Chapter 2

The economic environment for

business
1. Outline of macroeconomic policy
Macroeconomic policy involves
• Policy objectives – the ultimate aims of economic policy
• Policy targets – quantified levels or ranges which policy is intended to
achieve
• Policy instruments – the tools used to achieve objectives
1. Outline of macroeconomic policy

1.1 Microeconomics, macroeconomics and economic policy

• Microeconomics is concerned with the behavior of individual firms
and consumers or households.
• Macroeconomics is concerned with the economy at large, and with
the behavior of large aggregates such as the national income, the
money supply and the level of employment.
1. Outline of macroeconomic policy

1.2 Economic policies and objectives

The policies pursued by a government may serve various objectives.
• Economic growth: 'Growth' implies an increase in national income in 'real'
terms
• Control price inflation: This means achieving stable prices.
• Full employment: This means that unemployment levels are low, and
involuntary unemployment is short-term.
• Balance of payments stability: Deficits in external trade, with imports
exceeding exports, might also be damaging for the prospects of economic
growth. Continue…
1. Outline of macroeconomic policy
1.2 Economic policies and objectives
To try to achieve its intermediate and overall objectives, a government will
use a number of different policy tools or policy instruments. These include
the following.
• Monetary policy: Monetary policy aims to influence monetary variables
• Fiscal policy: Fiscal policy involves using government spending and taxation
in order to influence aggregate demand in the economy
• Exchange rate policy: Some economists argue that economic objectives can
be achieved through management of the exchange rate by the government
• External trade policy: A government might have a policy for promoting
economic growth by stimulating exports.
1. Outline of macroeconomic policy
1.3 Conflicts in policy objectives and instruments
Attempts to achieve one objective will often have adverse effects on others,
sooner or later.
1. There may be a conflict between steady balanced growth in the
economy and full employment.
2. The objectives of lower unemployment and economic growth have been
difficult to achieve because of the problems and conflicts with secondary
objectives.
• To create jobs and growth, there must be an increase in aggregate demand.
• The high rate of imports creates a deficit in the balance of payments
• To maintain the value of sterling, interest rates in the UK might need to be kept high, and high
interest rates appear to deter companies from investing
2. Fiscal policy
Fiscal policy is action by the government to spend money, or to collect
money in taxes, with the purpose of influencing the condition of the national
economy

2.1 Fiscal policy and demand management

A government might intervene in the economy by:
(a) Spending more money and financing this expenditure by borrowing
(b) Collecting more in taxes without increasing public spending
(c) Collecting more in taxes in order to increase public spending,
Continue…
2. Fiscal policy
2.1 Fiscal policy and demand management
Fiscal policy appears to offer a method of managing aggregate demand in
the economy.
• If the government spends more without raising more money in taxation (ie
by borrowing more) it will increase expenditure in the economy, and so
raise demand
• If the government kept its own spending at the same level, but reduced the
levels of taxation, it would also stimulate demand in the economy
• In the same way, a government can reduce demand in the economy by
raising taxes or reducing its expenditure.
2. Fiscal policy
2.2 Fiscal policy and business
Fiscal policy affects business enterprises in both service and manufacturing
industries in various ways.
1. By influencing the level of aggregate demand (AD) for goods and
services in the economy, macroeconomic policy affects the
environment for business. Business planning will be easier if
government policy is relatively stable.
2. Tax changes brought about by fiscal policy affect businesses.
3. Monetary and interest rate policy
• Monetary policy aims to influence monetary variables
such as the rate of interest and the money supply in order
to achieve targets set
• Money is important because:
• It 'oils the wheels' of economic activity, providing an easy
method for exchanging goods and services
• The total amount of money in a national economy may have a
significant influence on economic activity and inflation.
3. Monetary and interest rate policy
3.1 The role and aims of monetary policy
Monetary policy is the regulation of the economy through control of the
monetary system by operating on such variables as the money supply, the
level of interest rates and the conditions for availability of credit.
The effectiveness of monetary policy will depend on:
1. Whether the targets of monetary policy are achieved successfully.
2. Whether the success of monetary policy leads on to the successful
achievement of the intermediate target
3. Whether the successful achievement of the intermediate target leads
on to the successful achievement of the overall objective
3. Monetary and interest rate policy
3.2 Targets of monetary policy
Targets of monetary policy are likely to relate to the volume
of national income and expenditure.
• Growth in the size of the money supply
• The level of interest rates
• The volume of credit or growth in the volume of credit
• The volume of expenditure in the economy
3. Monetary and interest rate policy
3.2 Targets of monetary policy
Targets of monetary policy are likely to relate to the volume of national
income and expenditure.
• Growth in the size of the money supply
• The level of interest rates
• The volume of credit or growth in the volume of credit
• The volume of expenditure in the economy
3.3 The money supply as a target of monetary policy
To monetarist economists, the money supply is a possible intermediate
target of economic policy.
3. Monetary and interest rate policy
3.4 Interest rates as a target for monetary policy
• The authorities may decide that interest rates themselves should
be a target of monetary policy.
• It certainly seems logical that interest rates should have a strong
influence on economic activity.
• Empirical evidence suggests there is some connection between
interest rates and investment and consumer expenditure, however
connection is not a stable
• The Bank now sets rates at a level which it considers appropriate,
given the inflation rate target set by the Government.
3. Monetary and interest rate policy
3.5 Interest rate policy and business
• Interest rate changes brought about by government policy affect the borrowing costs
of business. Businesses will also be squeezed by decreases in consumer demand that
result from increases in interest rates.
Aggregate expenditure in the economy will decrease, for various reasons.
• A higher interest rate encourages savings at the expense of consumer expenditure.
• Higher interest rates will increase mortgage payments and will thus reduce the
amount of disposable income in the hands of home buyers for discretionary spending.
• The higher cost of consumer credit will deter borrowing and spending on consumer
durables.
• Higher prices of goods due to higher borrowing costs for industry will also reduce
some consumer expenditure in the economy.
Continue…
3. Monetary and interest rate policy
3.5 Interest rate policy and business
Investment expenditure may also decline for two reasons.
• Higher interest rates deter some investment due to increased
borrowing costs.
• Higher interest rates may make the corporate sector pessimistic
about future business prospects and confidence in the economy.
4. Exchange rates
An exchange rate is the rate at which one country's currency can
be traded in exchange for another country's currency.
• Exchange rates are determined by supply and demand, even
under fixed exchange rate systems.
• Governments can intervene to influence the exchange rate by
adjusting interest rates.
4. Exchange rates
4.1 Factors influencing the exchange rate for a currency
Supply and demand in turn are subject to a number of influences.

• The rate of inflation, compared with the rate of inflation in other countries
• Interest rates, compared with interest rates in other countries
• The balance of payments
• Speculation
• Government policy on intervention to influence the exchange rate

Continue…
4. Exchange rates
4.1 Factors influencing the exchange rate for a currency
Other factors influence the exchange rate through their
relationship with the items identified above.
• Total income and expenditure (demand) in the domestic
economy determines the demand for goods.
• Output capacity and the level of employment in the domestic
economy might influence the balance of payments
• The growth in the money supply influences interest rates and
domestic inflation.
4. Exchange rates
4.2 Consequences of an exchange rate policy
Reasons for a policy of controlling the exchange rate:
• To rectify a balance of trade deficit, by trying to bring about a fall
in the exchange rate.
• To prevent a balance of trade surplus from getting too large, by
trying to bring about a limited rise in the exchange rate.
• To emulate economic conditions in other countries.
• To stabilize the exchange rate of its currency.
4. Exchange rates
4.3 Fixed exchange rates
• A government might try to keep the exchange rate at its
fixed level, but if it cannot control inflation, the real value
of its currency would not remain fixed.
• If exchange rates are fixed, any changes in (real) interest
rates in one country will create pressure for the
movement of capital into or out of the country.
4. Exchange rates
4.4 Floating exchange rates
Floating exchange rates are exchange rates which are allowed to fluctuate
according to demand and supply conditions in the foreign exchange markets.
• Floating exchange rates are at the opposite end of the spectrum to fixed rates
• In practice, many governments seek to combine the advantages of exchange
rate stability with flexibility and to avoid the disadvantages of both rigidly fixed
exchange rates and free floating.
• Authorities will intervene in the foreign exchange market:
o To use their official reserves of foreign currencies to buy their own domestic currency
o To sell their domestic currency to buy more foreign currency for the official reserves
• Buying and selling in this way would be intended to influence the exchange rate
of the domestic currency.
• Speculation in the capital markets often has a much bigger impact in short-term
4. Exchange rates
4.5 European Economic and Monetary Union
There are three main aspects to the European monetary union.
1. A common currency (the euro).
2. A European central bank. The European central bank has
several roles.
i. Issuing the common currency
ii. Conducting monetary policy on behalf of the central government
authorities
iii. Acting as lender of last resort to all European banks
iv. Managing the exchange rate for the common currency
3. A centralized monetary policy applies across all the countries
within the union.
4. Exchange rates
4.6 Exchange rates and business
A change in the exchange rate will affect the relative prices of domestic and
foreign produced goods and Services

Fluctuating exchange rates create uncertainties for businesses involved in

international trade. Continue…
4. Exchange rates
4.6 Exchange rates and business
International trading companies can do a number of things to reduce their
risk of suffering losses on foreign exchange transactions, including the
following.
• Many companies buy currencies 'forward' at a fixed and known price.
• Dealing in a 'hard' currency may lessen the risks attached to volatile currencies.
• Operations can be managed so that the proportion of sales in one currency are
matched by an equal proportion of purchases in that currency
• Invoicing can be in the domestic currency.
• Outsource activities to the local market.
• Firms can aim at segments in the market which are not particularly price
sensitive.
5. Competition policy
5.1 Regulation and market failure
Market failure is said to occur when the market mechanism
fails to result in economic efficiency, and therefore the
outcome is sub-optimal
• The government influences markets in various ways, one
of which is through direct regulation
• An important role of the government is the regulation of
private markets where these fail to bring about an
efficient use of resources
Continue…
5. Competition policy
5.1 Regulation and market failure
The following are the cases where regulation of markets can often be the
most appropriate policy response:
• Imperfect competition: Where one company's large share or complete
domination of the market is leading to inefficiency or excessive profits, the
state may intervene.
• Social costs: A possible means of dealing with the problem of social costs or
externalities is via some form of regulation.
• Imperfect information: Regulation is often the best form of government
action whenever informational inadequacies are undermining the efficient
operation of private markets.
• Equity: The government may also resort to regulation to improve social
justice.
5. Competition policy
5.2 Types of regulation
• Regulation can be defined as any form of state interference with the
operation of the free market.
• This could involve regulating demand, supply, price, profit, quantity,
quality, entry, exit, information, technology, or any other aspect of
production and consumption in the market
• In many markets the participants (especially the firms) may decide to
maintain a system of voluntary selfregulation, possibly in order to try
to avert the imposition of government controls.
5. Competition policy
5.3 Competition policy in the UK
• Overall responsibility for the conduct of policy lies with
the Secretary of State for Trade and Industry.
• However, day to day supervision is carried out by the
Office of Fair Trading (OFT), headed by its Director General
(DG).
5. Competition policy
5.4 Monopolies and mergers
In a pure monopoly, there is only one firm, the sole producer of a good,
which has no closely competing substitutes.
A monopoly situation can have some advantages.
• In certain industries arguably only by achieving a monopoly will a company
be able to benefit from the kinds of economies of scale that can minimize
prices.
• Establishing a monopoly may be the best way for a business to maximize
its profits.

Continue…
5. Competition policy
5.4 Monopolies and mergers
However monopolies often have several adverse consequences.
• Companies can impose higher prices on consumers.
• The lack of incentive of competition may mean companies have
no incentive to improve their products or offer a wider range of
products.
• There is no pressure on the company to improve the efficiency of
its use of resources. 
5. Competition policy
5.5 Restrictive practices
• The other strand of competition policy is concerned with preventing the
development of anti-competitive practices such as price-fixing agreements
• Under the legislation, all agreements between firms must be notified to the
OFT and the DG will then decide if the agreement should be examined by
the Restrictive Practices Court.
• The presumption of the Court is that the agreement will be declared illegal,
unless it can be shown to satisfy one of the 'gateways' as defined in the
Restrictive Practices Act 1976.
5. Competition policy
5.6 European Union competition policy
• As a member of the European Union (EU), the UK is also now
subject to EU competition policy.
• This is enshrined in Articles 85 (dealing with restrictive practices)
and 86 (concerned with monopoly) of the Treaty of Rome.
5. Competition policy
5.7 Deregulation
• Deregulation can be defined as the removal or weakening of any form of
statutory (or voluntary) regulation of free market activity.
• Deregulation or 'liberalisation' is, in general, the opposite of regulation.
• Deregulation, whose main aim is to introduce more competition into an industry
by removing statutory or other entry barriers, has the following potential
benefits.
o Improved incentives for internal/cost efficiency
o Improved allocative efficiency
o Loss of economies of scale
o Lower quality or quantity of service
o Need to protect competition
5. Competition policy
5.8 Privatization
Privatization is a policy of introducing private enterprise into
industries which were previously state-owned or state-operated.
Privatization takes three broad forms:
• The deregulation of industries, to allow private firms to compete against
state-owned businesses where they were not allowed to compete before
• Contracting out work to private firms, where the work was previously done
by government employees
• Transferring the ownership of assets from the state to private shareholders

Continue…
5. Competition policy
5.8 Privatization
Privatization can improve efficiency, in one of two ways:
• If the effect of privatization is to increase competition, the effect might be
to reduce or eliminate allocative inefficiency.
• The effect of denationalization might be to make the industries more cost-
conscious
There are other possible advantages of privatization:
• It provides an immediate source of money for the government.
• It reduces bureaucratic and political meddling in the industries concerned.
• It encourages wider share ownership.
Continue…
5. Competition policy
5.8 Privatization
There are arguments against privatization too.
• State-owned industries are more likely to respond to the public interest,
ahead of the profit motive.
• Encouraging private competition to state-run industries might be
inadvisable where significant economies of scale can be achieved by
monopoly operations.
6. Government assistance for business
6.1 Official aid schemes
A government may provide finance to companies in cash grants
and other forms of official direct assistance, as part of its policy of
helping to develop the national economy, especially in high
technology industries and in areas of high unemployment.
Government incentives might be offered on:
• A regional basis, giving help to firms that invest in an economically
depressed area of the country.
• A selective national basis, giving help to firms that invest in an industry
that the government would like to see developing more quickly
6. Government assistance for business
6.2 The Enterprise Initiative
• The Enterprise Initiative is a package of measures offered by the
Department of Trade and Industry (DTI) to businesses in the UK.
• It includes regional selective grant assistance. A network of
'Business Links', which are local business advice centers, is also
provided
• Regional selective assistance is available for investment projects
undertaken by firms in Assisted Areas.
7. Green policies
• There are a number of policy approaches to pollution,
such as polluter pays policies, subsidies and direct
legislation.
• The environment is increasingly seen as an important
issue facing managers in both the public and private
sectors
• The problems of pollution and the environment appear to
call for international co-operation between governments
7. Green policies
7.1 Pollution policy
• Pollution, for example from exhaust gas emissions or the dumping of
waste, is often discussed in relation to environmental policy.
• If polluters take little or no account of their actions on others, this generally
results in the output of polluting industries being greater than is optimal.
• One solution is to levy a tax on polluters equal to the cost of removing the
effect of the externality they generate: the polluter pays principle.
• This will encourage firms to cut emissions and provides an incentive for
them to research ways of permanently reducing pollution.
7. Green policies
7.2 Legislation
• An alternative approach used in the UK is to impose legislation
laying down regulations governing waste disposal and
atmospheric emissions.
• Waste may only be disposed of with prior consent and if none is
given, or it is exceeded, the polluter is fined.
• There may also be attempts with this type of approach to specify
standards of, for example, air and water quality with appropriate
penalties for not conforming to the required standards
7. Green policies
7.3 Advantages of 'environmentally friendly policies' for a
business
• If potential customers perceive the business to be environmentally
friendly, some may be more inclined to buy its products.
• A corporate image which embraces environmentally friendly policies
may enhance relationships with the public in general or with local
communities.
• People may prefer to work for an environmentally friendly business.
• 'Ethical' investment funds may be more likely to buy the firm's shares.
8. Corporate governance regulation
The corporate governance debate impacts upon the way companies make
decisions, their financial organization and their relations with investors and
auditors.
8.1 Impact of corporate governance requirements on businesses
• The consequences of failure to obey corporate governance regulations should
be considered along with failure to obey any other sort of legislation.
• Businesses that fail to comply with the law run the risk of financial penalties and
the financial consequences of accompanying bad publicity.
• In regimes where corporate governance rules are guidelines rather than
regulations, businesses will consider what the consequences might be of non-
compliance, in particular the impact on share prices.
• Obedience to requirements or guidelines can also have consequences for
businesses..