Economic environment unit1

THE UGANDA INSTITUTE OF BANKING & FINANCIAL SERVICES

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Module 11: The Economic Environment


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LEARNING OBJECTIVES • By the end of this module, you should be able

to:• Explain the economic environment• Understand basic economic concepts • Explain the difference between micro and

macro economics• Understand the different economic situations

and their causes


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Introduction to Basic Economic Theory and Concepts

The Banking Economic Systems

Pricing and Price Mechanism

Inflation

The Government and Economy

Types of Business Organizations

MODULE COVERAGE

International Trade and Regional Groupings


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Components of economic environment When we talk of the economic environment, we refer to:1. Economic conditions2. Economic system3. Economic policies4. International economic environment5. Economic legislations

Economic Conditions• Economic policies of a business unit are largely affected by the economic conditions of an

economy. Any improvement in the economic conditions such as standard of living, purchasing power of public, demand and supply, distribution of income etc. largely affects the size of the market.Another economic condition that is very important for a business unit is the business cycle.

• The economic cycle has 5 different stages; prosperity, boom, decline, depression and recovery.


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The following are the main aspects Economic Conditions of a country:-1. Stage of an economic cycle2. National Income, Per Capita Income and Distribution of Income3. Rate of Capital Formation4. Demand and Supply trends5. Inflation rate in the economy6. Economic Growth Rate, Exports Growth Rate7. Interest rate prevailing in the economy8. Efficiency of public and private Sectors9. Size of MarketEconomic Systems:• An Economic System of a nation or a country may be defined as a framework of rules, goals

and incentives that controls economic relations among people in a society. It also helps in providing framework for answering the basic economic questions.

• Different countries of a world have different economic systems and the prevailing economic system in a country affect the business units to a large extent. Economic systems of a nation can be of any one of the following type:


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i) Capitalism- The economic system in which business units or factors of production are privately owned and governed is called capitalism. The profit earning is the sole aim of the business units. Government of that country does not interfere in the economic activities of the country. It is also known as free market economy. All the decisions relating to the economic activities are privately taken

ii) Socialism - Under socialism economic system, all the economic activities of the country are controlled and regulated by the Government in the interest of the public. The two main forms of Socialism are:

- Democratic Socialism - All the economic activities are controlled and regulated by the government but the people have the freedom of choice of occupation and consumption.

- Totalitarian Socialism - This form is also known as Communism. Under this, people are obliged to work under the directions of Government.

iii) Mixed Economy - The economic system in which both public and private sectors co-exist is known as mixed economy. Some factors of production are privately owned and some are owned by Government. There exists freedom of choice of occupation and consumption. Both private and public sectors play key roles in the development of the country.


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Economic PoliciesGovernment frames economic policies; economic policies affect the different business units in

different ways. It may or may not have favourable effect on a business unit. The Government may grant subsidies to one business or decrease the rates of excise or custom duty or the government may increase the rates of custom duty and excise duty, tax rates for another business. All the business enterprises frame their policies keeping in view the prevailing economic policies. Important economic policies of a country are as follows:-

• Monetary Policy - This is the policy formulated by the central bank of a country to control the supply and the cost of money (interest rate), in order to attain some specified objectives.

• Fiscal Policy - This may be termed as budgetary policy. It is related with the income and expenditure of a country. It is framed by the government of a country and it deals with taxation, government expenditure, borrowings, deficit financing and management of public debts in an economy.

• Foreign Trade Policy- This also affects the different businesses differently. When restrictive import policy is adopted by the government, it intends to protect the domestic businesses from foreign competition. When the liberal import policy has been adopted by the government then it will affect the domestic products in other way.


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• Foreign Investment Policy- The policy related to the investment by the foreigners in a country is known as foreign investment policy. When the government adopts liberal investment policy then it will lead to more inflow of foreign capital in the country which ultimately results in more industrialization and growth in the country.

• Industrial Policy - Industrial policy of a country promotes and regulates the industrialization in the country. It is framed by government. The government from time to time issues principles and guidelines under the industrial policy of the country.

Global/International Economic Environment:-If any business enterprise is involved in foreign trade, then it is influenced by not only its

own country economic environment but also the economic environment of the country from/to which it is importing or exporting goods. There are various rules and guidelines for these trades which are issued by many organizations like World Bank, WTO, and the United Nations.

Economic Legislation Besides the above policies, Governments of different countries frame various legislations

which regulates and control the business.


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Common Terminology in EconomicsEconomics is a social science because it deals with human behavior in society. It deals

with:• The creation of wealth from scarce resources;• The production and distribution of goods and services for consumption;• The behavior, interaction and well-being of the groups involved in the above activities;Scarcity• There exist only a finite amount of resources—human and non-human. Nature does

not freely provide as much of everything as people want. Therefore resources are scarce according to economists and must be used optimally

Resources• Resources or factors of production are inputs used in the production of goods and

services. They traditionally include land (original fertility and mineral deposits, topography, climate, water, and vegetation), labor (contributions of humans who work (thinking and doing)) and Capital (all manufactured resources including buildings, equipment, machines, and improvements to land).


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Positive EconomicsThis is about the way the economy actually works; it is purely descriptive statements or

scientific predictions about economic phenomena (e.g. if A happened then B will result) Normative economicsThis makes prescription about the way the economy should work; it gives opinion. It is

therefore value judgments about economic policies; it relates to whether things are good or bad. What ought to be.

MicroeconomicsThis is the branch of economics that analyzes the market in terms individual consumers and

firms in an attempt to understand the behavior of decision-making process of firms and households. It is concerned with the interaction between individual buyers and sellers and the factors that influence the choices made by buyers and sellers. In particular, microeconomics focuses on patterns of supply and demand and the determination of price and output in free markets.

Microeconomics is therefore the study of the economic behavior of households and firms and how prices of goods and services are determined. In microeconomics, principal concepts include supply and demand, marginalism, rational choice theory, opportunity cost, budget constraints, utility, and the theory of the firm.


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SupplyIn economics, this refers to the availing of goods and services for sale or exchange in the market. It is usually expressed in terms of quantity relative to price. DemandThis refers to the need or want for a particular good or service, backed by ability to pay (effective demand). Like supply, it is also expressed in terms of quantities in relation to supply.


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Market Equilibrium• The supply and demand model describes how prices vary as a result of a balance between

product availability and demand. The graph depicts an increase (that is, right-shift) in demand from D1 to D2 along with the consequent increase in price and quantity required to reach a new equilibrium point on the supply curve (S).

• Prices and quantities have been described as the most directly observable attributes of goods produced and exchanged in a market economy.

• For a given market of a commodity, demand is the relation of the quantity that all buyers would be prepared to purchase at each unit price of the good. Demand is often represented by a table or a graph showing price and quantity demanded (as in the figure above).

• Demand theory describes individual consumers as rationally choosing the most preferred quantity of each good, given income, prices, tastes, etc. A term for this is 'constrained utility maximization' (with income and wealth as the constraints on demand). Here, utility refers to the hypothesized relation of each individual consumer for ranking different commodity bundles as more or less preferred.


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The law of demand states that, in general, price and quantity demanded in a given market are inversely related. That is, the higher the price of a product, the less of it people would be prepared to buy of it (other things unchanged). As the price of a commodity falls, consumers move toward it from relatively more expensive goods (the substitution effect). In addition,

Purchasing power from the price decline increases ability to buy (the income effect). Other factors can change demand; for example an increase in income will shift the demand curve for a normal good outward relative to the origin, as in the figure.

• Supply is the relation between the price of a good and the quantity available for sale at that price. It may be represented as a table or graph relating price and quantity supplied.

• Producers, for example business firms, are hypothesized to be profit-maximizers, meaning that they attempt to produce and supply the amount of goods that will bring them the highest profit.


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• Market equilibrium occurs where quantity supplied equals quantity demanded, the intersection of the supply and demand curves in the figure on the left.

• At a price below equilibrium, there is a shortage of quantity supplied compared to quantity demanded. This is posited to bid the price up. At a price above equilibrium, there is a surplus of quantity supplied compared to quantity demanded. This pushes the price down.

• The model of supply and demand predicts that for given supply and demand curves, price and quantity will stabilize at the price that makes quantity supplied equal to quantity demanded.

• Similarly, demand-and-supply theory predicts a new price- quantity combination from a shift in demand (as to the figure), or in supply.

Market Equilibrium


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On the supply side of the market, some factors of production are described as (relatively) variable in the short run, which affects the cost of changing output levels. Their usage rates can be changed easily, such as electrical power, raw-material inputs, and over-time and temp work.

Other inputs are relatively fixed, such as plant and equipment and key personnel. In the long run, all inputs may be adjusted by management. These distinctions translate to differences in the elasticity (responsiveness) of the supply curve in the short and long runs and corresponding differences in the price-quantity change from a shift on the supply or demand side of the market.

Other applications of demand and supply include the distribution of income among the factors of production, including labour and capital, through factor markets. In a competitive labour market for example the quantity of labour employed and the price of labour (the wage rate) depends on the demand for labour (from employers for production) and supply of labour (from potential workers).


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Production • Production is the conversion of inputs into outputs. It is an economic process that uses

inputs to create a commodity for exchange or direct use. Production is a flow and thus a rate of output per period of time.

Cost• Cost is an amount that has to be paid or given up in order to get something; it is usually a

monetary valuation of (1) effort, (2) material, (3) resources, (4) time and utilities consumed, (5) risks incurred, and (6) opportunity forgone in production and delivery of a good or service.

Efficiency• A level of performance that describes a process that uses the lowest amount of inputs to

create the greatest amount of outputs. It is an important attribute because all inputs are scarce and so it makes sense to try to conserve them while maintaining an acceptable level of output or a general production level.

Opportunity cost• This is the highest valued alternative that must be sacrificed to attain something or satisfy a

want. Choices must be made between desirable yet mutually exclusive actions. It has been described as expressing "the basic relationship between scarcity and choice.


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Economic efficiency • This describes how well a system generates desired output with a given set of

inputs and available technology. Efficiency is improved if more output is generated without changing inputs, or in other words, the amount of "waste" is reduced.

Macroeconomics• Macroeconomics examines the economy as a whole to explain broad aggregates

and their interactions. Such aggregates include national income and output, the unemployment rate, price inflation and sub-aggregates like total consumption and investment spending and their components.

• It also studies effects of monetary policy and fiscal policy. This considers the performance of the economy as a whole. It looks at issues such as economic growth; inflation; changes in employment and unemployment, trade performance with other countries (i.e. the balance of payments) and the relative success or failure of government economic policies. It is thus focused on the movement and trends in the economy as a whole. It also studies effects of the monetary policy and fiscal policy.


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Economic growth• Growth economics studies factors that explain economic growth i.e. the

increase in output per capita of a country over a long period of time. The same factors are used to explain differences in the level of output per capita between countries, in particular why some countries grow faster than others, and whether countries converge at the same rates of growth. Much-studied factors include the rate of investment, population growth, and technological change.

Economic development• Economic development refers to the combined effect of growth and

redistribution of wealth in the economy. It adds the qualitative element to the purely quantitative measures of growth

Inflation • Inflation is a situation where there is a sustained and abnormal increase in

the general price level.


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Employment and unemployment:• In macroeconomics, full employment is a condition of the national economy, where

all or nearly all persons willing and able to work at the prevailing wages and working conditions are able to do so.

• Unemployment is a status in which individuals are without jobs and are seeking jobs. It is one of the most pressing problems of any economy especially the underdeveloped ones.

Types of Unemployment• Cyclical Unemployment: This type of unemployment is consistent with the trade

cycle. When the economy is in its boom phase, there is a reduction in the unemployment. Conversely, when it passes through the recessionary phase, unemployment rate rises.

Seasonal unemployment: • This type of unemployment is most common in hotel, catering or fruit picking

business.• Frictional unemployment: Frictional unemployment occurs when individuals are

between jobs.


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• Structural unemployment occurs due to a change in the composition of some industries. Technological progress may make an industry capital intensive from a purely labor intensive one. The release in labor from such an industry gives rise to the problem of unemployment.

• Hard core unemployment usually results when a worker is disabled and is not in a position to work. The worker may also give up his job after a few days due to dissatisfaction with the wage.

Balance of payments (BOP)• The balance of payments (BOP), the difference between international receipts and

international payments in an economy, is the measure countries use to monitor all international monetary transactions at a specific period of time. Usually, the BOP is calculated every quarter and every calendar year. All trade conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country.

• The BOP is divided into three main categories: the current account, the capital account and the financial account. Within these three categories are sub-divisions, each of which accounts for a different type of international monetary transaction.


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The current account is used to mark the inflow and outflow of goods and services into a country. Earnings on investments, both public and private, are also put into the current account.

Within the current account are credits and debits on the trade of merchandise, which includes goods such as raw materials and manufactured goods that are bought, sold or given away (possibly in the form of aid). Services refer to receipts from tourism, transportation (like the levy that must be paid in Egypt when a ship passes through the Suez Canal), engineering, business service fees (from lawyers or management consulting, for example), and royalties from patents and copyrights. When combined, goods and services together make up a country's balance of trade (BOT).

Receipts from income-generating assets such as stocks (in the form of dividends) are also recorded in the current account. The last component of the current account is unilateral transfers. These are credits that are mostly worker's remittances, which are salaries sent back into the home country of a national working abroad, as well as foreign aid that are directly received.

The capital account is where all international capital transfers are recorded. This refers to the acquisition or disposal of non-financial assets (for example, a physical asset such as land) and non-produced assets, which are needed for production but have not been produced, like a mine used for the extraction of diamonds.


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In the financial account, international monetary flows related to investment in business, real estate, bonds and stocks are documented. Also included are government-owned assets such as foreign reserves, gold, special drawing rights (SDRs) held with the International Monetary Fund, private assets held abroad, and direct foreign investment. Assets owned by foreigners, private and official, are also recorded in the financial account.

The Balancing ActThe current account should be balanced against the combined-capital and financial accounts.

However, this rarely happens; with fluctuating exchange rates, the change in the value of money can add to BOP discrepancies. When there is a deficit in the current account, which is a balance of trade deficit, the difference can be borrowed or funded by the capital account. If a country has a fixed asset abroad, this borrowed amount is marked as a capital account outflow. However, the sale of that fixed asset would be considered a current account inflow (earnings from investments). The current account deficit would thus be funded.

When a country has a current account deficit that is financed by the capital account, the country is actually foregoing capital assets for more goods and services. If a country is borrowing money to fund its current account deficit, this would appear as an inflow of foreign capital in the BOP.


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Monetary PolicyThis refers to actions taken by a central bank, currency board or other regulatory committee that

determines the size and rate of growth of the money supply which in turn affects interest rates. Monetary policy is maintained through actions such as increasing the interest rate, or changing the amount of money banks need to keep in the vault (bank reserves).

• Monetary policy can control the growth of demand through an increase in interest rates and a contraction in the real money supply. Higher interest rates reduce aggregate demand in the following ways:

• Discouraging borrowing by both households and companies • Increasing the rate of saving (the opportunity cost of spending has increased)• The rise in mortgage interest payments will reduce homeowners' real 'effective' disposable

income and their ability to spend. Increased mortgage costs will also reduce market demand in the housing market

• Business investment may also fall, as the cost of borrowing funds will increase. Some planned investment projects will now become unprofitable and, as a result, aggregate demand will fall

• Higher interest rates could also be used to limit monetary inflation. A rise in real interest rates should reduce the demand for lending and therefore reduce the growth of broad money.


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Fiscal policy• This refers to government actions that

may influence economic activity. It’s the means by which a government adjusts its levels of spending in order to monitor and influence a nation's economy.

• Governments can influence macroeconomic productivity levels by increasing or decreasing tax levels and public spending. This influence, in turn, curbs inflation (generally considered to be healthy when at a level between 2-3%), increases employment and maintains a healthy value of money.


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Common Economic IndicatorsGross Domestic Product (GDP)GDP is the total value of all goods and services produced in the country. This includes

consumer spending, government spending and business inventories. Real GDP is a variant that takes out the impact of inflation, so that GDP can be compared over time. Real GDP is the basic measure of business activity.

Consumer Price Index (CPI) This is a measure of the price of a basket of goods and services. Increase in this index

indicates in inflation and the reverse deflation. Producer Price Index (PPI)PPI is a measure of the price of commercial items, such as farm products and industrial

commodities. PPI indicates the cost of producing items and is also an indicator of inflation.

Trade deficitThis results when a country's imports exceed its exports. Trade surplus This results when a country's exports exceed its imports.


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Balance of payments (BOP) •Is the amount of foreign currency taken in minus the amount of domestic currency paid out.Unemployment rate •This indicates the number or percentage of unemployed people in a country. Increases in the unemployment rate tend to occur when the economy declines and vice versa.


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Economic Cycles Economic cycle refers to the recurring

and fluctuating levels of economic activity that an economy experiences over a long period of time.

The five stages of the economic cycle are growth (expansion), peak, recession (contraction), trough and recovery. At one time, these cycles were thought to be extremely regular, with predictable durations, but today they are widely believed to be irregular, varying in frequency, magnitude and duration.

Economic cyclesPhases of the Economic Cycle

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Economic environment unit1