BBM-ME-II

MODULE – A
Macroeconomic Environment
of Business
Key Macroeconomic Variables
and Policy Objectives
Prof. (Dr.) D N Panigrahi
PhD (Finance), MBA (Fin-FMS, DU), CFA & MS-Finance, CAIIB & DFS, M.Sc. (Physics)
 Macroeconomic Environment

The success of an individual business depends not only on its own particular
market and its own particular decisions but also on the whole
macroeconomic environment in which it operates, as can be seen in the
Financial Times article of Feb-16-2022, which looks at rising inflation in
early 2022.
Consumers were facing a squeeze on their living standards, which affected
the amount they could afford to buy goods and/or services.
Many businesses were consequently facing falling demand from consumers
and, at the same time, were experiencing rapidly rising costs of production.
This reduced the profits of such businesses, which impacted on their
investment in current assets (working capital) and fixed (capital) assets.
 Macroeconomic Environment

If the economy is booming (economic activity is expanding/rising), then

individual businesses are likely to be more profitable than if the economy is
in recession (economic activity is contracting/falling).
If the exchange rate rises (or falls), this will have an impact on the
competitiveness of businesses trading overseas (foreign or international
trade) and on the costs and profitability of business in general.
Similarly, business profitability will be affected by interest rates, the general
level of prices (inflation) and wages and the level of unemployment.
It is thus important for managers to understand the forces that affect the
performance of the economy. In this course, we will examine these
macroeconomic forces and their effects on the business sector.
 Macroeconomic Environment

In first few slides, we examine the macroeconomic environment in which

businesses operate. We identify the main macroeconomic variables that
determine this environment.
In particular, we look at the crucial issue of economic volatility. It is this
volatility that generates what we know as ‘the business cycle’. We consider
how this volatility affects other macroeconomic variables such as
unemployment and inflation and hence how they are interrelated.
A subsequent slide looks at macroeconomic issues arising from a country’s
economic relationships with the rest of the world (RoW). In particular, it
looks at the balance of payments and the role of exchange rates in
influencing economic performance.
 Macroeconomic Environment

Another slide looks at the significance of the financial and banking system
for both individual businesses and the economy.
In particular, it looks at the behaviour of financial institutions and banks and
the role of money. The chapter analyses the global financial crisis (GFC) that
occurred during 2007-09, the initial responses of policymakers to limit the
adverse impact and the subsequent responses to try to prevent a similar crisis
reoccurring.
You will be able to judge whether ‘Banks are dangerous institutions’, as
Mervyn King states.
 Macroeconomic Environment

[Banks are dangerous institutions. They borrow short and lend long. They create
liabilities which promise to be liquid and hold few liquid assets themselves. That
though is hugely valuable for the rest of the economy. Household savings can be
channelled to finance illiquid investment projects while providing access to
liquidity for those savers who may need it. Mervyn King, Former Governor of the
Bank of England, ‘Finance: a return from risk’, speech to the Worshipful
Company of International Bankers, at the Mansion House, 17 March 2009.]
Finally, in another slide, we examine various theories about how the
economy operates and the implications for business. We look at the
relationship between output, unemployment and inflation and examine the
possible causes of the business cycle.
We also see the important role played by the expectations of both business
and consumers.
 Two Main Goals of Macroeconomics Policy

The two main goals of macroeconomic policy are:

 1. to ensure that key macroeconomic variables (such as the rate of inflation)
are at acceptable levels
 2. to create a stable economic environment in which the economy can
flourish.
This module/slide begins by introducing the main macroeconomic objectives
that governments pursue (e.g., low inflation) and the instruments of policy
that they might use to achieve these objectives (e.g., interest rates). It goes
on to introduce one of the most basic concepts in macroeconomics, the
circular flow of income, and to examine how the level of national income (or
output) is determined and how it is measured. It then returns to examine the
seven main macroeconomic objectives in more detail.
 Key Macroeconomic Variables & Policy Objectives

The study of macroeconomics arises because there are some

important economic objectives that cannot be understood and
analysed at the level of microeconomics.
Macroeconomics is concerned with the allocation of a
nation’s resources and is concerned with seven main
variables.
These variables and the macroeconomic policy objectives
associated with each variable are shown in Table 13.1 and
form the basis of the macroeconomic analysis for this course.
 Table 13.1 – Macroeconomic Variables & Objectives
Macroeconomic Variable Macroeconomic Policy Objective

Economic growth A High but Sustainable/Stable Rate of Economic Growth (a steady rate of
rise of National Income)
Employment A Low Level of Unemployment
Price Stability (Inflation) A Low and Stable Rate of Inflation (A Gently Rising Price Level)

External Balance (BoP) & Exchange A favourable (and sustainable) balance of payments position (external
Rate balance) [Avoidance of Balance of Payments (BoP) deficits and excessive
exchange rate fluctuations]
Financial Wellbeing of An equitable distribution of income and manageable level of debt for
Households/Income Distribution households.

Financial Wellbeing of Businesses & A sustainable level of Corporate & Government (National) Debt [Avoidance
Governments/Corporate & National of excessively financially-distressed sectors of the economy, including
Debt Government]
Financial Stability A Stable Financial System
 Key Macroeconomic Variables & Policy Objectives

There are several macroeconomic variables that governments seek to

control. The macroeconomic environment will influence all aspects of
businesses, including their markets, their costs and their potential
profitability. We can group these macroeconomic elements into seven key
areas as depicted in the foregone Table 13.1.
 Short-term Economic Growth and the Business Cycle: Economic
growth is defined as the percentage change in the level of an economy’s
output from one period to the next – usually measured over short periods,
such as 12 or 3 months. If we measure the rate of economic growth over a
12-month period, we are measuring the economy’s annual rate of growth
while, if we measure it over a 3-month period, we are measuring the
quarterly rate of growth.
 Key Macroeconomic Variables & Policy Objectives

 To be able to measure how quickly an economy is growing, we need a

means of measuring the value of a nation’s output. The measure we use is
gross domestic product (GDP). Another slide will explain details of GDP
how it is calculated. However, to be able to compare changes in output
from one period to the next we must eliminate those changes in GDP that
result simply from changes in prices. In other words, we use real rather
than nominal GDP figures to analyse changes in the volume of output.
 Nominal GDP, sometimes called ‘money GDP’, measures GDP in the
prices of the time (also known as ‘current prices’). So, for example,
nominal GDP in 2023 would be the value of a country’s output at 2023
prices. The same principle applies to other years. Hence, no account is
made for the effect of inflation, rather the effect of inflation is incorporated
within these figures.
 Key Macroeconomic Variables & Policy Objectives

 In contrast, real GDP figures do adjust for inflation. They do this by

measuring GDP in the prices that ruled in some particular year – the base
year. Thus, we could measure each year’s GDP in, say, 2015 prices (known
as ‘GDP at constant 2015 prices’). This then enables us to see how much
real GDP had changed from one period to another by eliminating increases
(or decreases) in money GDP due simply to increases (or decreases) in
prices. In other words, we are able to see the real growth in GDP.
 KEY IDEA 38: The distinction between nominal and real figures.
Nominal figures are those using current prices, interest rates, etc. Real
figures are figures corrected for inflation.
 Pause for thought: When the rate of inflation is positive, which is greater:
the growth of nominal or real GDP?
 Key Macroeconomic Variables & Policy Objectives

 Fig. 26.1 below shows annual rates of economic growth (annual percentage
changes in real GDP) for a sample of economies. As you can see, countries
rarely experience stable growth. Thus, while there has been extraordinary
volatility in recent times with the global financial crisis (2007-09) and then
the COVID-19 pandemic (2020-22) followed by the war in Ukraine (Feb-
24-2022 onwards), instability is an inherent feature of the macroeconomy.
 KEY IDEA 39: Economies suffer from inherent instability. As a result,
economic growth and other macroeconomic indicators tend to fluctuate.
 Because of their inherent instability, economies experience a cycle [i.e.,
fluctuations (expansions & contractions) or ups and downs] in the levels of
economic activity. This cycle is known as the business cycle (or trade cycle
or economic cycle).
 Fig. 26.1 – Annual Economic Growth Rates
of a Sample of Countries from 1970 onwards
 Key Macroeconomic Variables & Policy Objectives

 In some periods, an economy will be booming; in others, economic growth

will be low or even negative.
 This volatility of growth is true not only of national economies, such as
India, the UK and the USA, but also country groups such as the eurozone,
and also the world economy.
 Therefore, there is an international business cycle. This suggests that
countries’ business cycles have both a national and a global dimension.
 What is more, this global dimension has increased in importance, resulting
in a growing synchronicity (the simultaneous occurrence of events which
appear significantly related but have no discernible causal connection) of
countries’ business cycles.
 Key Macroeconomic Variables & Policy Objectives

 Rate of economic growth: The percentage increase in output, normally

expressed over a 12-month period.
 Gross domestic product (GDP): The value of output produced within a
country, typically over a 12-month period.
 Nominal GDP: GDP measured in current prices. These figures take no
account of the effect of inflation.
 Real GDP: GDP measured in constant prices that ruled in a chosen base
year, such as 2000 or 2015. These figures do take account of the effect of
inflation.
 When inflation is positive, real GDP figures will grow more slowly than
nominal GDP figures.
 Key Macroeconomic Variables & Policy Objectives

 Real growth values: Values of the rate of growth of GDP or any other
variable after taking inflation into account. The real value of the growth in
a variable equals its growth in money (or ‘nominal’) value minus the rate of
inflation.
 Business cycle or trade (economic) cycle: The periodic fluctuations of
national output round its long-term trend. Periods of rapid growth are
followed by periods of low growth or even decline in national output.
 Longer-term economic growth: Although growth rates fluctuate, most
economies experience positive growth over the longer term. In other words,
most economies have output paths that trend upwards over time. This can
be seen in Fig. 26.2 below which plots the levels of real GDP and hence the
output paths over time for the same economies analysed in Fig. 26.1.
Fig. 26.2 – Output Paths since 1965
 Key Macroeconomic Variables & Policy Objectives

 Fig. 26.2 also highlights differences in the longer-term rates of growth of

economies. For growth to be sustained over the longer term, an economy’s
capacity must increase. Hence, differences in long-term economic growth
rates reflect differences in the growth of the productive capacity of
economies. We discuss this further later in the course.
 Governments aim to achieve economic growth over the long term. They
will aim for a stable rate of economic growth, which avoids both short-
term rapid growth that cannot be sustained and periods of recession.
However, economies are unstable and growth rates will fluctuate, as is
evident by recent history in both developed and developing nations.
 International business cycle: The tendency for groups of economies and
the global economy to experience synchronised fluctuations in economic
growth rates.
 Key Macroeconomic Variables & Policy Objectives

 Unemployment: The inherent instability of economies has implications for

the number of people in work and so for the number unable to find work.
 After all, higher levels of economic activity will tend to decrease
unemployment numbers, while reduced economic activity will tend to
increase them.
 Unemployment numbers, however, reflect more than just the position in the
business cycle. For example, many countries have seen significant effects
on their labour markets from rapid industrial change, technological advance
and globalisation.
 While some new jobs are created, others are lost. Many people made
redundant find they are not qualified for the new jobs being created.
 Key Macroeconomic Variables & Policy Objectives

 Maximising employment opportunities and reducing unemployment is a

key macroeconomic objective of governments, not only for the sake of the
unemployed themselves, but also because unemployment represents a
waste of human resources and because unemployment benefits are a drain
on government revenues. Unemployment poses many costs for different
groups across society. These costs are considered in more detail in Article
Box 10.4 shared with you.
 Measuring unemployment: Unemployment can be expressed either as a
number (e.g. 1.5 million) or as a percentage (e.g. 5 per cent). The most
usual definition that economists use for the number unemployed is: those of
working age who are without work, but who are available for work at
current wage rates.
 Key Macroeconomic Variables & Policy Objectives

 We normally refer to the rate of unemployment. This is the number

unemployed as a percentage of the total workforce or labour force. The
labour force is defined as those in employment plus those unemployed.
Thus, if 30 million people were employed and 1.5 million people were
unemployed, the unemployment rate would be: [1.5/(30 + 1.5)] * 100 =
4.76%.
 In many developed & developing economies, there has been a move
towards more flexible contracts and the issue of underemployment has
become more of a problem. This is where people work fewer hours than
they would like.
 [Rate of unemployment: The number unemployed expressed as a
percentage of the total workforce (i.e. those employed and those
unemployed).]
 Key Macroeconomic Variables & Policy Objectives

 Inflation: By inflation we mean a general rise in prices throughout the

economy. The rate of inflation is the percentage increase in the level of
prices over a 12-month period. Government policy aims to keep inflation
low and stable, as this will aid economic decision making by creating a
more certain economic environment. For example, businesses will be able
to set prices and wage rates and make investment decisions with far more
confidence.
 [Rate of inflation (annual): The percentage increase in the level of prices
over a 12-month period.]
 In recent years we have become used to low inflation rates, with some
countries, particularly Japan, even experiencing falling prices, or deflation.
We consider inflation in more detail in subsequent slide and analyse its
costs in Article Box 10.4 shared with you.
 Key Macroeconomic Variables & Policy Objectives

 Generally, inflation tends to rise in periods of rapid economic growth: firms

respond to the higher demand, partly by raising output, but partly also by
raising prices. Conversely, in a recession, inflation is likely to fall: firms,
faced with falling demand and rising stocks, are likely to be unwilling to
raise prices and may even cut them.
 However, inflationary pressures can occur at any point in the business cycle
from the supply-side. For example, as economies began to ‘open up’ from
the pandemic in 2021–22, economies experienced shortages of key inputs,
and rising energy and transportation costs. Problems were then
exacerbated by the invasion of Ukraine by Russia. Thus, while most
countries had become used to low inflation rates they now began to rise
sharply.
 Key Macroeconomic Variables & Policy Objectives

 Governments in most developed and developing economies (including

India) today have adopted a policy of inflation targeting and delegated the
responsibility for this to its central bank, which controls interest rates to
achieve the mandated inflation target (we consider this in detail in
subsequent slide).
 In India, the target for the CPI inflation rate (growth of consumer prices) is
4% in the medium term. The RBI then adjusts interest rates to try to keep
inflation on target within a band of +/- 2% (i.e., lower limit of 2% and
higher limit of 6%). In the US and the UK, inflation target rate is 2%
(within a band of +/-1%) over the medium term.
 A low and stable rate of inflation, in turn, affects the business climate and
confidence and can help to encourage investment.
 Key Macroeconomic Variables & Policy Objectives

 Foreign trade and global economic relationships: A county’s

macroeconomic environment is influenced both by domestic conditions and
by its economic relationships with other countries. These relationships
evolve as the global economy develops and the world order changes. The
rapid economic growth in economies such as China and India has had a
major effect on patterns of world trade and development.
 Then there is the evolution of international economic co-operation as
countries or groups of countries come together to shape their economic
relationships with each other.
 The balance of payments: One way of viewing the economic relationship
between a country and other economies is through its balance of payments
(BoP) account. This records all transactions between the residents of a
country and the rest of the world (RoW).
 Key Macroeconomic Variables & Policy Objectives

 Credit items include all receipts from other countries (which therefore earn
foreign currency), for example through the sale of exports, from inward
investment expenditure and from interest/dividends earned from abroad.
 Debit items include all payments to other countries (which therefore
represent our demand for foreign currency), for example through the
country’s purchase of imports, investment spending abroad and
interest/dividends paid to foreign investors who invested in the country.
 Governments aim to provide an environment in which exports can grow
without an excessive growth in imports.
 They also aim to make the economy attractive to inward investment.
 Key Macroeconomic Variables & Policy Objectives

 In other words, they seek to create a climate in which the country’s

earnings of foreign currency at least match, or preferably exceed, the
country’s demand for foreign currency: they seek to achieve a favourable
balance of payments.
 [Balance of payments account: A record of the country’s transactions
with the rest of the world. It shows the country’s payments to or deposits in
other countries (debits) and its receipts or deposits from other countries
(credits). It also shows the balance between these debits and credits under
various headings.]
 If we start to spend more foreign currency than we earn, one of two things
must happen.
 Both are likely to be a problem:
 Key Macroeconomic Variables & Policy Objectives

 ■ The balance of payments will go into deficit. In other words, there will
be a shortfall of foreign currencies. The government will therefore have to
borrow money from abroad, or draw on its foreign currency reserves to
make up the shortfall. This is a problem because, if it goes on for too long,
overseas debts will mount, along with the interest that must be paid; and/or
reserves will begin to run low.
 ■ The exchange rate will fall. The exchange rate is the rate at which one
currency exchanges for another. For example, the exchange rate of the
Indian Rupees (INR) into the US Dollar (USD) might be $1 = ₹83 or, ₹1 =
USD 0.012. If the government does nothing to correct the balance of
payments deficit, then the exchange rate must fall: for example, to $1 =
₹90 or, ₹1 = USD 0.011 or lower.
 Key Macroeconomic Variables & Policy Objectives

 A lower exchange rate (i.e. fewer dollars, pound, euros, etc. to the INR or a
weaker or depreciated Rupee) will make Indian goods cheaper to overseas
buyers, and thus help to boost Indian exports.
 A falling exchange rate is a problem, however, because it pushes up the
price of imports and may fuel inflation.
 Also, if the exchange rate fluctuates, this can cause great uncertainty for
traders and can damage international trade and economic growth.
 We consider the balance of payments and exchange rates in more detail
later in the course.
 [Exchange rate: The rate at which one national currency exchanges for
another. The rate is expressed as the amount of one currency that is
necessary to purchase one unit of another currency (e.g. $1 = ₹83).]
 Key Macroeconomic Variables & Policy Objectives

 Financial well-being: It is increasingly recognised that the behaviour of

individuals, businesses, governments and nations is affected by their
financial well-being.
 If consumers and firms are worried about their financial well-being, they
are likely to become more cautious: consumers may hold back on spending
and try to reduce their debts; businesses may be more cautious about
investing.
 If governments are concerned about government debt, they are likely to try
to reduce spending and/or increase taxation.
 The financial system is an integral part of most economies. Financial
markets, financial institutions and financial products have become
increasingly important in determining the economic well-being of nations,
organisations, government and people.
 Key Macroeconomic Variables & Policy Objectives

 The increasing importance of the financial system in everyday lives and to

economies is known as financialisation.
 One indicator of financialisation is the extent to which many of us now
interact with financial institutions and make use of financial products.
 Financialisation is, perhaps, most frequently associated with the levels of
indebtedness of individuals, businesses and organisations to financial
institutions.
 [Financialisation: A term used to describe the process by which financial
markets, institutions and instruments become increasingly significant in
economies.]
 Key Macroeconomic Variables & Policy Objectives

 The importance of financial stability and the problem of financial

distress: A core aim of the government/ policymakers and the central bank
is to ensure the stability of the financial system and the general financial
wellbeing of economic agents (people, firms, government, etc).
 After all, financial markets and institutions are an integral part of
economies. Their well-being is crucial to the well-being of an economy.
 [Economic agents: The general term for individuals, firms, government
and organisations when taking part in economic activities, such as buying,
selling, saving, investing or in any other way interacting with other
economic agents.]
 Key Macroeconomic Variables & Policy Objectives

 This importance of financial markets and institutions was most starkly

demonstrated by the events surrounding the global financial crisis of 2007–
09, when many banks looked as if they might become bankrupt.
 The crisis illustrated how the financial distress of financial institutions can
lead to global economic turmoil.
 Because of the global interconnectedness of financial institutions and
markets, problems can spread globally like a contagion.
 The financial crisis of the late 2000s showed how financially distressed
financial institutions, businesses and households can cause serious
economic upheaval on a global scale and it re-emphasised the importance
of financial stability in creating macroeconomic stability.
 Key Macroeconomic Variables & Policy Objectives

 As we shall see in another slide, a major part of the global response to the
financial crisis has been to try to ensure that financial institutions are more
financially resilient.
 In particular, financial institutions should have more loss-absorbing
capacity and therefore be better able to withstand ‘shocks’ and deteriorating
macroeconomic conditions.
 And it was not just financial institutions that were distressed in the late
2000s, we also witnessed financially distressed households and businesses,
many of whom were burdened by unsustainable levels of debt.
 Subsequently, financial distress was to affect government too, especially in
advanced economies. Governments were burdened by growing levels of
debt as they spent more to offset rapidly weakening private-sector
spending.
 Key Macroeconomic Variables & Policy Objectives

 At the same time, tax revenues fell because of lower or even negative
economic growth. The consequence was a prolonged period during which
many governments felt it necessary to tighten their budgets. And this
constraint on government spending was to put a further brake on economic
growth.
 The financial well-being (or financial health) of a country’s households,
companies and government can be gauged from their two basic financial
accounts, namely, income statement and balance sheet.
 Income statement records the income and expenses of any entity over a
specific time period and its net result: either net profit or net loss.
 Whereas balance sheet is a statement of assets (things owned) and
liabilities (things owed) of an entity as on a particular date and represents
the financial condition of the entity as on the date.
 Key Macroeconomic Variables & Policy Objectives

 To illustrate this, consider what would happen if, over a period of time, you
were to spend more than the income you receive. This would result in your
income account deteriorating.
 To finance your excess spending, you could perhaps draw on savings or
borrow from a bank. Either way, your financial balance sheet will
deteriorate.
 Or you may dispose of some physical assets, such as property, in which
case your capital balance or net woth will deteriorate.
 However excess spending is financed, net worth declines.
 Key Macroeconomic Variables & Policy Objectives

 The importance of balance-sheet effects in influencing behaviour and

economic activity has been increasingly recognised by economists and
policymakers, especially since the global financial crisis of 2007–9.
 The way that economies adjust to shocks, such as the COVID-19 pandemic
or the inflationary spike of 2021-22, can be affected both by the impact of
the shock on the balance sheets and the well-being of economic agents
before the shock.
 KEY IDEA 40: Balance sheets affect people’s behaviour. The size and
structure of governments’, institutions’ and individuals’ liabilities (and
assets too) affect economic well-being and can have significant effects on
behaviour and economic activity.
 Government Macroeconomic Policy Objectives

 From the above issues we can identify seven macroeconomic policy

objectives that governments typically pursue:
 ■ High and stable economic growth;
 ■ Low unemployment;
 ■ Low and stable rate of inflation;
 ■ The avoidance of balance of payments deficits and excessive exchange
rate fluctuations;
 ■ The avoidance of excessively financially-distressed sectors of the
economy, including government;
 ■ An equitable distribution of income and manageable level of debt for
households.
 ■ A stable financial system.
 Government Macroeconomic Policy Objectives

 Unfortunately, these policy objectives may conflict. For example, a policy

designed to accelerate the rate of economic growth may result in a higher
rate of inflation; a balance of payments deficit and excessive borrowing.
 Governments are thus often faced with awkward policy choices illustrating
how societies face trade-offs between economic objectives. All the choices
they make will impact on business.
 In understanding these choices and their implications, it is important to
analyse the determinants of the key issues that shape the macroeconomic
environment.
 Government Macroeconomic Policy Objectives

 KEY IDEA 41: Societies face trade-offs between economic objectives.

For example, the goal of faster growth may conflict with that of greater
equality; the goal of lower unemployment may conflict with that of lower
inflation (at least in the short run). This is an example of opportunity cost:
the cost of achieving more of one objective may be achieving less of
another. The existence of trade-offs means that policymakers must make
choices.
 Summary

 The macroeconomic environment of business is characterised by a

series of interrelated macroeconomic variables. These include:
economic growth, unemployment, inflation, the balance of
payments, exchange rates, the financial well-being of households,
businesses and governments, and the stability of the financial
system.
 Government macroeconomic policy seeks to influence these
variables: e.g. to increase the rate of economic growth and reduce
unemployment. However, the macroeconomic objectives of
governments will often conflict with each other and so, to some
extent, governments will have to prioritise.
 KEY IDEAS
 KEY IDEA 38: The distinction between nominal and real figures.
Nominal figures are those using current prices, interest rates, etc. Real
figures are figures corrected for inflation.
 KEY IDEA 39: Economies suffer from inherent instability. As a result,
economic growth and other macroeconomic indicators tend to fluctuate.
 KEY IDEA 40: Balance sheets affect people’s behaviour. The size and
structure of governments’, institutions’ and individuals’ liabilities (and
assets too) affect economic well-being and can have significant effects on
behaviour and economic activity.
 KEY IDEAS
 KEY IDEA 41: Societies face trade-offs between economic objectives.
For example, the goal of faster growth may conflict with that of greater
equality; the goal of lower unemployment may conflict with that of lower
inflation (at least in the short run). This is an example of opportunity cost:
the cost of achieving more of one objective may be achieving less of
another. The existence of trade-offs means that policymakers must make
choices.
 KEY TERMS

• Nominal and real GDP, Business cycle, Actual and

potential economic growth, Unemployment,
Inflation, Financialisation, Balance sheet effects,
Short-term and Long-term economic growth,
International business cycle

45