Business organisations operate in an economic environment which shapes, and is shaped by, their activities. In market-based economies this environment comprises variables which are dynamic, interactive and mobile and which, in part, are affected by government in pursuit of its various roles in the economy. As a vital component in the macro economy, government exercises a significant degree of influence over the flow of income and hence over the level and pattern of output by the public and private sectors. Other key influences include a country’s financial institutions and the international economic organizations and groupings to which it belongs or subscribes.
Business activity not only is shaped by the economic context in which it takes place, but helps to shape that context; consequently the success or otherwise of government economic policy depends to some degree on the reactions of both the firms and the markets (e.g. the stock market) which are affected by government decisions. The economic influences operate at different levels and this can affect businesses either favourably or adversely.
The concept of economic scarcity
Like politics, the term economic tends to be used in a variety of ways and contexts to describe certain aspects of human behaviour, ranging from activities such as producing, distributing and consuming, to the idea of frugality in the use of a resource (e.g. being ‘economical’ with the truth). Modern definitions stress how such behaviour, and the institutions in which it takes place (e.g. households, firms, governments, banks), are concerned with the satisfaction of human needs and wants through the transformation of resources into goods and services which are consumed by society. These processes are said to take place under conditions of economic scarcity.
The economist’s idea of ‘scarcity’ centres on the relationship between a society’s needs and wants and the resources available to satisfy them. In essence, economists argue that whereas needs and wants tend to be unlimited, the resources which can be used to meet those needs and wants are finite and accordingly no society at any time has the capacity to provide for all its actual or potential requirements. The assumption here is that both individual and collective needs and wants consistently outstrip the means available to satisfy them, as exemplified, for instance, by the inability of governments to provide instant health care, the best roads, education, defence, railways, and so on, at a time and place and of a quality convenient to the user. This being the case, ‘choices’ have to be made by both individuals and society concerning priorities in the use of resources, and every choice inevitably involves a ‘sacrifice’ (i.e. forgoing an alternative). Economists describe this sacrifice as the opportunity cost or real cost of the decision that is taken (e.g. every Naira spent on the health service is a Naira not spent on some other public service) and it is one which is faced by individuals, organisations (including firms), governments and society alike.
From a societal point of view the existence of economic scarcity poses three serious problems concerning the use of resources:
In practice, of course, these problems tend to be solved in a variety of ways, including barter (voluntary, bilateral exchange), price signals and the market queuing and rationing, government instruction and corruption (e.g. resources allocated in exchange for personal favours), and examples of each of these solutions can be found in most, if not all, societies, at all times. Normally, however, one or other main approach to resource allocation tends to predominate and this allows analytical distinctions to be made between different types of economic system. One important distinction is between those economies which are centrally planned and those which operate predominantly through market forces, with prices forming the integrating mechanism. Understanding this distinction is fundamental to an examination of the way in which business is conducted and represents the foundation on which much of the subsequent analysis is built.
The centrally planned economy
In this type of economic system – associated with the post – Second World War socialist economies of Eastern Europe, China, Cuba and elsewhere – most of the key decisions on production are taken by a central planning authority, normally the state and its agencies. Under this arrangement, the state typically:
The fact that an economy is centrally planned does not necessarily imply that all economic decisions are taken at central level; in many cases decision making may be devolved to subordinate agencies, including local committees and enterprises. Ultimately, however, these agencies are responsible to the centre and it is the latter which retains overall control of the economy and directs the use of scarce productive resources.
The problem of coordinating inputs and output in a modern planned economy is, of course, a daunting task and one which invariably involves an array of state planners and a central plan or blueprint normally covering a number of years (e.g. a five-year plan). Under such a plan, the state planners would establish annual output targets for each sector of the economy and for each enterprise within the sector and would identify the inputs of materials, labour and capital needed to achieve the set targets and would allocate resources accordingly. Given that the outputs of some industries (e.g. agricultural machinery) are the inputs of others (e.g. collective farms), it is not difficult to see how the overall effectiveness of the plan would depend in part on a high degree of co-operation and co-ordination between sectors and enterprises, as well as on good judgment, good decisions and a considerable element of good luck. The available evidence from planned economies suggests that none of these can be taken for granted and each is often in short supply.
Even in the most centralized economies, state planning does not normally extend to telling individuals what they must buy in shops or how to use their labour, although an element of state direction at times may exist (e.g. conscription of the armed forces). Instead, it tends to condition what is available for purchase and the prices at which exchange takes place, and both of these are essentially the outcome of political choices, rather than a reflection of consumer demands. All too often consumers tend to be faced by queues and ‘black markets’ for some consumer products and overproduction of others, as state enterprises strive to meet targets frequently unrelated to the needs and wants of consumers. By the same token, businesses which make losses do not have to close down, as the state would normally make additional funds available to cover any difference between sales revenue and costs. This being the case, the emphasis at firm level tends to be more on meeting targets than on achieving efficiency in the use of resources and hence a considerable degree of duplication and wastage tends to occur.
In such an environment, the traditional entrepreneurial skills of efficient resource management, price setting and risk taking have little, if any, scope for development and managers behave essentially as technicians and bureaucrats, administering decisions largely made elsewhere. Firms, in effect, are mainly servants of the state and their activities are conditioned by social and political considerations, rather than by the needs of the market – although some market activity normally occurs in planned economies (especially in agriculture and a number of private services). Accordingly, businesses and their employees are not fully sensitised to the needs of the consumer and as a result quality and choice (where it exists) may suffer, particularly where incentives to improved efficiency and performance are negligible. Equally, the system tends to encourage bribery and corruption and the development of a substantial black market, with differences in income, status and political influence being an important determinant of individual consumption and of living standards.
The free-market economy
The free-market (or capitalist) economy stands in direct contrast to the centrally planned system. Whereas in the latter the state controls most economic decisions, in the former the key economic agencies are private individuals (sometimes called ‘households’) and firms, and these interact in free markets, through a system of prices, to determine the allocation of resources. The key features of this type of economic system are as follows:
In short, the three problems of what to produce, how to produce and how to distribute are solved by market forces.
The diagram below illustrates the basic operation of a market economy. In essence, individuals are owners of resources (e.g. labour) and consumers of products; firms are users of resources and producers of products. What products are produced – and hence how resources are used – depends on consumers, who indicate their demands by purchasing (i.e. paying the price) or not purchasing, and this acts as a signal to producers to acquire the resources necessary (i.e. pay the price) to meet the preferences of consumers. If consumer demands change, for whatever reason, this will cause an automatic reallocation of resources, as firms respond to the new market conditions. Equally, competition between producers seeking to gain or retain customers is said to guarantee that resources are used efficiently and to ensure that the most appropriate production methods (i.e. how to produce) are employed in the pursuit of profits.
The distribution of output is also determined by market forces, in this case operating in the markets for productive services. Individuals supplying a resource (e.g. labour) receive an income (i.e. a price) from the firms using that resource and this allows them to purchase goods and services in the markets for products, which in turn provides an income for firms that can be spent on the purchase of further resources. Should the demand for a particular type of productive resource increase – say, as a result of an increase in the demand for the product produced by that resource – the price paid to the provider of the resource will tend to rise and hence, other things being equal, allow more output to be purchased. Concomitantly, it is also likely to result in a shift of resources from uses which are relatively less lucrative to those which are relatively more rewarding.
In practice, of course, no economy operates entirely in the manner suggested above; firms after all are influenced by costs and supply decisions as well as by demand and generally seek to shape that demand, as well as simply responding to it. Nor for that matter is a market-based economy devoid of government involvement in the process of resource allocation, as evidenced by the existence of a public sector responsible for substantial levels of consumption and output and for helping to shape the conditions under which the private sector operates. In short, any study of the market economy needs to incorporate the role of government and to examine, in particular, its influence on the activities of both firms and households.
The Macroeconomic Levels of analysis
Economics is concerned with the study of how society deals with the problem of scarcity and the resultant problems of what to produce, how to produce and how to distribute. Within this broad framework the economist typically distinguishes between two types of analysis:
The microeconomic approach is exemplified by the analysis of markets and prices which shows, for example, how individual consumers in the market for beer might be affected by a price change. This analysis could be extended to an investigation of how the total market might respond to a movement in the price, or how a firm’s (or market’s) decisions on supply are affected by changes in wage rates or production techniques or some other factor. Note that in these examples, the focus of attention is on decision-taking by individuals and firms in a single industry, while interactions between this industry and the rest of the economy are ignored: in short, this is what economists call a ‘partial analysis’.
In reality, of course, all sectors of the economy are interrelated to some degree. A pay award, for example, in the beer industry (or in a single firm) may set a new pay norm that workers in other industries take up and these pay increases may subsequently influence employment, production and consumer demand in the economy as a whole, which could also have repercussions on the demand for beer. Sometimes such repercussions may be relatively minor and so effectively can be ignored. In such situations the basic microeconomic approach remains valid.
In contrast, macroeconomics recognises the interdependent nature markets and studies the interaction in the economy as a whole, dealing with such questions as the overall level of employment, the rate of inflation, the percentage growth of output in the economy and many other economy-wide aggregates – exemplified, for instance, by the analysis of international trade and by the macroeconomic model. It should be pointed out, however, that while the distinction between the micro and macro approaches remains useful for analytical purposes, in many instances the two become intertwined
The ‘Flows’ of Economic Activity
Economic activity can be portrayed as a flow of economic resources into firms (i.e. productive organisations), which are used to produce output for consumption, and a corresponding flow of payments from firms to the providers of those resources, who use them primarily to purchase the goods and services produced. These flows of income and expenditure accordingly represent the fundamental activities of an economy at work. The Figure below illustrates the flow of resources and of goods and services in the economy – what economists describe as real flows.
In effect, firms use economic resources to produce goods and services, which are consumed by private individuals (private domestic consumption) or government (government consumption) or by overseas purchasers (foreign consumption) or by other firms (capital formation). This consumption gives rise to a flow of expenditures that represents an income for firms, which they use to purchase further resources in order to produce further output for consumption. This flow of income and expenditures is shown in the next figure (income flows in the economy).
The interrelationship between income flows and real flows can be seen by combining the two diagrams into one, which for the sake of simplification assumes only two groups operate in the economy: firms as producers and users of resources, and private individuals as consumers and providers of those resources. Real flows are shown by the arrows moving in an anti-clockwise direction, income flows by the arrows flowing in a clockwise direction.
Despite a degree of over-simplification, the model of the economy illustrated in the above figure is a useful analytical tool which highlights some vitally important aspects of economic activity which are of direct relevance to the study of business. The model shows, for example, that:
From the point of view of firms, it is clear from the model that their fortunes are intimately connected with the spending decisions of households and any changes in the level of spending can have repercussions for business activity at the micro as well as the macro level. In the late 1980s, for instance, the British economy went into recession, largely as a result of a reduction in the level of consumption that was brought about by a combination of high interest rates, a growing burden of debt from previous bouts of consumer spending, and a decline in demand from some overseas markets also suffering from recession. While many businesses managed to survive the recession, either by drawing from their reserves or slimming down their operations, large numbers of firms went out of business, as orders fell and costs began to exceed revenue. As a result, output in the economy fell, unemployment grew, investment by firms declined, and house prices fell to a point where some house owners owed more on their mortgage than the value of their property (known as ‘negative equity’). The combined effect of these outcomes was to further depress demand, as individuals became either unwilling or unable to increase spending and as firms continued to shed labour and to hold back on investment. By late 1992, few real signs of growth in the economy could be detected, unemployment stood at almost 3 million, and business confidence remained persistently low, (Worthington, and Britton, 2009).
The gradual recovery of the British economy from mid-I993 – brought about by a return in consumer confidence in the wake of a cut in interest rates – further emphasises the key link between consumption and entrepreneurial activity highlighted in the model. Equally, it shows, as did the discussion on the recession, that a variety of factors can affect spending (e.g. government policy on interest rates) and that spending by households is only one type of consumption in the real economy. In order to gain a clearer view of how the economy works and why changes occur over time, it is necessary to refine the basic model by incorporating a number of other key variables influencing economic activity. These variables – which include savings, investment spending, government spending, taxation and overseas trade – are discussed below.
Changes in Economic Activity
The level of spending by consumers on goods and services produced by indigenous firms is influenced by a variety of factors. For a start, most households pay tax on income earned, which has the effect of reducing the level of income available for consumption. Added to this, some consumers prefer to save (i.e. not spend) a pro- portion of their income or to spend it on imported products, both of which mean that the income of domestic firms is less than it would have been had the income been spent with them. Circumstances such as these represent what economists call a leakage (or withdrawal) from the circular flow of income and help to explain why the revenue of businesses can fluctuate over time.
At the same time as such ‘leakages’ are occurring, additional forms of spending in the economy are helping to boost the potential income of domestic firms. Savings by some consumers are often borrowed by firms to spend on investment in capital equipment or plant or premises (known as investment spending) and this generates income for firms producing capital goods. Similarly, governments use taxation to spend on the provision of public goods and services (public or government expenditure) and overseas buyers purchase products produced by indigenous firms (export spending). Together, these additional forms of spending represent an injection of income into the circular flow.
While the revised model of the economy illustrated in the Figure is still highly simplified (e.g. consumers also borrow savings to spend on consumption or imports; firms also save and buy imports; governments also invest in capital projects), it demonstrates quite clearly that fluctuations in the level of economic activity are the result of changes in a number of variables, many of which are outside the control of firms or governments. Some of these changes are autonomous (i.e. spontaneous), as in the case of an increased demand for imports, while others may be deliberate or overt, as when the government decides to increase its own spending or to reduce taxation in order to stimulate demand. Equally, from time to time an economy may be subject to ‘external shocks’, such as the onset of recession among its principal trading partners or a significant price rise in a key commodity (e.g. the recent oil price in 2014/15), which can have an important effect on internal income flows. Taken together, these and other changes help to explain why demand for goods and services constantly fluctuates and why changes occur not only in an economy’s capacity to produce output, but also in its structure and performance over time.
It is important to note that where changes in spending do occur, these invariably have consequences for the economy that go beyond the initial ‘injection’ or ‘withdrawal’ of income. For example, a decision by government to increase spending on infrastructure would benefit the firms involved in the various projects and some of the additional income they receive would undoubtedly be spent on hiring labour. The additional workers employed would have more income to spend on consumption and this would boost the income for firms producing consumer goods, which in turn may hire more staff, generating further consumption and so on. In short, the initial increase in spending by government will have additional effects on income and spending in the economy, as the extra spending circulates from households to firms and back again. Economists refer to this as the multiplier effect to emphasis the reverberative consequences of any increase or decrease in spending by consumers, firms, governments or overseas buyers.
Multiple increases in income and consumption can also give rise to an ‘accelerator effect, which is the term used to describe a change in investment spending by firms as a result of a change in consumer spending. In the example above it is possible that the increase in consumption caused by the increase in government spending may persuade some firms to invest in more stock and capital equipment to meet increased consumer demands. Demand for capital goods will therefore rise, and this could cause further increases in the demand for industrial products (e.g. components, machinery) and also for consumer goods, as firms seek to increase their output to meet the changing market conditions. Should consumer spending fall, a reverse accelerator may occur and the same would apply to the multiplier as the reduction in consumption reverberates through the economy and causes further cuts in both consumption and investment. As Peter Donaldson has suggested, everything in the economy affects everything else; the economy is dynamic, interactive and mobile and is far more complex than implied by the model used in the analysis above.
Government and The Macroeconomic:
Objectives Notwithstanding the complexities of the real economy, the link between business activity and spending is clear to see. This spending, as indicated above, comes from consumers, firms, governments and external sources and collectively can be said to represent total demand in the economy for goods and services. Economists frequently indicate this with the following notation:
Within this equation, consumer spending (C) is regarded as by far the most important factor in determining the level of total demand.
While economists might disagree about what are the most significant influences on the component elements of AMD, it is widely accepted that governments have a crucial role to play in shaping demand, not only in their own sector but also on the market side of the economy. Government policies on spending and taxation, or on interest rates, clearly have both direct and indirect influences on the behaviour of individuals and firms, which can affect both the demand and supply side of the economy in a variety of ways. Underlying these policies are a number of key objectives which are pursued by government as a prerequisite to a healthy economy and which help to guide the choice of policy options. Understanding the broad choice of policies available to government, and the objectives associated with them, is of prime importance to students of the business environment.
Most governments appear to have a number of key economic objectives, the most important of which are normally the control of inflation, the pursuit of economic growth, a reduction in unemployment, the achievement of an acceptable balance of payments situation, controlling public (i.e. government) borrowing, and a relatively stable exchange rate.
The Economic Conditions
Important economic conditions such as inflation, economic growth, unemployment, balance of payments are some of the economic factors in the economic environment that affect business organization operations. In what follows, we shall briefly discuss some of these factors.
Inflation is usually defined as an upward and persistent movement in the general level of prices over a given period of time; it can also be characterized as a fall in the value of money. For governments reducing such movements to a minimum is seen as a primary economic objective. Explanations as to why prices tend to rise over time vary considerably, but broadly speaking fall into two main categories. First, supply-siders tend to focus on rising production costs – particularly wages, energy and imported materials – as a major reason for inflation, with firms passing on increased costs to the consumer in the form of higher wholesale and/or retail prices. Second, excessive demand in the economy, brought about, for example, by tax cuts, cheaper borrowing or excessive government spending, which encourages firms to take advantage of the consumer’s willingness to spend money by increasing their prices. Where indigenous firms are unable to satisfy all the additional demand, the tendency is for imports to increase. This may not only cause further price rises, particularly if imported goods are more expensive or if exchange rate movements become unfavourable, but also can herald a deteriorating balance of payments situation and difficult trading conditions for domestic businesses.
Government concern with inflation – which crosses both party and state boundaries – reflects the fact that rising price levels can have serious consequences for the economy in general and for businesses in particular, especially if a country’s domestic inflation rates are significantly higher than those of its main competitors. In markets where price is an important determinant of demand, rising prices may result in some businesses losing sales, and this can affect turnover and may ultimately affect employment if firms reduce their labour force in order to reduce their costs. Added to this, the uncertainty caused by a difficult trading environment may make some businesses unwilling to invest in new plant and equipment, particularly if interest rates are high and if inflation looks unlikely to fall for some time. Such a response, while understandable, is unlikely to improve a firm’s future competitiveness or its ability to exploit any possible increases in demand as market conditions change.
Rising prices may also affect businesses by encouraging employees to seek higher wages in order to maintain or increase their living standards. Where firms agree to such wage increases, the temptation, of course, is to pass this on to the consumer in the form of a price rise, especially if demand looks unlikely to be affected to any great extent. Should this process occur generally in the economy, the result may be a wages/prices inflationary spiral, in which wage increases push up prices which push up wage increases which further push up prices and so on. From an international competitive point of view, such an occurrence, if allowed to continue unchecked, could be disastrous for both firms and the economy.
Growth is an objective shared by governments and organisations alike. For govern- ments, the aim is usually to achieve steady and sustained levels of non-inflationary growth, preferably led by exports (i.e. export-led growth). Such growth is normally indicated by annual increases in real national income or gross domestic product (where = real‘ = allowing for inflation, and ‘gross domestic product (GDP)‘ = the economy’s annual output of goods and services measured in monetary terms).2 To compensate for changes in the size of the population, growth rates tend to be expressed in terms of real national income per capita (i.e. real GDP divided by population).
Exactly what constitutes desirable levels of growth is difficult to say, except in very broad terms. If given a choice, governments would basically prefer:
It is worth remembering that, when measured on a monthly or quarterly basis, increases in output can occur at a declining rate and GDP growth can become nega- tive. From a business point of view, the fact that increases in output are related to increases in consumption suggests that economic growth is good for business prospects and hence for investment and employment, and by and large this is the case. The rising living standards normally associated with such growth may, however, encourage increased consumption of imported goods and services at the expense of indigenous producers, to a point where some domestic firms are forced out of business and the economy’s manufacturing base becomes significantly reduced (often called deindustrialisation). Equally, if increased consumption is based largely on excessive state spending, the potential gains for businesses may be offset by the need to increase interest rates to fund that spending (where government borrowing is involved) and by the tendency of government demands for funding to crowd out the private sector’s search for investment capital. In such cases, the short-term benefits from government induced consumption may be more than offset by the medium- and long-term problems for the economy that are likely to arise.
Where growth prospects for the economy look good, business confidence tends to increase, and this is often reflected in increased levels of investment and stock holding and ultimately in levels of employment.
In most democratic states the goal of full employment is no longer part of the political agenda as this can hardly be achieved, instead government pronouncements on employment tend to focus on job creation and maintenance and on developing the skills appropriate to future demands. The consensus seems to be that in technologically advanced market based economies some unemployment is inevitable and that the basic aim should be to reduce unemployment to a level which is both politically and socially acceptable. As with growth and inflation, unemployment levels tend to be measured at regular intervals (e.g. monthly, quarterly, annually) and the figures are often adjusted to take into account seasonal influences (e.g. school-leavers entering the job market). In addition, the statistics usually provide information on trends in long-term unemployment, areas of skill shortage and on international comparisons, as well as sectoral changes within the economy. All of these indicators provide clues to the current state of the economy and to the prospects for businesses in the coming months and years, but need to be used with care. Unemployment, for example, tends to continue rising for a time even when a recession is over; equally, it is not uncommon for government definitions of unemployment to change or for international unemployment data to be based on different criteria.
The broader social and economic consequences of high levels of unemployment are well documented: it is a waste of resources, it puts pressure on the public services and it is frequently linked with growing social and health problems. Its implication for businesses, however, tends to be less clear-cut. On the one hand, a high level of unemployment implies a pool of labour available for firms seeking workers (though not necessarily with the right skills), generally at wage levels lower than when a shortage of labour occurs. On the other hand, it can also give rise to a fall in overall demand for goods and services which could exacerbate any existing deflationary forces in the economy, causing further unemployment and with it further reductions in demand. Where this occurs, economists tend to describe it as cyclical unemployment (i.e. caused by a general deficiency in demand) in order to differentiate it from unemployment caused by a deficiency in demand for the goods produced by a particular industry (structural unemployment) or by the introduction of new technology which replaces labour (technological unemployment).
Balance of Payments A country’s balance of payments is essentially the net balance of credits (earnings) and debits (payments) arising from its international trade over a given period of time. Where credits exceed debits a balance of payments surplus exists; the opposite is described as a deficit. Understandably governments tend to prefer either equilibrium in the balance of payments or surpluses, rather than deficits. However, it would be fair to say that for some governments facing persistent balance of payments deficits, a sustained reduction in the size of the deficit may be regarded as signifying a ‘favourable’ balance of payments situation.
Like other economic indicators, the balance of payments statistics come in a variety of forms and at different levels of disaggregation, allowing useful comparisons to be made not only on a country’s comparative trading performance, but also on the international competitiveness of particular industries and commodity groups or on the development or decline of specific external markets. Particular emphasis tends to be given to the balance of payments on current account, which measures imports and exports of goods and services and is thus seen as an indicator of the competitiveness of an economy’s firms and industries. Sustained current account surpluses tend to suggest favourable trading conditions, which can help to boost growth, increase employment and investment and create a general feeling of confidence amongst the business community. They may also give rise to surpluses which domestic firms can use to finance overseas lending and investment, thus helping to generate higher levels of corporate foreign earnings in future years.
Controlling Public Borrowing
Governments raise large amounts of revenue annually, mainly through taxation, and use this income to spend on a wide variety of public goods and services. Where annual revenue exceeds government spending, a budget surplus occurs and the excess is often used to repay past debt. The accumulated debt of past and present governments represents a country’s National Debt.
In practice, most governments often face annual budget deficits rather than budget surpluses and hence have a ‘public sector borrowing requirement. While such deficits are not inevitably a problem, in the same way that a small personal overdraft is not necessarily critical for an individual, large scale and persistent deficits are generally seen as a sign of an economy facing current and future difficulties which require urgent government action. The overriding concern over high levels of public borrowing tends to be focused on:
The consensus seems to be that controlling public borrowing is best tackled by restraining the rate of growth of public spending rather than by increasing revenue through changes in taxation, since the latter could depress demand.
A Stable Exchange Rate
A country’s currency has two values: an internal value and an external value. Internally, its value is expressed in terms of the goods and services it can buy and hence it is affected by changes in domestic prices. Externally, its value is expressed as an exchange rate which governs how much of another country’s currency it can purchase (e.g. £1 = $2).
Since foreign trade normally involves an exchange of currencies, fluctuations in the external value of a currency will influence the price of imports and exports and hence can affect the trading prospects for business, as well as a country’s balance of payments and its rate of inflation.
On the whole, governments and businesses involved in international trade tend to prefer exchange rates to remain relatively stable, because of the greater degree of certainty this brings to the trading environment; it also tends to make overseas investors more confident that their funds are likely to hold their value. To this extent, schemes which seek to fix exchange rates within predetermined levels (e.g. the ERM), or which encourage the use of a common currency (e.g. the euro), tend to have the support of the business community, which prefers predictability to uncertainty where trading conditions are concerned.
Fiscal policy involves the use of changes in government spending and taxation to influence the level and composition of aggregate demand in the economy and, given the amounts involved, this clearly has important implications for business. Elementary circular flow analysis suggests, for instance, that reductions in taxation and/or increases in government spending will inject additional income into the economy and will, via the multiplier effect, increase the demand for goods and services, with favourable consequences for business. Reductions in government spending and/or increases in taxation will have the opposite effect, depressing business prospects and probably discouraging investment and causing a rise in unemployment.
Apart from their overall impact on aggregate demand, fiscal changes can be used to achieve specific objectives, some of which will be of direct or indirect benefit to the business community. Reductions in taxes on company profits and/or increases in tax allowances for investment in capital equipment can be used to encourage business to increase investment spending, hence boosting the income of firms producing industrial products and causing some additional spending on consumption.
Similarly, increased government spending targeted at firms involved in exporting, or at the creation of new business, will encourage increased business activity and additionally may lead to more output and employment in the economy.
In considering the use of fiscal policy to achieve their objectives, governments tend to be faced with a large number of practical problems that generally limit their room for manoeuvre. Boosting the economy through increases in spending or reductions in taxation could cause inflationary pressures, as well as encouraging an inflow of imports and increasing the public sector deficit, none of which would be particularly welcomed by entrepreneurs or by the financial markets. By the same token, fiscal attempts to restrain demand in order to reduce inflation will generally depress the economy, causing a fall in output and employment and encouraging firms to abandon or defer investment projects until business prospects improve.
Added to this, it should not be forgotten that government decision-makers are politicians who need to consider the political as well as the economic implications of their chosen courses of action. Thus while cuts in taxation may receive public approval, increases may not, and, if implemented, the latter may encourage higher wage demands. Similarly, the redistribution of government spending from one programme area to another is likely to give rise to widespread protests from those on the receiving end of any cuts; so much so that governments tend to be restricted for the most part to changes at the margin, rather than undertaking a radical reallocation of resources and they may be tempted to fix budgetary allocations for a number of years ahead.
Other factors too – including changes in economic thinking, self-imposed fiscal rules, external constraints on borrowing and international agreements – can also play their part in restraining the use of fiscal policy as an instrument of demand management, whatever a government’s preferred course of action may be. Simple prescriptions to boost the economy through large-scale cuts in taxation or increases in government spending often fail to take into account the political and economic realities of the situation faced by most governments.
Monetary policy seeks to influence monetary variables such as the money supply or rates of interest in order to regulate the economy. While the supply of money and interest rates (i.e. the cost of borrowing) are interrelated, it is convenient to consider them separately.
As far as changes in interest rates are concerned, these clearly have implications for business activity, as circular flow analysis demonstrates. Lower interest rates not only encourage firms to invest as the cost of borrowing falls, but also encourage consumption as disposable incomes rise and as the cost of loans and overdrafts decreases. Such increased consumption tends to be an added spur to investment, particularly if inflation rates (and, therefore ‘real’ interest rates) are low and this can help to boost the economy in the short term, as well as improving the supply side in the longer term.
Raising interest rates tends to have the opposite effect – causing a fall in consumption as mortgages and other prices rise, and deferring investment because of the additional cost of borrowing and the decline in business confidence as consumer spending falls. If interest rates remain persistently high, the encouragement given to savers and the discouragement given to borrowers and spenders may help to generate a recession, characterized by falling output, income, spending and employment and increasing business failure.
Changes in the money stock (especially credit) affect the capacity of individuals and firms to borrow and, therefore, to spend. Increases in money supply are generally related to increases in spending and this tends to be good for business prospects, particularly if interest rates are falling as the money supply rises. Restrictions on monetary growth normally work in the opposite direction, especially if such restrictions help to generate increases in interest rates which feed through to both consumption and investment, both of which will tend to decline.
As in the case of fiscal policy, government is usually able to manipulate monetary variables in a variety of ways, including taking action in the money markets to influence interest rates and controlling its own spending to influence monetary growth. Once again, however, circumstances tend to dictate how far and in what way government is free to operate. Attempting to boost the economy by allowing the money supply to grow substantially, for instance, threatens to cause inflationary pressures and to increase spending on imports, both of which run counter to government objectives and do little to assist domestic firms. Similarly, policies to boost consumption and investment through lower interest rates, while welcomed generally by industry, offer no guarantee that any additional spending will be on domestically produced goods and services, and also tend to make the financial markets nervous about government commitments to control inflation in the longer term.
This nervousness among market dealers reflects the fact that in modern market economies a government’s policies on interest rates and monetary growth cannot be taken in isolation from those of its major trading partners and this operates as an important constraint on government action. The fact is that a reduction in interest rates to boost output and growth in an economy also tends to be reflected in the exchange rate; this usually falls as foreign exchange dealers move funds into those currencies which yield a better return and which also appear a safer investment if the market believes a government is abandoning its counter inflationary policy.
Fiscal and monetary policies currently represent the chief policy instruments used in modern market economies and hence they have been discussed in some detail. Governments, however, also use a number of other weapons from time to time in their attempts to achieve their macroeconomic objectives. Such weapons, which are designed essentially to achieve a specific objective – such as limiting imports or controlling wage increases – tend to be known as direct controls. Examples of such policies include:
The Role of Financial Institutions
Interactions in the macro economy between governments, businesses and consumers take place within an institutional environment that includes a large number of financial intermediaries. These range from banks and building societies to pension funds, insurance companies, investment trusts and issuing houses, all of which provide a number of services of both direct and indirect benefit to businesses. As part of the financial system within a market based economy, these institutions fulfill a vital role in channeling funds from those able and willing to lend, to those individuals and organisations wishing to borrow in order to consume or invest. It is appropriate to consider briefly this role of financial intermediation and the supervision exercised over the financial system by the central bank.
Elements of the Financial System
A financial system tends to have three main elements:
Financial institutions, as indicated above, comprise a wide variety of organisations, many of which are public companies with shareholders. Markets include the markets for short-term funds of various types (usually termed money markets) and those for long-term finance for both the private and public sectors (usually called the capital market). Stock exchanges normally lie at the centre of the latter, and constitute an important market for existing securities issued by both companies and government.
The vital role played by financial intermediaries in the operation of the financial system is illustrated in the figure below and reflects the various benefits which derive from using an intermediary rather than lending direct to a borrower (e.g. creating a large pool of savings; spreading risk; transferring short-term lending into longer-term borrowing; providing various types of funds transfer services). Lenders on the whole prefer low risk, high returns, flexibility and liquidity, while borrowers prefer to minimize the cost of borrowing and to use the funds in a way that is best suited to their needs. Companies, for example, may borrow to finance stock or work-in-progress or to meet short-term debts and such borrowing may need to be as flexible as possible. Alternatively, they may wish to borrow in order to replace plant and equipment or to buy new premises – borrowing which needs to be over a much longer term and which hopefully will yield a rate of return which makes the use of the funds and the cost of borrowing worthwhile.
The process of channeling funds from lenders to borrowers often gives rise to paper claims, which are generated either by the financial intermediary issuing a claim to the lender (e.g. when a bank borrows by issuing a certificate of deposit) or by the borrower issuing a claim to the financial intermediary (e.g. when government sells stock to a financial institution). These paper claims represent a liability to the issuer and an asset to the holder and can be traded on a secondary market (i.e. a market for existing securities), according to the needs of the individual or organisation holding the paper claim. At any point, financial intermediaries tend to hold a wide range of such assets (claims on borrowers), which they buy or sell (‘manage’) in order to yield a profit and/or improve their liquidity position. Decisions of this kind, taken on a daily basis, invariably affect the position of investors (e.g. shareholders) and customers (e.g. depositors) and can, under certain circumstances, have serious consequences for the financial intermediary and its stakeholders.
Given the element of risk, it is perhaps not surprising that some financial institutions tend to be conservative in their attitude towards lending on funds deposited with them, especially in view of their responsibilities to their various stakeholders. UK retail banks, for instance, have a longstanding preference for financing industry’s working capital rather than investment spending, and hence the latter has tended to be financed largely by internally generated funds (e.g. retained profits) or by share issues. In comparison, banks in Germany, France, the United States and Japan tend to be more ready to meet industry’s medium- and longer-term needs and are often directly involved in regular discussions with their clients concerning corporate strategy, in contrast to the arm’s length approach favoured by many of their UK counterparts.
The Role of the Central Bank
A critical element in a country’s financial system is its central or state bank. The central Bank exercises overall supervision over the banking sector with the aim of maintaining a stable and efficient financial framework as part of its contribution to a healthy economy. Its activities have a significant influence in the financial markets (especially the foreign exchange market, and the money market). The activities of the central bank include the following roles:
International Economic Institutions and Organizations
Given that external factors constrain the ability of governments to regulate their economy, it is appropriate to conclude this analysis of the macroeconomic context of business with a brief review of a number of important international economic institutions and organisations which affect the trading environment. Foremost among these is the European Union. In the discussions below, attention is focused on the International Monetary Fund (IMF), the Organisation for Economic Co-operation and Development (OECD), the European Bank for Reconstruction and Development (EBRD), the World Trade Organisation (WTO) the World Bank.
The International Monetary Fund (IMF)
The IMF is an international organisation currently of 184 member countries. It came into being in 1946 following discussions at Bretton Woods in the USA which sought to agree a world financial order for the post-Second World War period that would avoid the problems associated with the worldwide depression in the interwar years. In essence, the original role of the institution – which today incorporates most countries in the world – was to provide a pool of foreign currencies from its member states that would be used to smooth out trade imbalances between countries, thereby promoting a structured growth in world trade and encouraging exchange rate stability. In this way, the architects of the Fund believed that the danger of international protectionism would be reduced and that all countries would consequently benefit from the boost given to world trade and the greater stability of the international trading environment.
While this role as international ‘lender of last resort’ still exists, the IMF’s focus in recent years has tended to switch towards international surveillance and to helping the developing economies with their mounting debt problems and assisting eastern Europe with reconstruction, following the break-up of the Soviet empires It has also been involved in the past in trying to restore international stability following the global economic turmoil in Asia and elsewhere and some countries would like it to adopt a more enhanced global surveillance role in the wake of the global credit crisis (2008). To some extent its position as an international decisionmaking body has been diminished by the tendency of the world’s leading economic countries to deal with global economic problems outside the IMF’s institutional framework. The United States, Japan, Germany, France, Italy, Canada, Britain and Russia now meet regularly as the Group of Eight (G8) leading industrial economies to discuss issues of mutual interest (e.g. the environment, Eastern Europe). These world economic summits, as they are frequently called, have tended to supersede discussions in the IMF and as a result normally attract greater media attention.
The Organisation for Economic Co-operation and Development (OECD) The OECD came into being in 1961, but its roots go back to 1948 when the Organisation for European Economic Co-operation (OEEC) was established to co- ordinate the distribution of Marshall Aid to the war-torn economies of Western Europe. Today it comprises 30 members, drawn from the rich industrial countries and including the G7 nations, Australia, New Zealand and most other European states. Collectively, these countries account for less than 20 per cent of the world’s population, but produce around two-thirds of its output – hence the tendency of commentators to refer to the OECD as the ‘rich man’s club’. Currently talks are under way to expand the membership of the Organisation to include other countries such as Chile, Russia and Israel.
In essence the OECD is the main forum in which the governments of the world’s leading industrial economies meet to discuss economic matters, particularly questions concerned with promoting stable growth and freer trade and with supporting development in poorer nonmember countries. Through its council and committees, and backed by an independent secretariat, the organisation is able to take decisions which set out an agreed view and/or course of action on important social and economic issues of common concern. While it does not have the authority to impose ideas, its influence lies in its capacity for intellectual persuasion, particularly its ability through discussion to promote convergent thinking on international economic problems. To assist in the task, the OECD provides a wide variety of economic data on member countries, using standardised measures for national accounting, unemployment and purchasing-power parities. It is for these data – and especially its economic forecasts and surveys – that the organisation is perhaps best known.
The European Bank for Reconstruction and Development (EBRD)
The aims of the EBRD, which was inaugurated in April 1991, are to facilitate the transformation of the states of central and Eastern Europe and beyond from centrally planned to free-market economies and to promote political and economic democracy, respect for human rights and respect for the environment. It is particularly involved with the privatisation process, technical assistance, training and investment in upgrading of the infrastructure and in facilitating economic, legal and financial restructuring. It works in co-operation with its members, private companies and organisations such as the IMF, OECD, the World Bank and the United Nations
The World Trade Organisation (WTO)
The World Trade Organisation, which came into being on 1 January 1995, superseded the General Agreement on Tariffs and Trade (the GATT), which dated back to 1947. Like the IMF and the International Bank for Reconstruction and Development (see below), which were established at the same time, the GATT was part of an attempt to reconstruct the international politico-economic environment in the period after the end of the Second World War. Its replacement by the WTO can be said to mark an attempt to put the question of liberalising world trade higher up the international political agenda.
With a membership of around 150 states (plus other observers), the WTO is a permanent international organisation charged with the task of liberalising world trade within an agreed legal and institutional framework. In addition it administers and implements a number of multilateral agreements in fields such as agriculture, textiles and services and is responsible for dealing with disputes arising from the Uruguay Round Final Act. It also provides a forum for the debate, negotiation and adjudication of trade problems and in the latter context is said to have a much stronger and quicker trade compliance and enforcement mechanism than existed under the GATT.
The World Bank (IBRD)
Established in 1945, the World Bank (more formally known as the International Bank for Reconstruction and Development or IBRD) is a specialised agency of the United Nations, set up to encourage economic growth in developing countries through the provision of loans and technical assistance. The IBRD currently has over 180 members.
The European Investment Bank (EIB)
The European Investment Bank was created in 1958 under the Treaty of Rome and is the financing institution of the European Union. Its main task is to contribute to the integration, balanced development and the economic and social cohesion of EU Member States. Using funds raised on the markets, it finances capital projects which support EU objectives within the European Union and elsewhere. Its interests include environmental schemes, projects relating to transport and energy and support for small and medium-sized enterprises.
Conclusively, economic factors affect the ability of business to meet its objectives. Businesses prosper during good economic conditions while poor economic conditions hinder their activities. The nature of economic system adopted, the quality of monetary and fiscal policies and the support of international agencies affect the growth and development of business organizations.
Business Organizations exist in and is affected by the broader macroeconomic activities which shape their performances. The economic is concerned with how societies allocate scarce economic resources to alternative uses and the ‘real costs’ of the choices that are made. Broadly speaking two main approaches to the problem of resource allocation exist: state planning and the market based. Most countries in the world operate the market-based economies which operate through a price mechanism. Within such economies the state also plays a key role in some allocation decisions. A number of financial organizations exist in the business economy which can influence business organizations. Economic forces affect the general health and well-being of a country or world region. They include interest rates, inflation, unemployment, and economic growth.
Economic forces produce many opportunities and threat for managers. Low levels of unemployment and falling interest rates mean a change in the customer base. More people have more money to spend, and as a result, organizations have an opportunity to sell more goods and services. Good economic times affect supplies. Resources become easier to acquire, and organizations have an opportunity to flourish.
In contrast, worsening macroeconomic conditions, pose a major threat because they limit managers‘ ability to gain access to the resources their organization needs. Profit oriented organizations such as retail stores and hotels have fewer customers for their goods and services during economic downturns .Even a moderate deterioration in national or regional economic conditions can seriously affect performance.
Poor economic conditions make the environment more complex and managers‘ job more difficult and demanding. Managers may need to reduce the number of individuals in their departments and increase the motivation of remaining employees. Successful managers realize the important effects that economic forces have on their organizations, and they pay close attention to what is occurring in the national and regional economies to respond appropriately.