Government and the macroeconomy: objectives - Business Environment

Not withstanding 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:

Aggregate Monetary Demand = Consumer spending + Investment spending
+ Government spending + Export spending
– Import spending
or AMD = C + I + G + X – M

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, 4 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 behavior 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.

Controlling inflation
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 of all political complexions reducing such movements to a minimum is seen as a primary economic objective (e.g. the current
UK government’s target for ‘underlying inflation’ was 2.5 per cent. Under the new
Consumer Prices Index the target is now 2 per cent). Monitoring trends in periodic price movements tends to take a number of forms; in the UK these include:

1 The use of a Retail Price Index (RPI), which measures how an average family’s spending on goods and services is affected by price changes. The RPI has traditionally been the measure used for ‘headline inflation’ in the UK and includes mortgage interest payments.

2 An examination of the ‘underlying rate of inflation’, which excludes the effects of mortgage payments (known as RPIX in the UK).

3 Measuring ‘factory gate prices’, to indicate likely future changes in consumer prices.

4 Comparing domestic inflation rates with those of the United Kingdom’s chief overseas competitors, as an indication of the international competitiveness of UK firms.

With regard to the latter, the UK has recently introduced a new measure of inflation known as the Consumer Prices Index (CPI) to allow for a more direct comparison of the inflation rate in the UK with that of the rest of Europe. The CPI excludes a number of items that have historically been part of the RPIX, especially items relating to housing costs (e.g. mortgage interest payments and council tax).

In addition, changes in monetary aggregates, which measure the amount of money (and therefore potential spending power) in circulation in the economy, and movements of exchange rates (especially a depreciating currency see are also seen as a guide to possible future price increases, as their effects work through the economy.

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 whole sale and/or retail prices. Second, demand-siders, in contrast, tend to emphasize the importance of 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 not only may 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.

Economic growth
Growth is an objective shared by governments and organisations alike. For governments, 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). 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:
_ steady levels of real growth (e.g. 3–4 per cent p.a.), rather than annual increases
in output which vary widely over the business cycle;
_ growth rates higher than those of one’s chief competitors; and
_ growth based on investment in technology and on increased export sales, rather than on excessive government spending or current consumption.

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 negative. In the United Kingdom, for example, a recession is said to exist following two consecutive quarters of negative GDP.

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, how-ever, 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 ‘de industrialization’). 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 Britain, for example, the monthly and quarterly surveys by the Confederation of British Industry (CBI) provide a good indication of how output, investment and stock levels change at different points of the business cycle and these are generally seen as a good indication of future business trends, as interpreted by entrepreneurs. Other indicators including the state of the housing market and construction generally help to provide a guide to the current and future state of the economy, including its prospects for growth in the short and medium term.

Reducing unemployment
In most democratic states the goal of ‘full employment’ is no longer part of the political agenda; 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 on the Exchequer (e.g. by reducing tax yields and increasing public expenditure on welfare provision), and it is frequently linked with grow and health problems. Its implication for businesses, however, tends to be less clearcut. 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).

A favourable 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.

While it does not follow that a sustained current account deficit is inevitably bad for the country concerned, it often implies structural problems in particular sectors of its economy or possibly an exchange rate which favours importers rather than exporters. Many observers believe, for instance, that the progressive decline of Britain’s visible trading position after 1983 was an indication of the growing uncompetitiveness of its firms, particularly those producing finished manufactured goods for consumer markets at home and abroad. By the same token, Japan’s current account trade surplus of around $120 billion in late 1995 was portrayed as a sign of the cut-throat competition of Japanese firms, particularly those involved in producing cars, electrical and electronic products, and photographic equipment.

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 (seebelow). Where annual revenue exceeds government spending, a budget surplus
occurs and the excess is often used to repay past debt (formerly known in the
United Kingdom as the ‘public sector debt repayment’ or PSDR). 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’ or PSBR (now known in the UK as ‘public sector net borrowing’ or PSNB). 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:

1 Its impact on interest rates, given that higher interest rates tend to be needed to attract funds from private sector uses to public sector uses.
2 The impact of high interest rates on consumption and investment and hence on the prospects of businesses.
3 The danger of the public sector ‘crowding out’ the private sector’s search for funds for investment.
4 The opportunity cost of debt interest, especially in terms of other forms of public spending.
5 The general lack of confidence in the markets about the government’s ability to control the economy and the likely effect this might have on inflation, growth and the balance of payments.
6 The need to meet the ‘convergence criteria’ laid down at Maastricht for entry to the single currency (e.g. central government debt no higher than 3 per cent of GDP).

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 = $1.50 or £1 = €1.63). 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.

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