IOC: The Economic Environment

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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:

  1. mechanism for paying - goods/services/assets
  2. intermediary between borrowers/savers - investments: debt/equity
  3. 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

CirculrFlowIncome.jpg

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