The macroeconomic environment Macroeconomics is the study of the aggregated effects of the decisions of individual economic units (such as households or businesses). It looks at a complete national economy, or the international economic system as a whole. Macroeconomic policy describes the policies and actions a government takes to control economic issues, including economic growth, inflation, employment and trade performance Circular flow of income In this model, we assume that households spend all that they earn (in economics this spending is known as consumption), and all the firms’ goods and services are sold to the households. This is a basic closed economy, without foreign trade, Factor incomes paid by firms Expenditure on goods and services Scanned with CamScannerBusiness and ‘Technology ACCA BI/EBT Withdrawals and injections into the circular flow of income a ¥ Income(Y) Households Firms Consumption (C) — meen > Saving (S) ,| Financial | ___») Investment spending (!) Taxation (T) | Comermert >| Government spending (G) t ~ | cr | Import demand (M) Y——»| Foreign >! Export demand (X) } sector Factors which affect the economy 1 The multiplier in the national economy The multiplier involves the process of circulation of income in the national economy, whereby an injection of a certain size leads to a much larger increase in national income. ‘The increase in national income will be a multiple of the initial increase in spending, with the size of the multiple depending on such factors as what proportion of any new investment is spent or what proportion is saved 2 Aggregate demand The total demand in the economy for goods and services is called the aggregate demand and it is made up of several components of the circular flow. These components include consumption, investment, government spending and exports minus imports. Scanned with CamScannerBusiness and Technology ACCA BT/EBT 3 Aggregate supply ‘The aggregate supply refers to the ability of the economy to produce goods and services. Aggregate supply is positively related to the price level. Where the aggregate demand curve intersects with the aggregate supply curve, the total demand for goods and services in the economy is equal to the total supply of goods and services in the economy. (This is known as the equilibrium level of national income.) Inflationary gaps Ina situation where resources are already fully employed, there may be an inflationary gap since increases in demand will cause price changes, but no variations in real output. A shift in demand or supply will not only change the national income, it will also change price levels. Deflationary gap Ina situation where there is unemployment of resources there is said to be a deflationary gap. Prices are fairly constant and real output changes as aggregate demand varies. A deflationary gap can be described as the extent to which the aggregate demand function will have to shift upward to produce the full employment level of national income. Stagflation A combination of unacceptably high unemployment, unacceptably high inflation and low/ negative economic growth. The Business cycle Four main phases of the business cycle can be distinguished. *A.Recession *B. Depression *C. Recovery *D. Boom Scanned with CamScannerBusiness and Technology ACCA BT/EBI Actual ilgut output _- Trend in cutput Time Recession tends to occur quickly, while recovery is typically a slower process. Business cycles or trade cycles are the continual sequence of rapid growth in national income, followed by a slowdown in growth and then a fall in national income (recession). After this recession comes growth again, and when this has reached a peak, the cycle turns into recession once more. Inflation Inflation is the name given to an increase in price levels generally. It is also manifest in the decline in the purchasing power of money. The RPI and the CPI Retail Prices Index (RPI). The RPI measures the percentage changes month by month in the average level of prices of the commodities and services, including housing costs, purchased by the great majority of households in the UK. Harmonised Index of Consumer Prices (HICP), was now to be used as the basis for the UK's inflation target. The UK HICP is called the Consumer Prices Index (CPI). The CPI excludes most housing costs. RPIX is the underlying rate of inflation measured as the increase in the RPI excluding mortgage interest payments. Another measure, called RPIY, goes further and excludes the effects of sales tax (VAT) changes as well. Scanned with CamScannerBusiness and Technology ACCA BI/EBT Causes of inflation Demand pull inflation: inflation resulting from a persistent excess of aggregate demand over aggregate supply. Supply reaches a limit on capacity at the full employment level. Cost push inflation: inflation resulting from an increase in the costs of production of goods and services, eg through escalating prices of imported raw materials or from wage increases, Import cost factors Import cost push inflation occurs when the cost of essential imports rise regardless of whether or not they are in short supply. Additionally, a fall in the value of a country's currency will have import cost push effects since a weakening currency increases the price of imports. Expectations and inflation A further problem is that once the rate of inflation has begun to increase, a serious danger of expectational inflation will occur. This can lead to the vicious circle known as the wage-price spiral, in which inflation becomes a relatively permanent feature because of people's expectations that it will occur. Money supply growth Monetarists have argued that inflation is caused by increases in the supply of money. Economic growth Economic growth may be measured by increases in the real gross national product (GNP) per head of the population. Actual economic growth is the annual percentage increase in national output, which typically fluctuates in accordance with the trade cycle. Scanned with CamScannerBusiness and ‘Technology ACCA BI/EBI Potential economic growth is the rate at which the economy would grow if all resources (eg people and machinery) were utilised. Unemployment Reasons for Unemployment Frictional Structural Technological This type of unemployment is caused when the supply of labour exceeds the demand for labour, but real wages do not fal for the labour market to clear. This type of unemployment is normally caused by strong trade unions which resist a fall in their wages. Another cause of this type of unemployment is the minimum wage rate, when itis set above the market clearing level. It is inevitable that some unemployment is caused not so much because there are not enough jobs to go round, but because of the friction in the labour market (difficulty in matching quickly workers with jobs), caused perhaps by a lack of knowledge about job opportunities. In general, it takes time to match prospective employees with employers, and individuals will be unemployed during the search period for a new job. Frictional unemployment is temporary, lasting for the period of transition from cone job to the next. This occurs in certain industries, for example building, tourism and farming, where the demand for labour fluctuates in seasonal patterns throughout the year. This occurs where long-term changes occur in the conditions of an industry. A feature of structural unemployment is high regional unemployment in the location of the industry affected. The primary cause is a significant reduction in the level of demand. This is a form of structural unemployment, which occurs when new technologies are introduced, (a) Old skills are no longer required. (b) There is likely to be a labour saving aspect, with machines doing the job that people used to do. With automation, employment levels in an industry can fall sharply, even when the industry's total output is increasing. Ithas been the experience of the past that domestic and foreign trade go through cycles of boom, decline, recession, recovery, then boom again, and so on. (a) During recovery and boom years, the demand for output and jobs is high, and ‘unemployment is low. (b) During decline and recession years, the demand for output and jobs falls, and unemployment rises to a high level. Cyclical unemployment can be long term, and a government might try to reduce it by doing what it can to minimise a recession or to encourage faster economic growth. Scanned with CamScannerBusiness and ‘Technology ACCA BI/EBI The rate of unemployment culated ‘The rate of unemployment in an economy can be (Number of unemployed / Total workforce) X 100 % Fiscal policies overnment policy on taxation, public borrowing and public spending. Fiscal pol ‘The formal planning of fiscal policy is usually done once a year and is set out in the Budget. which the Government determines and through which The two components of the bu it exercises its fiscal policy are: (a) Expenditure, (b) Revenues, A third element of the fiscal policy is (©) Borrowing. To the extent that a government's expenditure exceeds its income it must borrow to make up the difference. ‘The amount that the Government must borrow each year is now known as the Public Sector Net Cash Requirement (PSNCR) in the UK. Its former name was Public Sector Borrowing Requirement (PSBR). Where the Government borrows from has an impact on the effectiveness of fiscal policy. Budget surplus and budget deficit When a government's income exceeds its expenditure, and there is a negative PSNCR or Public Sector Debt Repayment (PSDR), we say that the Government is running a budget surplus. Scanned with CamScannerBusiness and Technology ACCA BT/FBT This may be a deliberate policy (known as contractionary policy) to reduce the size of the money supply by taking money out of the economy. When a government's expenditure exceeds its income, so that it must borrow to make up the difference, there is a PSNCR and we say that the Government is running a budget deficit. is known as When the government is injecting money into the economy, thi expansionary policy. Taxation A direct tax is paid direct by a person to the Revenue authority. An indirect tax is collected by the Revenue authority from an intermediary (a supplier) who then attempts to pass on the tax to consumers in the price of goods they sell. Indirect taxes are of two types. A specific tax is charged as a fixed sum per unit sold. @ Anad valorem tax is charged as a fixed percentage of the price of the good. Further classification: (a) A regressive tax takes a higher proportion of a poor person's salary than of a rich person's. Television licences and road tax are examples of regressive taxes since they are the same for all people. (b) A proportional tax takes the same proportion of income in tax from alll levels of income. (©) A progressive tax takes a higher proportion of income in tax as income Direct taxes tend to be progressive or proportional. Indirect taxes can be regressive, Monetary Policies Monetary policy: government policy on the money supply, the monetary system, interest rates, exchange rates and the availability of credit. Scanned with CamScannerBusiness and Technology ACCA BI/FBT Monetary policies on interest rates: Maintaining relationship between interest rates and the level of expenditure in the economy, or between interest rates and the rate of inflation. Monetary policies on exchange rate: Maintaining relationship between exchange rates and the level of import and exports. Economic indicators An economic indicator provides information about economic conditions and might be used as a way of judging the performance of government. (a) Aleading indicator is one which gives an advance indication of what will happen to the economy in the future. predict what will happen to the balance of payments and to the rate of inflation. (b) A coincident indicator is one which gives an indication of changes in economic conditions at the same time that these changes are occurring. (c) A lagging indicator, you will have guessed, is one which ‘lags behind’ the economic cycle. Balance of payments ‘The balance of payments (BOP), also known as balance of international payments, summarizes all transactions that a country's individuals, companies and government bodies complete with individuals, companies and government bodies outside the country. These transactions consist of imports and exports of goods, services and capital, as well as transfer payments such as foreign aid and remittances. ‘The balance of payments divides transactions in two accounts: the current account and the capital account ‘The current account includes transactions in goods, services, investment income and current transfers. ‘The capital account, broadly defined, includes transactions in financial instruments and central bank reserves. The current account is included in calculations of national output, while the capital account is not. Scanned with CamScannerACCA BT/EBT Business and Techn If a country cannot fund its imports through exports of capital, it must do so by running down its reserves. This situation is often referred to as a balance of payments defi using the narrow definition of the capital account that excludes central bank reserves. A surplus or deficit on the balance of payments usually means a surplus or deficit on the current account. Equilibrium in the balance of payments occurs when the the exchange rate remains stable and autonomous credits and debits are equal in value Balance of trade is the balance of payments which are usually referring to the deficit or surplus on the current account, or possibly to the surplus or deficit on trade in goods only. Scanned with CamScanner