UNIT 1. Chapter 7. External economic influences on business behaviour

Question 1

Def. Macro economics

Answer 1

The study of entire economy like economic output, inflation, interest rates, or governments policies, rather than individual markets.

Question 2

What do the macro-economics objectives consider? (6)

Answer 2

• Economic growth (GDP)
• Inflation
• Unemployment
• Balance of payments
• Exchange rate stability
• Transfer of wealth

Question 3

Def. GDP

Answer 3

Gross Domestic Product is the total value of goods and services produced in a country in one year - real GDP has been adjusted for inflation.

Question 4

Def. Economic growth

Answer 4

An increase in a country’s productive potential measured by an increase in tis real GDP.

Question 5

Why is economic growth important to countries? (5)

Answer 5

• Increased number of quality goods and services for consumers -> higher living standards
• Increased employment due to higher levels of output, higher consumer income.
• More resources for health and education
• Reduction of absolute poverty
• Higher taxes -> higher income for the government.

Question 6

Def. Business investment

Answer 6

Expenditure by businesses on capital equipment, new technology and research and development.

Question 7

What are the factors that lead to economic growth?

Answer 7

• Increase in output resulting from technological changes and expansion of industrial capacity
• Increase in economic resources, such as higher working population or discovery of new resources of oil and gas.
• Increase in productivity

Question 8

Def. The business cycle

Answer 8

The regular swings in economic activity, measured by real GDP, that occur in most economies, varying from boom conditions to recession when total national output declines.

Question 9

What are the four key stages of the business cycle?

Answer 9

• Boom
• Recession
• Slump
• Growth/ Recovery

Question 10

Explain what happens during the boom period. (3)

Answer 10

• Boom - A period of very fast economic growth with rising incomes and profits.
• Inflation is then caused due to high demand for goods and services -> higher prices -> higher wages are demanded -> higher costs. This causes the recession.
• Governments/central banks increase interests rates to reduce inflationary pressure.

Question 11

Explain what happens during the recession period. (4)

Answer 11

• Recession - A period of declining real GDP. Effect of failing demand and higher interests rates makes the GDP growth slow down.
• Incomes and consumer demand falls -> lower profits.
• Higher unemployment because lower demand -> less workers needed.
• Government tax revenue falls

Question 12

Explain what happens during the slump period. (2)

Answer 12

• Slump - A prolonged recession causes a slump where real GDP falls substantially and prices fall.
• This occurs if the government fails to take corrective economic action.

Question 13

Explain what happens during the recovery period. (2)

Answer 13

• Recovery/Growth is eventually achieved when real GDP starts to increase again.
• This may be because corrective government action takes effect, or rate of inflation falls => the country’s products become competitive and demand starts to increase.

Question 14

Def. Inflation

Answer 14

An increase in the average price level of goods and services. It results from a fall in the value of money.

Question 15

Def. Deflation

Answer 15

A fall in average price level of goods and services.

Question 16

What causes inflation? (2)

Answer 16

• Cost-push causes of inflation: When business face higher costs, they raise prices to keep profits.
• Demand-pull causes of inflation: When the demand rises, producers would raise prices to increase profit margins.

Question 17

The government and central bank policies to control inflation (3)

Answer 17

Cost push inflation:
• High exchange rate -> makes imports cheaper for the business -> less cost push inflation
Demand pull inflation:
• High interest rates -> discourage consumers from borrowing and spending.
• Higher tax rates and reduction of government spending -> Reduces consumer demand as consumers have less disposable income.

Question 18

Benefits of inflation (if the rate is low) (2)

Answer 18

• Value of debts owed by companies will fall because the value of money is falling -> so when they are repaid, they are rapid with money of less value.
• Rising prices means that the value of land and fixed assets is higher -> increases the value of business.

Question 19

Drawbacks of inflation (at high rates) (6)

Answer 19

• Higher wage demands
• Consumers would be more price sensitive
• Higher rates of interest
• Cash flow problems due to higher prices of raw materials etc.
• If inflation is lower in another country, it will lose competitiveness in overseas markets.
• Reluctancy to sell with extended credits periods (because when repaid the value of money is lower).

Question 20

However is deflation beneficial? Effects of deflation

Answer 20

• Consumers delay buying because they’ll wait till the prices become even lower -> lower demand -> falling profits.
• Business are less likely to borrow to invest because the amount borrowed would be of higher value later on.
• Future of profitability of new projects would be doubtful.

Question 21

Def. Unemployment

Answer 21

This exists when members of the working population are willing and able to work, but are unable to find a job.

Question 22

Def. Working population

Answer 22

All those in the population of working age who are willing and able to work.

Question 23

What are the 3 main factors that cause unemployment?

Answer 23

• Cyclical unemployment
• Structural unemployment
• Frictional unemployment

Question 24

Def. Cyclical unemployment

Answer 24

Unemployment resulting from low demand for goods and services in the economy during a period of slow economic growth or a recession. Businesses would need less employees, therefor unemployment rates go up.

Question 25

Def. Structural unemployment

Answer 25

Unemployment cause by the structural decline in important industries, leading to significant job losses in one sector of industry.

Question 26

What are the possible causes of structural unemployment?

Answer 26

• Changes in consumer tastes and expenditure patterns

* Improvement in technology -> employers look for adaptable and multi skilled workers.

Question 27

Def. Frictional unemployment

Answer 27

Unemployment resulting from workers losing or leaving jobs and taking a substantial period of time to find alternative employment.

Question 28

Government policies towards cyclical unemployment (2)

Answer 28

• The government tries to keep inflation low in order to avoid recession
• The government would try to keep the rate of exchange competitive so that level of exports wouldn’t fall which would cause unemployment.

Question 29

Government policies towards structural unemployment (1)

Answer 29

• Government can provide education and training programmes

Question 30

Government policies towards frictional unemployment (1)

Answer 30

• Government can have better provision of job opportunities by establishing or supporting job centres.

Question 31

What is the cost of unemployment? (5)

Answer 31

• Opportunity costs as the economy could be producing more goods and services.
• Costs of supporting unemployed workers and their families
• Unemployment may lead to social problems such as crime.
• Lower disposable income, so lower demands
• Lower living standards

Question 32

Def. Balance of payment (current account)

Answer 32

This account records the value of trade in goods and services between one country and the rest of the world. A deficit means that the value of goods and services imported exceeds the value of goods and services exported.

Question 33

Def. Imports

Answer 33

Goods and services purchased from other countries

Question 34

Def. Exports

Answer 34

Goods and services sold to consumers and business in other countries.

Question 35

Why is it bad for economy to have a large and persistent deficit? How can the government prevent it? (2 1)

Answer 35

It would cause:
• A fall or depreciation in the value of its currency’s exchange rate
• An unwillingness of foreign investors to put money into the economy.

The government can prevent it by: Limiting foreign exchange or putting barriers such as tariffs or quotas.

Question 36

Def. Exchange rate

Answer 36

The price of one currency in terms of another

Question 37

Def. Exchange rate depreciation

Answer 37

A fall in the external value of a currency as measure by its exchange rate against other currencies. E.g. if a dollar depreciated, it means that a dollar would equal less pounds.

Question 38

Def. Exchange rate appreciation

Answer 38

A rise in the external value of a currency as measured by its exchange rate against other currencies.

Question 39

What are the demand and supply of the currency? (3 3)

Answer 39

Demand:
• Foreign buyers of domestic goods and services
• Foreign tourists spending money in the country
• Foreign investors
Supply:
• Domestic businesses buying foreign imports
• Domestic population travelling abroad
• Domestic investors abroad

Question 40

Benefits and drawbacks of appreciation of currency to domestic firms

Answer 40

Benefits:
• Imports of raw materials are cheaper
• Reduces the rates of inflation in the economy
Drawbacks:
• Exports of goods and services are more expensive -> less competitive
• Imported products are cheaper, so are more competitive against the domestic products.

Question 41

Benefits and drawback of depreciation of currency to domestic firms

Answer 41

Benefits:
• Prices of exports are more competitive overseas -> higher export value -> easier to expand overseas
• Business that sell domestically will experience less competition against imported goods and services.
Drawbacks:
• Businesses that rely on imported raw materials experience higher costs
• Retailers selling imported goods would also have to raise their prices.

Question 42

Def. Fiscal policy

Answer 42

Is concerned with decisions about government expenditure, tax rates and government borrowing. These operate largely through the government’s annual budget decisions.

Question 43

Def. Government budget deficit

Answer 43

The value of government spending exceeds revenue from taxation.

Question 44

Def. Government budget surplus

Answer 44

Taxation revenue exceeds the value of government spending.

Question 45

Scenario 1. The economy is in recession and unemployment is rising. What would the government do?

Answer 45

• Increase in government expenditure plans, such as school construction to create jobs.
• Reduce taxes to increase the value of disposable income of consumers, which should encourage spending.

Question 46

Scenario 2. The economy is booming and is in danger of overheating.

Answer 46

• Reduce government spending
• Raise tax rates

pg. 125

Question 47

Def. Monetary policy

Answer 47

is concerned with decisions about the rate of interest and the supply of money in the economy.

Question 48

How would higher interest rates affect businesses?

Answer 48

• Increases interest costs and reduces profits for businesses that have very high debts
• Reduces consumer borrowing and this reduces demand for goods bought on credit
• Tends to lead to an appreciation of the country’s exchange rate because higher domestic interests encourage overseas capital to flow into the country.

Question 49

Extra: Why does higher domestic interest rates lead to an appreciation of the country’s exchange rate?

Answer 49

Because with higher interest rates, more foreign investors (speculators) would want to leave their capital on deposit in domestic banks. To do so, they would have to convert into the domestic currency, hence raising the demand for it -> higher exchange rate value.

Question 50

What are the 3 exchange rate policies?

Answer 50

• ‘Fixed’ exchange rate: set firmly by the monetary authority with respect to a foreign currency.
• ‘Floating’ exchange rate: determined in foreign exchange markets depending on demand and supply, and it generally fluctuates constantly.
• Joining a common currency e.g. euro

Question 51

Drawbacks of floating rates - benefits of joining the common currency ( 3 (3) (2) )

Answer 51

1. Frequent appreciation and depreciation of a currency against others causes problems such as:
   + Fluctuating prices of raw materials, making costing difficult.
   + Fluctuations in export prices make unstable level of demand.
   + Uncertainty over profits earned.
2. Hard to make plans to purchase goods from abroad because costs would fluctuate.
3. Having different exchange rates adds to cost by:
   + Commission costs to banks to convert currencies
   + ‘Contracts’ to ensure the risks of dealing overseas can be expensive.

Question 52

Claimed advantages of floating rates - or reasons for not joining a common currency (2)

Answer 52

1. Replacing the currency with a common currency will lead to common tax policies -> reduces independence of each government to control its own taxes.
2. By joining a common currency, there would be one rate of interest across that currency zone, but the interest rate could be too high for some economies and too low for others.

Question 53

What are ‘supply side’ policies?

Answer 53

Government policies that aim to increase industrial competitiveness to improve the supply efficiency of the economy.

Question 54

Examples of supply side policies?

Answer 54

• Low rates of income tax: With high taxes rates, employees or entrepreneurs would feel demotivated to work hard and gain promotion because they don’t get their full ‘award’.
• Low rate of corporation tax: Lower tax on net profit which could be reinvested into the business.
• Increase labour market flexibility and labour productivity by:
+ Subsidies for worker training programmes
+ Increased funding for higher education
+ Lower rates of income tax to encourage workers to take the risk of setting up their own businesses

Question 55

Def. Market failure

Answer 55

When markets fail to achieve the most efficient allocation of resources and there is under or overproduction of certain goods and services.

Question 56

What are the 3 market failures?

Answer 56

• External costs: e.g. pollution resulting from manufacturing, noise pollution.
• Labour training: Many firms do not provide sufficient training for the employees -> shortage of skilled workers.
• Monopoly producers: exploiting consumers, or preventing other business to enter the market.

Question 57

Def. External costs

Answer 57

Costs of an economic activity that are not paid for by the product or consumer, but by the rest of society e.g. pollution from manufacturing process

Question 58

What are the policies used in order to correct the external influences? (2)

Answer 58

• Regulatory policies: The rules established by the government (law).
• Market based policies: Policies designed to manipulate markets, prices, and incentives to correct market failures.

Question 59

Def. Income elasticity of demand

Answer 59

Measures the responsiveness of demand for a product after a change in consumer incomes.

Income elasticity of demand = % change in demand of the product / % change in consumer incomes.

Question 60

Income elasticity can be describes for which types of goods? (3)

Answer 60

• Normal goods: Between 0 and 1. These are essential goods, that the sales wouldn’t fluctuate a lot if the consumer incomes were to rise or drop. e.g. bread.
• Luxury goods: >1. These are expensive but preferred alternative goods, which cannot be afforded when incomes are low. Eg. Computers.
• Inferior goods: Negative ( <0) These are products that have higher demand when consumer income drops. E.g. second hand furniture.