ACCA paper f9 financial management study materials F9FM session02 d08

1 MACROECONOMIC POLICY 1.1 Definition The setting of economic objectives by the government e.g., full employment, economic growth, the avoidance of inflation and the use of control inst

OVERVIEW

Objective

Ü To understand the economic environment within which organisations operate

Ü To understand the financial environment in which financial management is practised

ECONOMIC

POLICY

FINANCIAL MARKETS THEORY

THE ECONOMIC ENVIRONMENT

BANKING SYSTEM

THE FINANCIAL MANAGEMENT ENVIRONMENT

1 MACROECONOMIC POLICY

1.1 Definition

The setting of economic objectives by the government (e.g., full employment,

economic growth, the avoidance of inflation) and the use of control

instruments to achieve those objectives (e.g fiscal policy and monetary policy)

1.2 Objectives of macroeconomic policy

In economies such as that of the UK it is generally accepted that macroeconomic policies have been adopted in order achieve the following objectives:

Ü full employment;

Ü economic growth and thereby improved living standards;

Ü an acceptable distribution of wealth;

Ü price stability and therefore limited inflation;

Ü a solid balance of payments - a continual external deficit, where a country is importing more goods and services than it is exporting, is unsustainable and is likely to lead to an exchange rate crisis

The above objectives can often be in conflict, and therefore the achievement of them all at the same time is difficult Economic growth can, for example, lead to excess demand for

resources and lead to an increase in inflation

1.3 Recent performance of the UK economy

Macroeconomic policies adopted by governments may affect the business sector by altering both the costs and the level of demand a business may experience Therefore in order for managers in industry to make effective policy decisions, they must understand current government economic policy and, due to the increasing interdependence of national

economies through both the movement of trade and capital, world macroeconomic trends Recent world economic events include:

Ü the growing importance of China and India in world trade;

Ü the fall in the value of the US dollar ;

Ü the launch of the European single currency – the Euro – in which UK is not currently participating

Ü the ‘dot.com bubble’ – following over-optimism by both business and investors of the potential returns from the high technology sector

Ü High but volatile commodity prices

In recent years the UK economy has experienced unemployment at a lower rate than the European average

UK interest rates (set by an independent Bank of England) are historically also low but still above those of the European Central Bank Inflation is also relatively low and some sectors

of the economy are even under deflationary pressure

2.1 Definition

Monetary policy can be defined as those actions taken by the government or

the central bank to achieve economic objectives using monetary instruments

These actions may either directly control the amount of money in circulation

(the money supply) or attempt to reduce the demand for money through its

price (interest rates) For instance, if the rate of interest on funds is increased,

the cost of borrowing is increased and therefore the demand for goods is

decreased and the result of this tends to be a decrease in the rate of inflation

By exercising control in these ways governments can regulate the level of

demand in the economy Those who see the use of monetary policies as crucial

in the control of macroeconomic activity are known as monetarists

2.2 Direct control of the money supply

Governments or central banks can directly control the money supply in the following ways:

Ü Open market operations:

If the central bank sells government securities the money supply is contracted, as some

of the funds available in the market are “soaked up” by the purchase of the government securities Equally, if the central bank were to buy back securities then funds would be released into the market The sale of government securities will lead to a reduction in bank deposits due to the level of funds that have been “soaked up” This in turn can lead to a further reduction in the money supply, as the banks’ ability to lend is reduced

This is known as the multiplier effect

Ü Reserve asset requirements:

The central bank can set a minimum level of liquid assets which banks

must maintain This limits their ability to lend and thereby reduces the

money supply

Ü Special deposits:

The central bank can have the power to call for “special deposits” These deposits do not count as part of the banks’ reserve base against which they can lend Hence they have the effect of reducing the banks ability to lend and thereby reducing the money supply

2.3 Reducing the demand for money

Governments can reduce the demand for money, and therefore indirectly the money supply,

by encouraging an increase in short-term interest rates This has been the main way in which monetary policy has operated in the UK in recent years

2.4 The problems of monetary policy

Problems arise due to the following:

Ü there is often a significant time lag between the implementation of a policy and its effects;

Ü the ineffectiveness of credit control in the modern international economy;

Ü the fact that the relationship between interest rates, level of investment and consumer expenditure is not actually stable and predictable;

Ü the undesirable side effects of increasing interest rates:

̌ less investment, leading to reduced industrial capacity, leading to increased

2.5 How the money supply may be measured

If governments are wanting to control the money supply it is necessary to be able to measure the supply of money in the economy

A number of alternative indicators have emerged including the following:

M0 Notes and coins in circulation and in banks’ tills

M3 M0 plus deposits at banks

M4 M3 plus deposits at building societies

M5 M4 plus private sector holdings of certain types of government debt

Whilst M5 may be the most suitable measure to use it is the hardest to control Equally, whilst M0 is the easiest measure to control it is probably the least representative of overall economic activity In recent times UK governments have attempted to monitor both M0 and M4

3 FISCAL POLICY

3.1 Definition

Action by the government to achieve economic objectives through the use of

the fiscal instruments of taxation, public spending and the budget deficit or

surplus Governments can use public expenditure and taxation to regulate the

level of demand within the economy Those who view fiscal policy as crucial in

the control of macroeconomic activity are known as Keynesians

3.2 The Keynesian approach

If the economy is in recession fiscal policy can be used to reflate the economy and the

following actions could be taken:

Ü increase government spending in order to directly increase the level of demand in the economy; for instance, if a government agrees a number of large road-building projects, the demand for goods and services within the economy is increased;

Ü reduce taxation in order to boost both consumption and investment

However, problems can occur due to the following:

Ü government spending is an intervention into the free market and can easily lead to the misallocation of resources – e.g support for inefficient industries;

Ü there is often a significant time lag between the authorisation of additional spending and its actual occurrence;

Ü tax cuts are not efficient at boosting domestic demand, as in times of recession some of the extra disposable income made available will be saved, and of the extra monies actually spent some of it will inevitably be on imports;

Ü a large budget deficit is likely to occur which will lead to a large Public Sector

Borrowing Requirement (PSBR);

Ü the rate of inflation is likely to rise, as demand may increase for resources which are in limited supply and for which the prices will therefore tend to increase

If there is too much demand in the economy (it is overheating), then fiscal policy can be used

to depress demand or deflate the economy, and the following actions could be taken:

Ü reduce government spending in order to decrease directly the level of demand in the economy;

Ü increase taxation in order to reduce consumption and to assist with the redistribution of wealth

However, problems can arise due to the following:

Ü it is not possible to cut government spending dramatically as some goods and services provided by government are unsatisfactorily provided for by the private sector;

Ü increasing taxation discourages enterprise

Keynesians favour adjusting the level of government spending in preference to adjusting tax rates, as they believe it has a quicker and greater impact on the level of demand in the

economy

3.3 The relationship between fiscal and monetary policy

Fiscal and monetary policies are interdependent and governments will use both fiscal and monetary policies to achieve their monetary and budgetary targets Which policies dominate depends on the economic theory preferred by the government of the day In the UK there was a Keynesian approach to the management of the economy from the 1930s to the 1970s However, this was believed to have contributed to the “boom-bust” economic cycles that were experienced Hence recent governments have followed a more monetarist approach

4.1 Definition

Supply side policies are policies which focus on creating the right conditions in

which private enterprise can grow and therefore raise the capacity of the

economy to provide the output demanded The private sector, being driven by

the profit motive, is deemed to be more efficient at providing the output

required than the public sector

4.2 Supply side policy examples

Supply side policies include:

Ü low tax rates to encourage private enterprise;

Ü the promotion of a stable, low inflation economy with minimal government

intervention;

Ü limited government spending;

Ü a balanced fiscal budget;

Ü deregulation of industries;

Ü a reduction in the rights of employees and the power of their trade unions;

Ü an increase in the training and education of the workforce;

Ü an increase in the provision of the infrastructure required by business – for example business parks;

Ü a reduction in planning legislation

4.3 Supply side policies and fiscal policy

Supporters of supply side policies believe that, if business is to flourish, the economy must

be in a stable condition and therefore fiscal policy should be in equilibrium In other words, government spending should not exceed government receipts from taxation Additionally, if the private sector is to be encouraged, tax rates should be kept to a minimum and

government expenditure also should be kept to a minimum

4.4 Supply side policies and monetary policy

In order to provide the stable low inflation economy in which business can flourish,

monetary policy is used to control inflation

4.5 Problems with the supply side approach

Problems with using supply side policies include the following:

Ü there is a time delay before the policies have any impact;

Ü the private sector will not provide all the goods and services required by society – for example health provision

The maintenance of a low level of inflation is one of the government’s key economic

objectives

Alternative measures of inflation also exist which, for instance, look at the increases in the costs of manufacturing industry

a result of the increase in the cost of imported goods, in which case the term imported cost-push inflation is used

Monetarists, on the other hand, believe that inflation arises as a result of “too much money chasing too few goods” Therefore, in the short term inflation should be controlled by

controlling the money supply, whilst in the long term inflation should be controlled by enhancing the ability of the economy to produce the goods and services in demand

Inflation is also thought to be brought about by people’s expectations, as anticipation of future price increases is built into wage negotiations in order to protect future real incomes

In turn, expected increases in costs such as wage costs are built into output prices This is sometimes known as the “wage-price spiral” and it suggests that inflation is ongoing and inevitable

5.4 The general economic consequences of inflation

The general economic consequences of inflation include the following:

Ü The redistribution of income from those in a weak bargaining position, for example students, to those in a strong bargaining position who are therefore able to maintain the real value of their income;

Ü A disincentive to save as the purchasing power of investments may be reduced;

Ü Where inflation reaches very high levels money is no longer able to carry out its key functions of being a medium of exchange and a store of value;

Ü A fall in the exchange rate;

Ü A need for higher nominal interest rates

5.5 The consequences of inflation for companies

Inflation impacts upon companies in many ways and these are outlined below:

Ü Entrepreneurial activity is reduced as it is harder to estimate the likely returns from a new venture and higher interest rates make borrowing more expensive;

Ü International competitiveness suffers where prices rise faster than those of foreign competitors;

Ü Uncertainty is increased and hence new investment by existing businesses is reduced;

Ü Higher interest rates reduce the number of profitable investment opportunities and therefore the level of investment;

Ü In periods of rapid inflation the need to search for the best price currently available for the purchases required and the need to be constantly updating selling prices adds significant costs to industry

5.6 How does inflation distort the evaluation of business performance?

Conventional historic cost accounts have the following problems during periods of

significant inflation:

Ü The current value of assets is ignored;

Ü The historic cost of assets understates the value of the assets;

Ü Changes in asset values are ignored until they are realised;

Ü Gains arising from holding assets are treated as being fully distributable

The result of the above is that profits become overstated (current revenues are charged with

a measure of historic cost), and capital becomes understated and therefore ROCE (return on capital employed) is also overstated

Alternative approaches which have been suggested include the following:

Ü The valuation of assets at their deprival value;

Ü The use of Current Purchasing Power (CPP) or Current Cost Accounting (CCA) in order

to eliminate the above distortions and ensure the maintenance of the shareholders’ funds in real terms

6 GOVERNMENT INTERVENTION IN THE ECONOMY

6.1 Why do governments intervene in the operation of the free market?

Governments intervene in the operation of the free market for the following reasons:

Ü Where monopolies, mergers or restrictive practices operate against the public interest;

Ü Where there is a natural monopoly and competition is wasteful;

Ü Where an industry is of key national strategic importance;

Ü Where the free market creates social injustice;

Ü Where companies fail to take account of the effect of their actions which impact outside

of the company, these are known as “externalities”; a common example is the pollution which a company may cause;

Ü Where the free market fails to provide sufficient public or merit goods, such as health care or education;

Ü Where the free market is unable to provide the amount of capital required, e.g when a large infrastructure project, such as the construction of a new tunnel or bridge, is being undertaken

6.2 Competition policy

Governments develop competition policies in order to increase the efficiency of the economy

by stimulating competition

The key components of competition policy in the UK have been as follows:

Ü Monopolies and mergers legislation - to prevent the development of monopolies which would have the power to act against the public interest;

Ü Restrictive practices legislation - to eliminate practices such as the setting of retail prices

by manufacturers;

Ü Deregulation in certain industries - to remove regulations which restrict competition in the industry An example of deregulation in the UK is that of the stock market which took place in 1986, causing dealing costs to reduce and therefore the volume of trading

to increase greatly;

Ü The creation of internal markets within certain areas of the public sector Within both the health and education sectors operating units such as hospitals or schools must compete for the resources they require based on the services they provide to their users such as patients and students

Ü The UK Competition Commission – a government department which investigates situations which may be against the public interest e.g excessive market power The Competition Commission uses 25% market share as an indicator of potential unfair influence

6.3 Privatisation

A large number of state-owned firms have been sold to the private sector either by sale to the general public, direct sale to another company or management buy-out Examples

include British Telecom, British Gas and the electricity distribution companies

The arguments in favour of privatisation include:

Ü an increase in competition where a state monopoly is split into a number of operating companies prior to sale or where the monopoly position is removed;

Ü a short-term boost to government revenues and therefore a favourable impact on the PSBR;

Ü a widening of share ownership, thereby increasing individuals’ stake in the economy as

a whole;

Ü reduction in the PSBR in future as borrowings by the newly-privatised industries are no longer public borrowings

The arguments against privatisation include:

Ü many privatisations have replaced state monopolies with private sector monopolies, which have then required regulation to ensure that their monopoly position is not abused;

Ü the breaking-up of large businesses into smaller companies results in the loss of

economies of scale;

Ü the quality of service may deteriorate

6.4 Other government intervention

Governments also intervene in the economy through the use of official aid schemes These aid schemes include the use of cash grants, consultancy advice and tax incentives in order to encourage investment in high technology or investment in areas of particularly high

unemployment

Grants are also available from European Institutions For example, the European Regional Development Fund has assisted with many infrastructure projects in the remoter regions of the UK

Ü Although the UK has not yet joined the single currency, UK companies that have a foreign parent company may be asked to do business in Euros Such companies

therefore face foreign exchange risk as sterling rises and falls against the Euro Such transaction exposure can be hedged

Ü The introduction of the Euro allows easier comparison of prices between member countries This should reduce price differentials in Europe and increase competition

Ü If the UK decides to join the Euro then UK interest rates will fall towards those in the Euro region This will have implications for company finance as debt becomes cheaper

Ü Within the Euro region there is also a move towards tax harmonisation e.g introducing the same corporation tax rates across the area This obviously has implications for financial management e.g project appraisal

8.1 Definition

Organisations which bring together potential lenders and potential borrowers

The following financial institutions act as financial intermediaries:

Ü Commercial clearing banks found on the high street of most towns

Ü The National Savings Bank operated by the Post Office

Ü Merchant banks, which provide banking services, including advice on

items such as share issues and mergers, for business customers

Ü Building societies, which take deposits from the domestic sector and lend

to those buying their own house

Ü Insurance companies, which can invest much of their premium income in

long-term assets, as their outgoings are reasonably easy to predict

Ü Investment and unit trusts, which attract investors and then reinvest the

funds raised in other companies

Ü Pension funds, which receive regular premiums and thus have predictable

cash outflows and can invest in the long term

Ü Finance companies, which provide business and domestic credit, leasing

finance and factoring/invoice discounting services These companies are

very often a subsidiary of another financial institution

Ü Discount house, which trade in interest rate sensitive investments, such as

bills of exchange