IOC: The Economic Environment
Factors Determining Economic Activity
Levels of market activity 4
1 State Controlled Economies
- AKA Planned economies
Government decides on what is produced and how distributed
Excessive bureaucracy + removes choice
2 Market Economies
Supply and demand - determines resource allocation
- Market clearing price
- Price customer willing to pay - balanced against price supplier willing to accept
- High price - attracts suppliers
- Low price - suppliers leave market
market:
- goods
- productive assets - labour - wages
- money - interest rate
- machinery - capital goods
3 Mixed Economies
Market economy + state control - vast majority
state control:
- welfare, defence, police, education, public transport, health
Governments finance
- direct taxing - companies + wages
- indirect tax - VAT, petrol, alcohol
- borrowing on capital markets
Civil servants- raising + allocating spending - largest labour market
4 Open Economies
Few barriers to trade/controls over foreign exchange
- Barriers
- Sanctions - prevention of free trade
- Protectionism - preservation of domestic market
World trade organisation - WTO - promote free trade - arbitrate disputes
Central Banks
Government manage - Taxation/economic + monetary policy
- Stabilisation policies
- Fiscal policy - Governments spending + taxation
- Monetary policy - Interest rages + money supply
Implement policies using central banks
Role
| BoE | Role |
|---|---|
| Y | Public body increasingly independent of government |
| Y | Banker to baking system - accept deposits/lend |
| Y | Banker to government |
| N Debt Management Office (DMO) | Manage national debt |
| Y Prudential Regulatory Authority (PRA) | Regulate domestic banking system |
| Y | Lender of last resort - prevent collapse |
| Y Monetary Policy Committee (MPC) | Set short term rate of interest |
| Y | Control money supply |
| Y | Issue notes/coins |
| Y | Hold nations gold/foreign reserves |
| Y | Influence currency - intervention in currency markets |
| N Financial Services Compensation Scheme (FSCS) | Provide deposit protection |
Bank of England
Founded 1694
Purpose
Monetary stability
stable prices => confidence in currency
- Monetary policy committee MPC
- set interest rates
- ensure inflation kept within government set range
Gauge inflation factors:
- Economic exchange rage
- Economic growth
- Government spending/taxing plans
- Customers borrowing/spending
- Wage inflation
9 members including - Governor of BoE + Four members appointed by the Chancellor of the Exchequer
meet every month
Financial stability
- Detect and reduce risks to financial system
- Macro financial policy
- Set by financial policy committee
- Supervision and oversight
Inflation target - 2% (CPI) - controlled via base rate
Quantitative Easing
Low inflation - normally cut base rate to provide stimulus, when base rate close to zero, another mechanism required
Inject money directly into economy = quantitative easing
Government bonds - high quality debt - creates money (Not printing)
Effects:
- seller of bonds - more money to spend
- buy assets
- boost prices/boost liquidity
- higher asset prices, lower yields -> reduced cost of borrowing
- banks have more reserves -> can lend more -> spending increases
Theory: extra money goes though economy
Financial Stability
Maintain 3 vital functions:
- mechanism for paying - goods/services/assets
- intermediary between borrowers/savers - investments: debt/equity
- insuring against/dispensing risk
4/2013 reform
- new committees:
- Prudential Regulation Authority (part of BoE) - supervision of banks + infrastructure - e.g. London Clearing House
- Financial Conduct Authority (Not part of BoE)
Federal Reserve FED (1913)
comprises 12 regional federal reserve banks - each monitor + provide liquidity to banks in their region
- Free from political interference
Governed & Monetary policy determined by:
Federal Open Market Committee FOMC
Made up of:
- Board of seven appointed by US president
- President of 12 Federal Reseve banks
- Chairman appointed by US president
Responsible for:
- Provide price stability
- Sustain economic growth
- Meets every 6 weeks - can have emergency session outside
- Lenders of last resort - rescue banks
- Prevent panic/systemic risk
European Central Bank - 1/1999 Euro creation
- Based in Frankfurt
- Monetary policy for entire Eurozone
- Objective
- maintain price stability
- Keep inflation close but below 2% - Harmonised Index of Consumer Prices (== CPI)
President + Council (3 Governors for each eurozone national central bank)
Supposedly independent of EU Government - has succumbed to political pressure
Only during recent crises has acted as lender of last resort
Inflation
Persistent increase in general level of prices
Price increase - caused by -> excess demand, scarce resource, increased government spending.
- Credit creation
- Buying "on credit" - buy and pay later
- re-lend % of money deposited - money used to buy -> savings -> relent
- 96% of money comes from credit creation
- 4% from notes/coins
too much increase in supply -> too much money chasing too few goods
Restrict creation though interest rate controls - BoE Monetary Policy Committee
Impact of inflation
- Problems
- continually adjusting prices
- value of salaries/pensions eroded
- exports less attractive
- future values - pensions/investments - difficult to assess
- Advantages
- Raising house prices
- Borrowers debt value eroded
- National debt eroded
Key economic indicators
Health of economy - long term investment decision aid
Inflation measures
- National basket of average person
- Wages/government benefits
Consumer Price Index CPI = synonym = Harmonised index of consumer prices HICP
Geometric mean
- EU standard - excludes mortgages - EU largely rent
- Excludes house depreciation - cost of upkeep
Retail Price Index AKA Headline Rate
- Includes mortgages/rent + food + transport + entertainment
- representative average - excludes pensions & top 4% - has changed since inception
CPI used for inflation to compare with Europe
Measures
- Total income paid to individuals by firms
- Total expenditure on firms output
- Value of total from firms
GDP - Quarterly
= Consumer spending + Government spending + Investments + Exports - Imports
Economic growth - Economic cycle
Trend of growth - sustainable growth
- growth and productivity of labour force
- rate of new innovative technology - replace obsolete - from effective investment - domestic/overseas
- infrastructure maintenance/growth - transport, communication, energy
Mature economy
Labour 1% growth, overall UK ~1.25, US ~1.75