Chapter: 11 | Macroeconomic policy

Macroeconomic policy is the management of the economy by government in such a way as to influence
the performance and behaviour of the economy as a whole.

wealth.
The full employment of resources applies in particular to the labour force. The aim is both full and stable employment. Price
stability means little or no inflation putting upward pressure on prices. Economic growth is measured by changes in national
income from one year to the next and is important for improving living standards. The balance of payments relates to the ratio
of imports to exports. A payment surplus would mean the value of exports exceeds that of imports. A payment deficit would
occur where imports exceed exports. What is considered an appropriate distribution of income and wealth will depend upon
the prevailing political view at the time
The Objecctives are in conflict with each other eg Full employment versus Price stability
Economic growth versus Balance of payments

There may be conflict between full employment and price stability. It is suggested that inflation and employment are inversely
related. The achievement of full employment may therefore lead to excessive inflation through an excess level of aggregate
demand in the economy. Rapid economic growth may, in the short-term at least, have damaging consequences for the
balance of payments since rapidly rising incomes may lead to a rising level of imports.
Policy objectives may conflict and hence governments have to consider trade-offs between objectives. The identification of
targets for policy should reflect this.
Making an impact – How macroeconomic policy affects the business sector

Macroeconomic policy in business sector affects in two ways (i) Maintain Stable Aggregate Demand helps business plan
investment employement and output, (ii) influenece costs through exchange rates, Fiscal Policy and Monitary Policy
Aggregate Demand (AD) is the total demand for goods and services in the economy
Macroeconomic policy aims to influence Aggregate Demand (AD) in the economy.
AD level is critical for determining unemployment and inflation rates.
Low AD can lead to unemployment, while high AD can result in inflation due to excess demand.
Changes in AD affect businesses differently.
Effective business planning requires predicting short- to medium-term macroeconomic policy trends.
Predicting the consequences of policy on sales growth is essential for businesses.

Stable government policy makes it easier for businesses to plan, especially for investments, employment, and future capacity.
Exchange Rates: Macroeconomic policies can lead to changes in exchange rates. This can affect businesses by making
imported goods more expensive, which in turn can increase production costs.

Taxation: Fiscal policies often involve changes in taxation, such as income tax or sales tax. These changes can directly impact
businesses by altering labor costs and potentially affecting consumer demand and prices.

Interest Rates: Monetary policy decisions can influence interest rates. When interest rates rise, businesses with debt may face
higher borrowing costs, impacting their profitability. Additionally, higher interest rates can make potential investments less
attractive, affecting business expansion and growth plans.
These factors underscore how macroeconomic policies can have tangible effects on businesses' costs and financial planning.

Monetary policy
Money is a crucial aspect of a modern economy, serving as a medium of exchange.
Monetary policy aims to influence overall monetary conditions in the economy.
Two key challenges with monetary policy are choosing targets and dealing with interest rate changes.
Choosing targets involves deciding whether to target the money supply or interest rates:
Money supply affects expenditure, output, and prices.
Interest rates impact the demand for money and credit.
Controlling both money supply and interest rates simultaneously is not practical.

Governments have typically shifted focus from controlling the money supply to monitoring it due to limited success.
Controlling interest rates is easier but can have uncertain effects:
Interest rate changes can affect demand; higher rates tend to discourage spending.
Investment is more sensitive to interest rate changes than consumption.
High interest rates can have long-term implications for economic growth.
Interest rate policies may lead to instability in credit-based sectors like consumer durables and housing.
Modern economies are highly interconnected, leading to capital mobility between countries.
 Changes in domestic interest rates compared to those in other financial centers can result in significant capital flows.
Inflows of capital increase the domestic currency's demand and raise the exchange rate.
Outflows of capital lead to currency sales and depress the exchange rate, potentially causing undesirable exchange rate
fluctuations.
Monetary policy impacts various factors:
Availability of Finance: Credit restrictions reduce loans, making it hard for new, small-medium businesses to raise funds. This
influences companies to seek stable, long-term finance.
Cost of Finance: Monetary policy restrictions or high interest rates increase borrowing costs, discouraging investments and
expansion by companies. Rising interest rates also affect shareholders' required returns.

Consumer Demand: Credit control and high interest rates reduce consumer demand, making borrowing expensive and
saving attractive. This leads to organizations contracting operations.
Exchange Rates: Domestic interest rate increases attract capital, raising exchange rates. Organizations dealing globally must
consider exchange rate movements and manage exchange rate risk.

Inflation: Monetary policy is used to control inflation. Inflation affects financial decisions, particularly timing purchases, sales,
borrowing, and debt repayment.
Inflation Impact on Business:
Demand-Pull Inflation: Occurs when excess demand allows companies to raise prices and expand profit margins. Profits and
cash flow may increase in nominal terms and the short run.
Cost-Push Inflation: Arises from production cost increases, like rising raw material or labor costs. It initially reduces profit margins,
and the extent of restoration depends on passing cost increases to customers.
In practice, even demand-pull inflation can have negative effects on profits and cash flow due to cost increases.
Excess demand for goods leads to output expansion, which drives up costs like wages.
Companies pass on increased costs as higher prices, often reducing profits and cash flow in the long run.

Fiscal policy
Fiscal Policy and Government Budget:
Governments engage in public expenditure, which can be financed by taxation or borrowing.
Fiscal policy involves using the government budget to influence Aggregate Demand (AD) and economic activity.
The government budget reflects public expenditure and income over a year, funded by taxation or borrowing.
Three budget positions: balanced (expenditure matches taxation), deficit (expenditure exceeds taxation, financed by
borrowing), surplus (expenditure is less than taxation, used to repay previous deficits).
Taxation:
Primary means to finance public expenditure.
Taxes categorized into direct (levied on income receivers) and indirect (levied on consumption, passed on to others).
Indirect taxes tend to have a regressive impact, affecting lower-income individuals more.
Impact of Excessive Taxation:
While taxation generates government income, excessive taxation may have adverse economic consequences:
Disincentives to work and effort, especially with progressive income tax.
Business discouragement, reduced investment, and research and development (R&D) due to high business taxation.
Incentives against foreign investment, as multinational firms may avoid economies with high tax rates.
Possible reduction in tax revenue if taxpayers seek tax-avoidance schemes.
If tax rates exceed a certain level, total tax revenue may decrease.
Government Borrowing:
Government can borrow directly (e.g., long-term bonds) or indirectly (e.g., Treasury bills) from the public.
Long-term bonds (gilts) for long-term financing, Treasury bills for short-term cash flow needs.
Problems of Fiscal Policy:
Crowding Out: Government borrowing can lead to "financial crowding out" where higher borrowing increases interest rates,
reducing private sector investment. This can hinder long-term economic growth.
The impact of crowding out on other borrowers is uncertain, but a significant public sector borrowing requirement (PSNCR)
may lead to reduced private investment.

During economic depressions, government spending can stimulate the economy when private sector investment is low.
Incentives: Taxes influence economic activities and have intended effects (e.g., excise duties on alcohol and tobacco for
health priorities).
High taxes, especially progressive ones, can disincentivize work.
Some taxes, like employer national insurance (NI) payments, increase labor costs and may reduce employment.
 Government intervention and regulation
As well as the general measures to impact business operations discussed above, governments can also take more specific
Competition Policy and Market Structure:
In competitive markets, prices are determined by supply and demand, with producers accepting market prices.
In some markets, monopolies exist, allowing producers to set prices. Monopolies can lead to economic inefficiency and
Issues with Monopolies:
Economic inefficiency occurs when monopolies produce at higher costs without incentives for technological improvement.
Monopolies may engage in price discrimination, charging different prices to different customers (e.g., peak and off-peak
A lack of competition can reduce incentives for innovation and discourage new firms from entering the industry.
Advantages of Monopolies:
Large firms with monopolistic power can achieve economies of scale, which reduce production costs.
Natural monopolies occur when economies of scale are so significant that only one producer is feasible, as seen in public
utilities like energy and water.
Monopoly profits can fund research and development, driving technological and organizational innovation.
Government Responses to Monopoly Power:
Public Provision: Nationalization of economic activities, often considered for natural monopolies, can eliminate unfair pricing
practices and reap economies of scale. However, it may also lead to cost inefficiencies.
Regulation: Regulatory bodies can oversee monopolistic industries, such as OFTEL and OFGAS for utilities or the Financial
Services Authority (FSA) for financial markets. Regulation aims to ensure fair competition and protect consumers from unfair
treatment.
Competition Policy and Control of Monopoly:
Competition policy focuses on two main areas:
Monopolies and Mergers: Concerns arise when firms possess substantial market power (over 25% market share) or when
mergers result in a new company with significant market dominance.
Restrictive Practices: Focuses on uncompetitive trading practices that harm consumer interests.

Legislation typically prohibits anti-competitive agreements, like price-fixing cartels, and abuse of dominant market positions.

Government Assistance to Businesses:

Governments support businesses through grants, subsidies, and access to expert advice and information.
Assistance aims to:
Boost entrepreneurship and innovation.
Facilitate urban renewal and revive declining industries.
Provide workforce training.
Sponsor essential research projects.
Criteria for grant awards are strict, often considering factors like business location, size, and industry sector.
Green Policies and Externalities:
External costs (e.g., environmental damage) are often not considered in a firm's project evaluation, but they have societal
impacts.
Green policies address these externalities through:
Green legislation.
Punitive taxation on environmentally damaging practices.
Externalities refer to costs or benefits not borne by producers or consumers but by society.
Examples of externalities include river pollution from manufacturing processes (production) and vehicle emissions causing air
pollution (consumption).
When external costs are significant compared to private costs, the price system may misallocate resources because
producers and consumers often disregard these external effects.
Policies to control environmental damage, like differential taxes on leaded and unleaded petrol, are becoming more
common as environmental concerns grow.
There's ongoing debate about introducing broader "carbon taxes" in the European Union to address externalities affecting the
environment.
Green policies aim to correct resource misallocation due to externalities, particularly those harming the environment.

Corporate governance Corporate governance is defined as ‘the system by which companies are directed and controlled’
Corporate Governance Framework:
Introduced following collapses of large businesses and concerns about corporate governance.
Common principles in various countries include regulations on:
Separation of supervisory and management functions.
 Transparency in board recruitment and remuneration.
Appointment of non-executive directors (NEDs).
Establishment of audit and remuneration committees.
Implementation of risk control procedures to monitor strategic, business, and operational activities.
Aimed at improving corporate governance standards.
Key Issues in Corporate Governance:
Introduced after high-profile business collapses like Enron and WorldCom.
Aims to address deficiencies in traditional governance systems where boards were responsible for companies, and auditors
appointed by shareholders but remunerated by directors.
Governance regulations, codes, and legislation vary by country but typically cover:
Achieving a balanced board with separation of chairperson and CEO roles.
Inclusion of a sufficient number of independent non-executive directors (NEDs) on the board.

Role of NEDs in preventing boards from being dominated by executive directors and ensuring the company is not run solely for
the benefit of senior executives.
Establishment of a remuneration committee to determine executive directors' pay, with service contracts generally not
exceeding one year.
Efforts to give shareholders more influence over directors' remuneration.
Role of the audit committee in working with external auditors.
Responsibility of the board for monitoring all aspects of risk, not just the internal control system.
The Turnbull Committee, set up by the ICAEW, reported on risk management in corporate governance, leading to risk reports
provided by listed companies in their annual reports.
Audit Committees:
Many global listed companies have audit committees.
An audit committee:
Typically consists of three to five members.
Comprises NEDs with no operating responsibilities.
Primarily assists the board in its stewardship responsibilities by reviewing:
Systems of internal control.
Audit processes.
Financial information provided to shareholders.