.3=91.9 100 105.8 110.5 116.3
2015: 163.2 = 63.2% increase from 2005
116.3 = 16.3% increase from 2012
● TEST4: which of the following statements about the base year is/are correct? A the
base year has to be changed from time to time
6. Combining series of index numbers

● Splicing the series: combining two series into a single one

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● A change of base or a small change of composition

● There will be a year with two different index numbers, and the change of base will be
shown in the series
● TEST5:
Price index
(2012 = 100)
141/163 = 87
91
95
100
106
110
116
7. Relative price indices

● Subscripts: 0 - base year, 1 - current year
● Value = the total expenditure on the item, and other sorts of weights are denoted by
w
● Price index = 100 * (P1/P0)
● Price relative = P1/P0 & leave the multiplication by 100 to the end of the calc
● Relative price index = sum(w*(P1/P0))/sum(w) * 100
Relative price index = sum (weight*relative price) / sum(weight) * 100
○ the weights could be base-year quantities (Q0) or values (P0*Q0) =

base-weighted, or
○ current-year quantities (Q1) or values (P1*Q1) = current-weighted, or
○ they could be decided on some other basis, such as the weighting of exam
marks
● ILLUSTRATION5:

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Relative Q0 Rel * Q0 V0 (P0*Q0) Rel * V0

price (P1/P0) (Quantity (total value of
in 1995) all sales)
A 1.157 65 75.21 57.85 66.93
B 1.182 23 27.19 32.89 38.88
C 1.155 37 42.74 47.73 55.13
D 1.816 153 277.85 74.97 136.15
TOTAL These are 278 422.99 213.44 297.09

increases from
1995-2015, e.g.
A increased by
15.7%
(a) sum(Rel*Q0)/sum(Q0) * 100 = 422.99 / 278 * 100 = 152.2 - prices have risen on
average by 52%
(b) sum(Rel*V0)/sum(V0) * 100 = 297.09 / 213.44 * 100 = 139.2 - prices have risen on
average by 39%
Why the difference? Because D’s price rise is 82%, so the size of the index will be heavily
influenced by the weight given to D:
(a) 153 is bigger than all the other quantities put together, so D gets more than half of
the total weight & the index strongly reflects the high price rise of D
(b) D’s value is only about ⅓ of the total because its price is low, so the price index is
smaller

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● TEST6: calculate the current-weighted relative price index with weights (a) Q & (b) V
Relative Q1 Rel * Q1 V1 (P1*Q1) Rel * V1
price (P1/P0) (Quantity (total value of
in 2015) all sales)
A 1.157 69 79.83 71.07 82.23
B 1.182 28 33.12 47.32 55.98
C 1.155 42 48.51 62.58 72.28
D 1.816 157 285.11 139.73 253.75
TOTAL These are 296 446.57 320.7 464.24

increases from
1995-2015, e.g.
A increased by
15.7%
(a) Quantity weighted: 446.57/296 * 100 = 150.9

(b) Values weighted: 464.24/320.7 * 100 = 144.8
8. Choice of base weighting or current weighting

● Current-weighted indices remain up to date, reflect shifts away from goods subject to
high price rises & don‘t exaggerate inflation like base-weighted indices
● However, current-weighted indices are more costly and time-consuming to calculate
● Base weights remain stable for the lifetime of the index & allow for easier comparison
between years
● Always compare like to like (e.g. the retail price index (RPI) is current-value-weighted
so if you’re comparing against it, you should also do the same weighting)
9. Quantity indices
● Price is the most important and frequently encountered, but sometimes QUANTITY
INDICES instead of price indices

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● They show how the amount of certain goods/commodities vary over time or
location
● Important when considering changes in sales figures, volumes of trade, etc.
● For price indices, quantity is the best weighting factor
● For quantity indices, price is the best weighting factor
● Relative quantity index = sum(weight * (Q1/Q0)) / sum(weight) * 100
● Aggregate quantity index = sum(w*Q1) / sum(w*Q0) * 100
● The weights could be prices, values, or sth else

● TEST7:
○ Index of the Q sold in 2015 with 2014 as a base, using weights given &
relatives method
Q1/Q0 W * Q1/Q0 Weights
A 1.429 121.465 85
B 1.25 85 68
C 1 45 45
Total 251.465 198

Relative quantity index = 251.465 / 198 * 100 = 127
● TEST8: the relative sizes of current-weighted and base-weighted price indices are C
base-weighted bigger than current-weighted, because bw index numbers don’t
reflect the fact that customers buy less of items that are subject to high price
rises
● TEST9: advantage of base-weighting B the index is easy to calculate
10. Inflation
● One of the most common areas indices are used is in measuring and dealing with
inflation

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10.1 Terminology
● When describing cash flows, important to clarify whether inflation is included in the
figures
● Money cash flows: include predicted inflation & other price rises
● Real cash flows: general inflation taken out (e.g. a 3% pay rise & a 3% inflation
means no actual difference in real terms)
● Some payments are index linked, meaning they automatically increase in line with
inflation (or at least the specific index used to measure inflation)
10.2 Measuring UK inflation

● Before 2003, RPI (retail prices index) was UK’s main indicator of inflation
● Since then, gov has focused policy on the Consumer Prices Index (CPI)
● CPI measures average change from month to month in the prices of consumer goods
and services (same as RPI)
● Differs from RPI in the particular households it represents, the range of goods &
services included, and the way the index is constructed (i.e. different shopping
basket)
● Both are fixed quantity price indices (only the prices of goods affect the index from
month to month)
● Contents of the baskets of goods & services, and their associated weights are
updated annually (e.g. in the recent years amended to include coffee pods, protein
powder, etc. & exclude CDs, sat navs, etc.)
10.3 Adjusting for inflation

● E.g. a company may wish to adjust its revenue figures to reveal the real change in
sales, or employees to reveal real salary increases
● TEST10:
○ 1 Jan 2019 CPI = 340
■ Index-linked pension is $3,200/annum
■ Index-linked savings bond $360
○ 1 Jan 2020 CPI = 360
■ Relative rise = 360/340 = 1.0588 = 5.88%

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■ Pension = 3,200 * 1.0588 = 3,388.16

■ Savings bond = 360 * 1.0588 = 381.17
● TEST11: compile average earnings from 2008-2011
Sooo getting all wages back to 1994 base. Average prices in 2008 are 2.011 times
higher than Jan 1994. So the purchasing power of $1 will have decreased by this
factor in the time.
2008 = 83.50/2.011 = 41.52 (this is the same as TEST12 … 83.50*1/2.011 … that 1
is the 1994 CPI index number)
2009 = 96.94/2.356 = 41.15
2010 = 113.06/2.719 = 41.58
2011 = 125.58/3.037 = 41.35
So essentially nothing changed. The apparent rises in wages have been almost
exactly cancelled out by similarly sized price rises.
● TEST12: 2007 = 100
Salaries 2008 Index 2008

18,100 100
17,260 95
16,277 90
15,775 87
15,668 87
15,879 88
○ A: express salaries at constant 2008 prices // multiply each value by

106.9/CPI of year in question
○ B: index the results with 2008 = 100 // adjusted salary/2008 salary * 100
○ C: comment on your results // real salaries paid to trainees has decreased
until 2013, where it increased a little. The decline over the entire 5yr period is
12%.
● TEST13: How are the weights obtained for the RPI? B the amount the average
household spent on the item

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Ch 10 - Informational Context of Business II:

Inter-relationships between variables
1. Introduction
● Strength & nature of the relationship between two sets of figures
● Strength - looking at correlation
● Nature (aka can we find an equation linking the two) - looking at regression
● Regression may give us an equation to use for forecasting, but correlation will tell us
how useful the equation is
2. Big data and analytics

● Big data can lead to better products/services & user experience when viewed with
context:
○ Allows businesses to expand their knowledge of their customers
○ How customers behave, allowing a more meaningful connection with
customers
○ Help boost marketing activities from the customer behaviour analysis on
multiple channels & understanding when the customer is most likely to
buy
● Pitfalls: lack of internal analytic skills & high cost of hiring professionals, also data
quality and consistency
● E.g. airlines, supermarkets
● TEST1: analysis of big data directly useful for a supermarket? B identifying trends in
buying patterns of 18-40 year olds
3. Pearson’s correlation coefficient

● A measure of the amount of linear correlation present in a set of pairs of data
● r = Pearson’s correlation coefficient

● n = the number of data points (i.e. sample size)
● Between -1 and +1:
○ r = +1 perfect positive linear correlation (data points lie exactly on a
straight line of positive gradient
○ r = -1 perfect negative linear correlation (straight line with a
negative gradient)
○ r = 0 no linear correlation
● Strength of correlation judged by proximity to +1 or -1
○ The further away from zero, the stronger the linear correlation

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● Negative values of r also strong, just that y is decreasing as x increases

● Helps us decide whether the data can be used to help us make forecasts
● E.g.
● TEST2:
○ Σx = 440,
○ Σy = 330,
○ Σx2 = 17,986,
○ Σy2 = 10,366,
○ Σxy = 13,467
○ n = 11
○ r = ((11*13,467)-(440*330)) /
KOREN((11*17,986-(440^2)))*(11*10,366-(330^2))) = 2,937 / K(4,246*5,126)
= 0.63
○ Answer B

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4. The coefficient of determination

● Coefficient of determination = r^2
● Gives the proportion of changes in y that can be explained by changes in x,
assuming a linear relationship between x and y
● E.g. r = +0.7, r^2 = 0.49 // 49% of the observed changes in y can be explained by the
changes in x, but 51% of the change must be due to other factors
● Spurious correlation
○ High value of the correlation coefficient, but no direct cause and effect
relationship between the sets of data
○ Often a third hidden factor is influencing both
○ E.g. intelligent parents have intelligent children & intelligent parents give their
children more vitamins
■ Quantities of vitamins taken as children & intelligence = high
correlation, even if there is no scientific link between the two
● TEST3: r = +0.9
○ A there is a strong linear relations between x and y YES
○ B y increases as x increases YES, positive correlation
○ C 90% of the changes in y can be explained by the changes in x NO (81%)
○ D the slope of the regression line of y on x is positive
● TEST4: r = 0.8 between monthly advertising expenditure & monthly sales over a year
○ A higher sales are caused by higher expenditure on advertising NO
(causation can’t be deduced from high correlation)
○ B if advertising expenditure is increased to $100k, sales will increase NO
(can’t be sure the positive correlation will continue for advertising greater than
$50k in the data above)
○ C 64% of the changes in sales can be explained by changes in expenditure
YES
○ D 24 months data would be more reliable than 12 months YES
4.1 Interpreting correlation coefficients

● Sample size (n): the smaller the sample size, the easier it is for a large value of r to
arise purely by accident
○ With a sample of 10 data points, r must be at least 0.6 before you can feel
confident that any sort of linear relationship holds
○ With 20 data points, min correlation needed is about 0.4
● Extrapolation: if your x-values range from 0.9 to 2.1, then r = 0.993 tells you there
is a near-perfect linear relationship between x and y in that range, but gives you no
info on the relationship outside that range
● Accidental correlation: correlation is not causation & no mathematical way of
checking when the high correlation is accidental between two unconnected variables
● Hidden third variable: use common sense LOL
● TEST5: r = 0.85, this means (C) there is a strong relationship between x and y
● TEST6: consumption expenditure & disposable income r = 0.8, coefficient of
determination is (A) 0.64

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● TEST7: r^2 = 0.85

○ A when temp increases by 1C, sales increase by by 85% FALSE
○ B when temp increases by 1C, sales increase by 15% FALSE
○ C on 85% of days it’s possible to accurately predict sales if an accurate
prediction of temp exists FALSE
○ D 85% of the changes in sales from one day to the next can be explained by
corresponding changes in temp TRUE
5. Rank correlation: Spearman’s coefficient

● Use when one or both of the variables is not in a suitable quantitative form
● E.g. if a student comes top in maths exam, does that mean they’ll also come top in
their econ exam? We’re interested in their rank rather than their absolute mark.
● R = Spearman’s coefficient
● d = difference in ranks, n = sample size

● E.g.

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● TEST8: 1 = worst taste, 8 = best taste
Sample Taste Price d d^2
A 1 1 0 0
B 2 3 (average of -1 1
2, 3, 4)
C 3 5 -2 4
D 4 3 (average of 1 1
2, 3, 4)
E 5 6 -1 1
F 6 7.5 -1.5 2.25
G 7 7.5 -0.5 0.25
H 8 3 (average of 5 25
2, 3, 4)
Sum d^2 = 34.50
R = 1 - (6*34.5)/(8*63) = 0.59
There’s some positive correlation between price and tastes, with the more expensive
wines tending to taste better. But given the sample size, the result is not really
reliable & cannot be extrapolated to wines costing more than $4.
If the taste rankings had been allocated in the opposite order (1 tasting best), the
correlation would be negative indicating that the cheaper wines tasted worse.
● TEST9: r = 0.95, B the value of the correlation coefficient tells us that there is a
strong linear relationship between temp and sales
5.1 Which correlation coefficient to use?

● If the data have already been ranked, then use the rank correlation coefficient (R)
● Where actual values of x and y are given, Pearson’s coefficient should generally be
used (r) since info is lost when converting into ranks
● Pearson’s coefficient MUST be used if you intend to use regression for forecasting
(see later)

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● Spearman’s coefficient is only advantageous because the arithmetic is easier &

Spearman checks for a linear relationship between the ranks rather than actual
figures - so if you just want to confirm that the variables increase together & have no
concern about the linearity of their relationship, you might prefer to use R
6. Regression
● When two values are correlated, how can we forecast y from x (for appropriate
values of x)
● y = a function of x
● Linear correlation: y = a + bx where y is dependent on the value of x, which is
independent of y
○ a = the point where the line cuts the y-axis (the intercept)
○ b = the gradient or slope of the line
7. Least-squares regression
● Regression analysis finds the line of best fit computationally rather than by estimating
the line on a scatter diagram
● Seeks to minimize the distance between each point and the regression line
● Regression line: y = a + bx

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● E.g. develop a linear model for forecasting sales from the number of salespersons
Sales = dependent variable, y

Number of salespersons = independent variable, x
a is the value of y when x=0

b is the increase in y for each unit increase in x

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a=111.05 this is how many units will be sold if no salespeople are used (which might
actually not be accurate, because x = 0 is outside the range of the data)
b=10.12 each extra salesperson generates an extra 10.12 sales on average
y = 11.05 + 10.12 * x
x = 14, y = 252.73
Rounding to the whole number, we are forecasting that 253 units will be sold in a
region employing 14 salespeople.
x = 25, y = 364.05
364 units at 25 salespeople
Note: we will have more confidence with the x = 14 forecast than 25, as the former is
within the original range of measurements (between 10 and 18).
8. Limitations over the use of linear regression

● An equation of a straight line may or may not be useful for forecasting
● The actual relationship between the two sets of figures may not be linear -
investigate this by calculation r^2 (coefficient of determination)
○ E.g. r^2 = 0.6 - 60% of the variation in y can be explained using our
regression line equation and variations in x, but 40% can’t be explained by
the regression line equation
● Even if we have a high level of correlation, this may be due to spurious correlation
and the presence of other causal factors
● Extrapolation aka using the regression line to make forecasts outside of the range
of the orig data (e.g. height and age between 10-16 VS height and age between
10-90)
○ Interpolation = forecasting within the established range of data is more
reliable than extrapolation
● TEST10: sales (y) & advertising expenditure (x) - units ($000)

○ y = 5,000 + 10x
○ x = $100,000
○ y = 5000 + 10*100 = 6,000 (in $000) so D $6m
● TEST11: y = a + bx, intercept on the y-axis is $234, y = $491, x = 20
○ The value of the slope is? b = ?
○ 491 = 234 + b * 20
○ b = (491-234)/20 = 12.85 (answer C)
● TEST12: coefficient of determination is 0.49 (r^2 = 0.49)
○ A y = 0.49x FALSE
○ B y = a + 0.49x FALSE
○ C 49% of the variation in y can be explained by the corresponding variation in
x TRUE
○ D 49% of the variation in x can be explained by the corresponding variation in
y FALSE

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● TEST13: regression equation linking costs ($m) to number of units produced (000s)
is y = 4.3 + 0.5x
○ A: for every extra unit produced, costs rise by $500k FALSE
○ B: for every extra 1k units produced, costs rise by $500k TRUE
○ C: for every extra 1k units produced, costs rise by $4.3m FALSE
○ D: for every extra unit produced, costs rise by $4,300 FALSE
● TEST14: all the following except one will adversely affect the reliability of regression
forecasts - which is the exception?
○ A: small sample
○ B: low correlation
○ C: extrapolation
○ D: negative correlation - THIS ONE
● TEST15: y = 50 - 2x, n = 15, x between 0 and 20
○ A: when x = 0, y is estimated to be 25 FALSE (y = 50)
○ B: y decreases by 2 whenever x increases by 1 TRUE
○ C: the equation cannot be relied upon for x-values greater than 20 TRUE
○ D: the correlation between x and y must be negative TRUE

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Ch 11 - Informational Context of Business III:

Forecasting
1. Introduction
● Linear regression method for forecasting only incorporates one causal factor (x)
● Time series analysis is one approach to forecasting more complex scenarios
2. Components and models of time series

● 4 components of variation in time series:
○ T trend: the general, overall movement of the variable (sharp fluctuations
smoothed out - often called the underlying trend), any other components
occur around this trend
○ S seasonal component: the regular variations that certain variables show at
various times of the year (which you can’t see with data recorded annually,
obviously)
○ C cyclical component: longer-term variations caused by business cycles
(corresponding with the economic cycles usually)
○ R the residual (irregular/random) component: the part of the variable that
can’t be explained by the factors mentioned above, random fluctuations and
unpredictable or freak events (e.g. fire). If the first 3 components are
explaining the variable’s behaviour well, the irregular component will have
little effect subject to rare accidents
● The four components combine to produce the variable in one of two ways:
○ Additive model: Y = T + S + C + R (all components are in the same units as
the orig variable)
○ Multiplicative model: Y = T * S * C * R (T in the same units as the variable,
the other 3 components are just multiplying factors)
○ Inflation and growth can erode the validity of the figures used in the additive
model, so most firms use the multiplicative approach

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● TEST1:
○ P: the impact of a strike = D the residual component
○ Q: an economic cycle of ups and downs over 5 yrs = B the cyclical
component
○ R: long-term increase of 5% per annum = A the trend
○ S: an increase in sales over xmas = C the seasonal component
● TEST2: multiplicative model, trend and seasonal values are 523, 465 and 1.12
respectively, no cyclical element - find the residual element
○ 523 = 465 * 1.12 * R
○ R = 523 / 520.8 = 1.0042 (C)
3. Establishing the underlying trend

● Two methods for determining the trend (out of many):
○ Assume a linear trend, then determine the trend line using linear regression
○ If the assumption of a linear trend is not reasonable, use moving averages
○ Both of these are often referred to as smoothing the data
● TEST3:

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○ (a) trend: sales have gone steadily up through the years, seasonal pattern:
Q4 most sold, Q1 least
○ (b) T = 28.54 + 2.3244*t, calculate Qs for 20X7
Q17 = 28.54 + 2.3244 * 17 = 68.05
Q18 = 70.38
Q19 = 72.70
Q20 = 75.03
● TEST4: T = 43 + 5.9t, t = 1 is the first Q of 2011
○ Q4 of 2015: t = 20, T = 43 + 5.9*20 = 161
4. Forecasting seasonal components

● The seasonal component is different in the two models:
○ Multiplicative model: usually considered better, because it ensures that
seasonal variations are assumed to be a constant proportion of the
sales
○ Additive model: assumes seasonal variations are a constant amount, and
thus would constitute a diminishing part of an increasing sales trend
● No cyclical or residual variations: Y = T*S, so S = Y/T
● Additive: Y = T + S, so S = Y - T
● S is found as the ratio of the actual values to the trend, averaged over all available
data, assuming the same degree of seasonality is continued into the future
● E.g. continued from the example above (McNamee lol)
○ The mean shows that Q1 sales have been 98% of the trend, Q2 sales 97% of
the trend, etc. Then adopt this as the required forecast seasonal components.
(so S = 0.9836 for all Q1).

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● Tidying up the seasonal adjustments

○ On average the 4 seasonal components should cancel out over a year, so we
check that they add up to 4 (an average of 1 each)
○ E.g. from above 0.9836 + 0.9697 + 1.1759 + 0.8719 = 4.0011
○ Now we reduce to 4, so we subtract (4.0011-4)/4 = 0.0003
○ New components: 0.9833, 0.9694, 1.1756, 0.8716
○ In this example the adjustment is tiny, so can be ignored & you can round to
0.98, 0.97, 1.18 and 0.87
○ In the additive model, the 4 seasonal adjustments should add up to zero
● TEST5: continued from TEST3, T = 28.5425 + 2.324411765*t
○ Find S as the arithmetic mean of Y/T for each quarter, then tidy them up
○ Y = actual sales, T = trend given by the regression equation
Q1 Q2 Q3 Q4
2013 T = 30.867 33.191 35.516 37.840

S = 0.8034 1.0937 1.0728 1.2553
2014 40.165 42.489 44.813 47.138

0.7768 0.9885 0.9685 1.1859
2015 49.462 51.787 54.111 56.435

0.8087 0.9423 0.9979 1.2244
2016 58.760 61.084 63.409 65.733

0.9309 0.9462 0.9510 1.0482
Mean 0.8300 0.9927 0.9976 1.1785
Mean total = 3.9988 - 4 = -0.0012, 0.0012/4 = 0.0003 adjustment

Final S = 0.8303, 0.9930, 0.9979, 1.1788, sum = 4
To 2 decimal places: 0.83, 0.99, 1.00, 1.18
● TEST6: additive model, seasonal components are +25, -54, -65, +90
○ Adjusting: sum = -4, so we need to add 4 total to get to 0
○ Adjusted: 26, -53, -64, 91
5. Producing the final forecast

● We’re omitting the cyclical component from this first treatment cuz it’s hard to do, has
no effect on the short term, and also cuz economists r cunts and can’t agree on an
approach

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● The residual component is by nature unpredictable. The best we can do is hope

random fluctuations r smol & no freak events occur, so that R has no overall effect.
● This would mean C=1 & R=1, so we just simplify the model to Y = T*S
● E.g. McNamee forecasted sales for 20X5:
● TEST7: do as above for Bates - forecast the sales for B for 20X7
○ S = 0.8303, 0.9930, 0.9979, 1.1788
○ T = 28.54 + 2.3244*t, calculate Ts for 20X7
Q17 = 28.54 + 2.3244 * 17 = 68.05
Q18 = 70.38
Q19 = 72.70
Q20 = 75.03
○ Q1: Y = S*T = 0.8303 * 68.05 = 56.5
○ Q2: Y = 0.9930 * 70.38 = 69.9
○ Q3: Y = 0.9979 * 72.70 = 72.6
○ Q4: Y = 1.1788 * 75.03 = 88.4
● TEST8: trend of sales T = 345.12 - 1.35x
○ x = 16, S = -23.62
○ Additive forecasting model
○ T = 345.12 - 1.35 * 16 = 345.12 - 21.6 = 323.52
○ Forecast is 23.62 below the trend, so:
○ Y = T + S = 323.52 - 23.62 = 299.9 = 300 to the nearest unit
● TEST9: based on 20 past quarters, the underlying trend equation for forecasting is:
○ T = 23.87 + 2.4x
○ Q21 has S = 1.08
○ T = 23.87 + 2.4*21 = 74.27
○ Forecast = 74.27 * 1.08 = 80 (B)
6. Seasonal adjustment
● We remove the seasonal effect from the figure for weekly revenue, monthly profit,
etc.
● Deseasonalize: Y = T*S > T = Y/S
○ Or Y = T+2 > T = Y-S
● The seasonally adjusted figure is an estimate of the trend
● E.g. McNamee cont.: Q4 sales are $50k, S = 0.8716 (which is a mistake, it’s actually
0.8719)

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○ Seasonally adjust: T = Y/S = $50,000 / 0.8716 = $57,365

● TEST10: Bates cont.: Q1 sales $60k
○ T = 60,000 / 0.8303 = $72,263
7. Moving average trends

● An approach that doesn’t depend on linearity
● We use averages to eliminate seasonal and random fluctuations to isolate the
trend
● E.g. McNamee cont.
○ Four-quarterly total: the sum of each set of four consecutive quarterly sales
figures (e.g. the second one is 41 + 52 + 39 + 45 = 177
○ Centered eight-quarterly total: we wish each value of the trend to be
eventually associated with a specific quarter - to overcome this, the figures
are centered aka each pair of values is added to give the centered
eight-quarterly totals: 174 + 177 = 351 for Q3, 177 + 184 = 361 for Q4
○ Moving average / trend: dividing the eight quarterly totals by 8 gives us the
trend values shown
○ Then complete the process of forecasting from these trend values
● TEST11: Bates cont., calculate the trend for the sales of article B as a centered
four-point moving average
Sales (Y) Four-quarterly Centered T

total eight-quarterly
total

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Q1 24.8
Q2 36.3 146.7
Q3 38.1 153.1 299.8 37.4750
4 47.5 158.8 311.9 38.9875
5 31.2 164.1 322.9 40.3625
6 42 172.5 336.6 42.0750
7 43.4 181.3 353.8 44.2250
8 55.9 188.1 369.4 46.1750
9 40 198.7 386.8 48.3500
10 48.8 211.9 410.6 51.3250
11 54 226.6 438.5 54.8125
12 69.1 235.6 462.2 57.7750
13 54.7 241.9 477.5 59.6875
14 57.8 241.7 483.6 60.4500
15 60.3
16 68.9
● TEST12: more McNamee

○ A: find the seasonal component from the new trend values, assuming the
multiplicative model: S = Y/T
52/43.88 = 1.1851
0.8642
0.9548
0.9770
1.1989
0.8824
0.9927
0.9761

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Q1 totals = 0.9548 + 0.9927 = 1.9475, mean 0.9738

Q2 totals = 0.9970 + 0.9761 = 1.9531, mean 0.9766
Q3 totals = 1.851 + 1.1989 = 2.3840, mean 1.1920
Q4 totals = 0.8642 + 0.8824 = 1.7466, mean 0.8733
TOTAL = 4.0157, 0.0157/4 = -0.0039
Adjusted: S = 0.9699, 0.9727, 1.1881, 0.8694
○ B: forecast sales for 20X5: Y = T * S - THEY JUST MAKE UP THE FUCKING
TRENDS I HATE IT the end.
■ Q13 = 51.8 * 0.9699 = 50.24 = $50,000
■ Q14 = 50.19 = $50,000
■ Q15 = 61.19 = $61,000
■ Q16 = 44.69 = $45,000
○ C: deseasonalise fourth-quarterly sales of $50k
■ Q13: sales = 50,000 / 0.8694 = $57,511 = $57,500
● TEST13: Bates cont.
○ A: evaluate the seasonal component for each quarter based on the moving
average trend from TEST11
○ B: forecast the sales of B for 20X7 using trend forecasts of 66.7, 68.8, 70.9,
73
8. Forecasting limitations
● Take care when placing reliance on the forecasts calculated
● For data that was not strongly correlated in the first place, the forecasts will not
necessarily be very reliable
● When extrapolating data, results will also be less reliable
● If operational conditions change, two sets of data may become less strongly
correlated than in the previous time period
● External forces, such as inflation or the forecast being made during a boom or a
recession, should also be taken into account when making predictions
● Any assumptions made in terms of linear relationships or on the cyclical nature of
seasonal variations may not hold true
● Plus, there is always the residual variations that may affect the accuracy of the
forecasts

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Copy of CIMA Cert in Business Accounting BA1

Financial Management A (University of Johannesburg)

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CIMA Cert in Business Accounting

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● Credit/deposit multiplier: ​the amount by which total deposits can increase as a

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● Annuity Factor ​= (1-(1+r)^-n)/r = Cumulative Present Value TABLES!!

● Perpetuity Factor ​= 1/r

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■ So IRR = 5 + 4.7 = 9.7%

● Adjusting for inflation

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- this is given in the exam

○ d = difference in ranks, n = sample size

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Ch 1 - Microeconomic and Organisational Context

1.1 What is an organisation?

1.2 Why do we need organisations?

1.3 Profit orientation

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○ However, when demutualising most building societies give their members

1.4 Classifying organisation by ownership/control

● Co-operatives​: autonomous association of persons united voluntarily to meet their

2.1 Maximising shareholder wealth

Measure and increase shareholder value:

● Managing long- and short-term perspectives

● Profits ​= sales - expenses

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● Net cash flows​ = cash receipts - cash payments

2.2 Short-term measures of financial performance (p10)

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2.3 Long-term measures of financial performance

2.4 Share values

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5.1 The principal -- agent problem

5.2 Possible areas of conflict

5.3 The objectives of corporate governance

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○ Control managers/directors​ by increasing reporting & disclosure

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6.1 When transaction costs change

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Ch 2 - Microeconomic and Organisational Context

1.1 Different market systems

1.2 Market forces

2.1 Individual demand

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2.2 Market demand

2.3 Conditions of demand

● Main conditions of demand:

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○ Population​: increase in population creates a larger market (e.g. seasonal

3.1 Price elasticity of demand (PED)

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3.2 Factors that influence PED

3.3 The link between PED and total revenue

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○ Change in demand & total revenue = ??

4.1 The supply curve of a firm

● Credit/deposit multiplier: the amount by which total deposits can increase as a

● Annuity Factor = (1-(1+r)^-n)/r = Cumulative Present Value TABLES!!

● Perpetuity Factor = 1/r

● Co-operatives: autonomous association of persons united voluntarily to meet their

● Profits = sales - expenses

● Net cash flows = cash receipts - cash payments

○ Control managers/directors by increasing reporting & disclosure

○ Population: increase in population creates a larger market (e.g. seasonal

○ > lower quality (e.g. disrepair of flats)

● TEST4: least risky investment: (A) CD from a global bank

○ (a)(i) 1+real rate of interest for 2013 = (1 + 5.5%)/(1 + 2.3%) = 3.1%

○ Deposit liabilities of DTIs form the bulk of a country’s money supply, so