The Economic Environment chp 2

The Economic Environment

• The economic environment consists of various factors that influence the financial services sector.
• Economic activity is determined by factors such as natural resources, skilled workforce, and government policies.

Factors Determining Economic Activity

• There are two main categories of factors that affect economic growth: demand-side factors (e.g., consumer spending) and supply-side factors (e.g., productive capacity).
• Governments raise finance for public expenditure through taxes, indirect taxes, and borrowing in the capital markets.

Economic Systems

• There are three main types of economic systems: planned economy, market economy, and mixed economy.
• A planned economy is controlled by the government, which decides what and how to produce.
• A market economy is driven by supply and demand, where businesses produce goods and services to meet consumer demand.
• A mixed economy combines elements of both planned and market economies.

Open Economies

• An open economy has few barriers to trade or controls over foreign exchange.
• Open economies can be either market-oriented or mixed economies.
• The World Trade Organization (WTO) promotes free trade between economies and arbitrates disputes.

The Economic Cycle

• The economic cycle consists of four stages: peak, contraction, trough, and expansion.
• The stages of the economic cycle are characterized by changes in GDP, with peak being the highest point, contraction being the decline, trough being the lowest point, and expansion being the growth phase.
• Fiscal and monetary policies are used to stabilize the economy during the economic cycle.

Fiscal Policy

• Fiscal policy involves government spending and taxation to influence the level of economic activity.
• Fiscal policy can be expansionary (loose) or contractionary (tight), depending on the stage of the economic cycle.
• Tools of fiscal policy include the budget, taxation, and government spending.

Monetary Policy

• Monetary policy regulates the economy through control of the monetary system.
• Monetary policy involves control of the money supply, interest rates, and credit conditions.
• Tools of monetary policy include reserve requirements, interest rates, and credit controls.

Central Banks

• Central banks operate at the center of a nation's financial system.
• Central banks are guided by the Bank for International Settlements (BIS).
• Central banks have responsibilities such as acting as banker to the government, regulating the banking system, and managing the national debt.
• Central banks also influence the value of a nation's currency and provide a depositors' protection scheme.

Macroeconomic Policy

• Macroeconomic policy aims to influence the performance of the economy as a whole.
• Macroeconomic policy objectives include full employment, low inflation, and balance of payments equilibrium.
• Macroeconomic policy tools include fiscal and monetary policy.
• Macroeconomic policy varies depending on the stage of the economic cycle.### Central Banks
• The Federal Reserve System (Fed) in the US:
  • Comprises 12 regional Federal Reserve Banks
  • Monitors banks and provides liquidity
  • Federal Open Market Committee (FOMC) makes decisions to promote price stability and sustainable economic growth
  • Meets every 6 weeks to examine economic data and determine if the Fed funds rate should be altered
• European Central Bank (ECB):
  • Based in Frankfurt
  • Responsible for setting monetary policy for the eurozone
  • Objective is to maintain internal price stability
  • Influences factors that affect inflation, such as the external value of the euro and growth in the money supply
• Bank of England (BoE):
  • Founded in 1694
  • Gained operational independence in 1997
  • Monetary Policy Committee (MPC) sets monetary policy
  • Primary focus is to ensure inflation is kept within a government-set range
• Bank of Japan (BoJ):
  • Founded in 1882
  • Gained operational independence in 1997
  • Responsible for monetary policy and issuing and managing the external value of the Japanese yen

Budget Deficits and National Debt

• Key function of government is to manage public finances
• Key economic indicators: public sector debt (national debt) and budget deficit
• Debt measures are presented as a percentage of GDP
• Budget deficit is the difference between government expenditure and government income
• In a buoyant economy, government spending is less than income, and substantial tax revenues are generated
• In a slowing economy, government spending exceeds tax revenues, and the government must raise borrowing by issuing government bonds

Level of Unemployment

• Extent of unemployment indicates the health of the economy
• Natural rate of unemployment exists due to people seeking new jobs, returning to the workforce, or lacking skills
• Higher levels of unemployment indicate low demand for goods and services and people
• High unemployment levels negatively impact government finances due to increased social security payments and decreased tax revenues

Exchange Rates

• Exchange rate is the price of one currency in terms of another
• Changes in exchange rates affect economic activity and investment decisions
• Appreciation of a currency (e.g., USD) against another currency (e.g., EUR) makes exports cheaper and imports more expensive
• Exchange rate regimes:
  • Fixed rate system: exchange rate is pegged to a particular currency
  • Floating rate system: exchange rate is determined by demand and supply
  • Target zone: exchange rate is managed within a band
  • Crawling peg: exchange rate is gradually adjusted
  • Managed float: exchange rate is largely floating, with occasional intervention

Economic Indicators

• Key indicators:
  • Gross domestic product (GDP)
  • Balance of payments
  • Budget deficit/surplus
  • Level of unemployment
  • Exchange rates
  • Inflation/deflation
• Inflation:
  • Persistent increase in general price levels
  • Caused by excess demand, scarcity of resources, and government spending
  • High levels of inflation can cause problems for businesses, employees, and savers
  • Governments seek to control inflation at a level of about 2-3% per annum
• Deflation:
  • General fall in price levels
  • Can cause high unemployment, reduced spending, and a reluctance to borrow
  • Can lead to a vicious circle of reduced spending and a decreasing burden of debt

Gross Domestic Product (GDP)

• Measures economic activity on an expenditure basis
• Calculated quarterly
• Can be measured in three ways:
  • Total income paid by firms to individuals
  • Individuals' total expenditure on firms' output
  • Value of total output generated by firms
• GDP is the most commonly used measure of a country's output

Inflation Measures

• Consumer price index (CPI) measures changes in prices to estimate the average level of prices in the economy
• CPI is a basket of typical goods and services consumed by households
• Weights are attached to items in the basket reflecting their importance in a typical household budget
• Inflation rate is the percentage change in the latest index compared with the value recorded 12 months previously### Economic Growth
• Long-term productivity growth is dependent on education and training, and the utilization of labor-saving new technology
• The US's long-term trend rate of economic growth has averaged nearly 3%
• Developing economies can experience economic growth rates of up to 10% per annum

The Economic Cycle

• The economic cycle, or business cycle, arises from the deviation of actual growth from trend growth in the short term
• When an economy is growing in excess of its trend growth rate, actual output exceeds potential output, often with inflationary consequences
• When a country's output contracts, it is said to be in recession, or entering a deflationary period, resulting in spare capacity and unemployment

Balance of Payments (BoP)

• The BoP is a summary of all transactions between a country and the rest of the world
• If a country imports more than it exports, there is a BoP deficit, and if it exports more than it imports, there is a BoP surplus

Components of the Balance of Payments

• Trade balance: the difference between the value of imported and exported goods (visible trade balance) and services (invisible trade balance)
• Current account: the total value of goods and services that flow into and out of a country, including trade balance figures, dividends, and remittances
• Capital account: international capital transactions related to investment in business, real estate, bonds, and stocks

Exchange Rates

• The 'right' exchange rate is critical to the level of international trade, international competitiveness, and a country's economic position
• If a country's exchange rate rises, exports will be less competitive, unless producers reduce their prices, and imports will be cheaper and more competitive

Explore the chapter discussing the broader economic environment in the financial services sector. Learn about economic activity determination in different economic and political systems, stages of the economic cycle, government's role in economic policy, and the management of economic activities by governments and central banks.