Analysis of the Business Environment - Assignment Example

Analysis of the Business Environment Question The Below Target Inflation in Eurozone Introduction Economic growth is determined by the quality of living standards of the people. The prices of goods and services affect economic growth and the quality of people’s lives. Increase or decrease in general prices of goods and services (inflation and deflation) can stimulate or reduce economic growth (Sloman et al., 2010). In Eurozone, the inflation rate has been decreasing since 2013 and deflation is expected in the year 2015 since some countries have already started experiencing its effects. The anticipated Eurozone inflation rate is 2% annually (Great Britain: H.M. Treasury, 2013). However, the recent move has portrayed a declining trend in the inflation rate that has aroused the fear of occurrence of inflation. This study evaluates the present inflation rates in UK and the reasons why UK may fear occurrence of anticipated deflation. Inflation Inflation is contributed by a number of factors such as increase in demand than supply of goods and services, decline in supply of goods or services, increase in supply of money in the economy, etc. (Granville, 2013, p. 143). For example, increases in factory wages, taxes and cost of imports will make companies’ increase the cost of products thus leading to cost-push inflation. Inflation is a characteristic of a growing economy because increased spending stimulates economic growth (Office for National Statistics, 2014). Although inflation affects various people differently its effects in the economy depend on whether that inflation was anticipated or expected (Great Britain: H.M. Treasury, 2013). In the case of anticipated inflation whereby the inflation rate corresponds to the expectations of a majority of the people compensatory strategies can be undertaken to minimize it costs (Office for National Statistics, 2014). For example, banks will adjust interest rates while employers will adjust wages and salaries for their employees in order to compensate for the effects of inflation. Inflation may cause harm to the economy because investors may shun from investing their resources because of uncertainty about expected income (Curwin, & Slater, 2007). It results to market inefficiencies that make it tough for the companies to budget for long-term plans. Also, traders may be tempted to hold goods hoping for future increase in prices (Trading Economics, 2014). In addition, strain productivity because companies will be compelled to move resources away from products and services in order to concentrate on profit and losses from currency inflation. Furthermore, inflation increases the opportunity cost of holding money. High inflation can impose increases in the hidden tax especially because inflated earnings thrust taxpayers into higher tax bracket in case the tax brackets are not indexed for inflation (Granville, 2013). On the other hand, during inflation central bank can adjust to the real interest rate in order to mitigate the recession. Inflation will also encourage investments in non-monetary capital projects. Deflation has severe economic consequences for the affected country’s currency and price of goods. Countries use foreign currencies to carry out international transactions. According to Lipsey &Chrystal (2011), the inflation rate in the Eurozone has remained below 1% since October 2013, the situation that has raised concern that if the government does not intervene the decrease in general prices of goods may occur. The falling deflation is mainly caused by decline in domestic demand. Consumption and investments have continued to decline resulting in a drop in business lending. On the other hand, deflation refers to a sustained decline in general prices of goods and services (Smith, 2014). During a deflation, the value of products and services one can purchase increase hence leading to increasing in purchasing power. The focus of the modern economists is to maintain small and steady rate of inflation in order to reduce severity of economic recessions by enabling the labour market to adapt quickly to the downturn and avoid the risk of liquidity trap that may stop monetary policy from stabilizing the economy (Smith, 2014). The monetary authorities such as central banks have a responsibility to regulate the monetary policy by adjusting interest rates, setting of banking reserve requirements and through open market operations (Encyclopaedia Britannica, Inc., 2014). The central bank attempts to contain excessive inflation and deflation in order to minimize the excessive growth or decline of prices (Smith, 2014). High pace of inflation can be caused by excessive growth of the money supply over the rate of economic growth. On the other hand, low or moderate inflation can be credited to fluctuations in available supplies especially during scarcity or changes in real demand for goods and services. Deflation Deflation refers to the general decrease in price of goods and services. It occurs where the rate of inflation declines below 0% and is characterized by increase in value of the currency. Deflation is characterized by decline in incomes and asset values (Sloman et al., 2010, p. 249). These are due to stagnation of economic growth or recession due to lower prices of goods and services. Most parts of Eurozone are experiencing a decline in prices and incomes. According to Npr (2014), deflation can be a real thing if it is as a result of reducing energy prices. However, in an uncertain economy such as Europe deflation can be very detrimental. Reduction in prices of goods and services results in the reduction of purchases because consumers anticipate further price reductions in the future. When purchases go down the trading partners of that country suffer because of lost revenue (Floud et al., 2014). Reduction of asset prices and incomes results in hardships when paying debts thus resulting in further damages to the economy. Furthermore, borrowers will default on their loans, and lenders make loss hence they may end up collapsing (Npr, 2014). The Eurozone inflation at the beginning of 2013 was 2% while it has remained below 1% for the whole of 2014 thus signifying a possibility of a deflation. Studies indicate that even where economy has not suffered deflation, but the level of inflation is below 2% there are adverse economic consequences (Powell, 2013). Deflation of euro will result in currency appreciation and price deflation that will lead to weaker competitive conditions (Office for National Statistics, 2014). Price deflation can result from deflation of debt or increase in real value of debt not indexed to prices resulting to drying up of credit controls. It will also lead to further deflation or fall in commodity prices and a consequent increase in real return on cash balances and lower aggregate demand (Floud et al., 2014). Tools used by central bank to control deflation The European Central Bank (ECB) applies various tools to regulate inflation rate in the economy. The most common tools available include fiscal and monetary policies (Smith, 2014). The use of monetary policy to regulate inflation involves increasing government spending and reducing taxes. On the other hand, use of monetary policy includes such measures as indirectly reducing medium and long-term interest rates through managing market expectations and increasing the money supply (Curwin, & Slater, 2007). In the exercise of its mandate to regulate market prices, the ECB is focusing on quantitative easing whereby they are targeting to purchase government and private bonds to the tune of 1 trillion euro (Smith, 2014). This move is expected to increase the supply of funds in the economy in order to promote public spending. As government expenditure increases so is the flow of funds and inflation. ECB has embarked on purchasing asset-backed securities and instruments secured by proceeds from mortgages and public sector loans (Ferrero, 2014). The suggested asset plan is worth 1trillion euro, and there is a proposal to continue purchasing more assets in order to increase the raise the price for risky assets. Another plan unveiled by the European Community is to endorse 315 billion euro spending on infrastructure projects such as energy, communication, transportation, etc. (Holmes, 2013). The strategy to increase government spending is aimed at improving Possible Side Effects of Tools Used by ECB to Control Deflations The use of quantitative easing may fail to achieve the intended goal. Critics have argued that the use of quantitative easing will transform expectations. Consequently, consumers and companies will build future expectations of further price decrease and continue suspending their consumptions (Ferrero, 2014). Central bank has limited capacity to contain deflation through quantitative easing. Furthermore, the government is expected to embark on policy reforms during economic deflation in order to ease pressure on wage policies and interest rates (Smith, 2014). Deliberate government intervention can hinder opportunity for a financial bubble and burst considering the market is under intense regulations. Whereas deflations are supposed to pressure the government to come up with strategic measure to stabilize the economy quantitative easing relieves the government of that pressure resulting in laxity in policy adjustment techniques (Smith, 2014). Therefore, the government should explore policy strategies to reverse the deflationary state of the economy in order to promote public spending and anticipated inflation. Another possible side effect of quantitative easing is that increased flow of money in the economy may not necessarily be invested in Eurozone (Smith, 2014). This implies that investors may take the money elsewhere outside Eurozone, and that may have undesired consequences to the economy. In an economy where the unemployment rate is greater than 11%, the government regulations intended to create flexibility of labour and product market will have a deflationary effect (Smith, 2014). That is because labour flexibility will make employers reduce the cost of labor and reduce product prices in order to strengthen market share (Ferrero, 2014). Furthermore, engaging in deregulation functions intended to intensify competition for product market will result in lower prices or further deflation. In an anticipation of deflation, the significant effects of the same includes because money holding will substitute lending as a saving mechanism (Begg et al., 2005). Firstly, there will be a continuous decline in prices followed by an incentive to hoard money, and that may result in instability (Ferrero, 2014). The instability will arise from the fear that while saving money creates an opportunity for increased in value for money on hoard the same may drive the value of goods and services up. When the process of spending the money on board begins, it is likely to have a long-term effect which may be interrupted by periods of inflation and real economic interruptions (Smith, 2014). Secondly, substituting money holding for lending in the financial market will undermine the role of that market of directing savings into investments. It will distinguish the financial mechanisms for those markets because the increased competitions from high return money assets will drive the interest rates close or equal to zero (Ferrero, 2014). For example, the growing desire for saving will increase the desire for hoarding more money. Consequently, the consumer prices will continue to go down thus making production for consumer goods less appealing. In conclusion, ECB has to engage various strategies to control the deflation rate in Eurozone. However, the suggested quantitative easing technique may fail to achieve the anticipated goal of increasing flow of money the economy by reducing long term and medium interest rate because investors may decide to spend the money elsewhere outside the Eurozone. Question 2: Macroeconomic Variables Introduction Macroeconomics refers to study of economy as a whole and the variables that regulates macro-economy, the government policies measures to stabilize the economy, fiscal and monetary policies as well as the supply side of the economy (Alkhudairy, 2008). Macroeconomic variables signals or indicates the present trends in the economy. The government should investigate, evaluate and understand the significant economic variables that determine the contemporary performance of the macro-economy. It helps the management to understand the forces of economic growth, why inflation or deflation occurs, the expected trends and the various policy measures appropriate for achieving the desired economic performance (Alkhudairy, 2008). This study examines the major primary economic macroeconomic goals the UK government is pursuing including low price inflation, stable economic growth, low unemployment and the favourable balance of payment (avoid trade deficit). The government uses various fiscal and monetary policies to achieve its macroeconomic goals. Monetary policy Monetary policy relates to changes in interest rates as influenced by the government or the central bank (Curwin & Slater, 2007). The government or central bank adjusts the interest rates either upwards or downwards depending on the prevailing economic conditions and the expected objectives. Increasing interest rates increases the cost of acquiring loans and since borrowers pay higher interests to the lenders from their profits it acts as disincentive for borrowing. Investors may opt to postpone their investments plans as they wait for the interest rates to come down. On the other hand, consumers tend to spend less on luxury goods and new assets (Curwin& Slater, 2007). However, in an anticipated deflation in UK the government and central bank are focusing on reducing interest rates in order to encourage borrowings and investments. Consequently, this is expected to increase inflation in order to spur economic growth (Holmes, 2013). Fiscal policy The government regulates economic inflation and demand by using fiscal policy. The government raises income from tax levies and spends it on development expenditures (Trading Economics, 2014). Government always scrutinizes the aggregate demand in the economy thus inflation is a good indicator of the aggregate economic demand. The government can increase inflation by increasing expenditures in order to create employment opportunities and reduce the unemployment rates in the economy (Begg et al., 2005). Main Macroeconomic variables Economic growth Economic growth evaluates the expansion of the economy over time. It refers to increase in productive capacity of the economy and is measured in terms of rate of change or real gross domestic products (GDP) (Elliott & Atkinson, 2012). GDP is the value of yield produced within an economy over 12 months. Economic growth is the principal determinant of country’s economic advancement in standards of living. It is examined over time comparative to the performance of the economy over the same period in the immediate past. The UK government objective is to ensure a table positive economic growth (Smith, 2014). UK economy stands at sixth position in the globe with service sector accounting for over 75% of total GDP. Transport, Distribution, Hotels, and Restaurants are the key service sectors with a total of 18% of GDP. Since 1955, the UK economy has been growing at an average rate of 0.61% to date (Powell, 2013). In the third quarter of 2014, the economy grew at 0.70%. In the third quarter of 2014, the household expenditure increased by 0.9%. The government promotes economic growth by supporting business infrastructures, providing business incentives, supporting domestic and foreign investments, promoting public spending, etc. The objective of UK government is to achieve a higher economic growth. For example, in 2014 there was an estimated economic growth of 3% (International Monetary Fund. Research Dept., 2014). Low Unemployment Unemployment refers to the ratio of people not working but willing to engage in employment. The rate of employment points out the overall health of the economy (International Monetary Fund. Research Dept., 2014). The rate of job creation or job loss, the rate of people in the workforce and the rate of unemployment can reflect the level of economic growth. The rate at which the wages are growing determines inflation or deflation (Elliott & Atkinson, 2012). Low unemployment rate is an indicator of growing economy because of an increase in disposable income thus increases in inflation. The unemployment rate is UK started rising sharply in 2008 due to global financial meltdown and reached 5%. Towards the end of the global recession in 2009, the unemployment rate had increased to 8% ad attained the climax by the end of 2011 with over 2.7 million people being unemployed (BBC, 2014). However, the recent trend has shown tremendous decline in unemployment and by the end of October 2014, the rated had reduced to 6%. During the same period there were 30.80 million people at work depicting a rise by 588,000 more workers compared to the persons working in 2013 (BBC, 2014). Reducing unemployment contributes to economic growth because there is an increased in disposable income from the employments that results to increase in spending that stimulates economic growth (BBC, 2014). The UK government aims to sustain unemployment rate below 6%. Therefore, the UK government is achieving its objective of creating more employment opportunities and reducing unemployment rate. Inflation Inflation refers to a sustained increase in general prices for goods and service determined as annual percentage (Lipsey &Chrystal, 2011). It is determined by the annualized percentage change in the general price index over time. During inflation, the value of a currency is determined in terms purchasing power or the real and tangible goods the currency can buy. Inflation distorts prices and destabilizes the definite relationship that must occur between the value and price that forms the basis for market exchange (Trading Economics, 2014). Increase in inflation leads to decline in purchasing power. Increase in inflation results to decrease in value of a currency or the amount of goods and services a given amount of money can buy at any given time (Lipsey &Chrystal, 2011). The declining inflation in Eurozone is likely to result in deflation in the year 2013. The European Central Bank (ECB) has attempted to intervene by using quantitative easing technique with the aim of increasing money for investing through reduction of medium and long-term interest rates. The government objective is to enhance inflation to 2% level in order to stabilize economic growth (Khan, 2014). Balance of payment (BOP) Balance of payment (BOP) refers to the difference between government receipts from abroad, and expenditures or payments made abroad (Elliott & Atkinson, 2012). The BOP can be balance, surplus or deficit. The surplus in BOP occurs when receipts exceeds payments is a determinant of a growing economy (Khan, 2014). Currently, the UK has a deficit in its BOP thus indicating a declining economic growth. The UK consumers prefer imported goods to goods made in Britain hence the deficit in BOP (Khan, 2014). This implies that the UK residents and paying more to residents of other countries that what they receive from them. In the year 2013, the UK BOP deficit reached £72.4 billion which is equivalent to 4.2% of the country’s GDP and the highest deficit in the last 25 years (Office for National Statistics, 2014). In the third quarter of 2014, the country’s import rose to 1.3% against export that increased by 0.6% in the same period. The BOP deficit is mainly due to deficit in finished manufactured goods, decline in income from Brits assets overseas, poor growth and slow demand viewpoint in the largest Britain-Europe largest market for goods and services and general government transfers (Office for National Statistics, 2014). The UK government objective is to avoid trade deficit by applying various mechanisms such as increasing exports and decreasing imports. They aim to raise demand for the local goods in order to reduce imports value as a measure for reducing the balance of payment deficit (Khan, 2014). Conclusion The country’s performance is determined by various macroeconomic indicators compared to the immediate past period. The UK economy is performing well despite the increasing BOP. Although the economy had started declining in performance during and after 2008 global financial meltdown, the trend has reversed in the recent past. Unemployment rate, inflation economic growth and BOP are improving indicating a growing economy. Therefore, UK economy has continued to perform perfectly well. Bibliography Alkhudairy, K. S. (2008). Stock Prices and the Predictive Power of Macroeconomic Variables. ProQuest. Pp. 119-138. AL-Riyami, M. H. (2008). Sources of Macroeconomic Fluctuations in a Small, Developing, Oil- exporting Economy: The Case of the Sultanate of Oman. ProQuest. Pp.10- 47 BBC, (2014). Economy Tracker: Unemployment. Retrieved on 31st December 2014 from Begg, D., Fischer, S., Dornbusch, R. (2005). Economics, (8th Ed.). Mc Graw-Hill Curwin, J. & Slater, R. (2007). Quantitative Methods for Business Decisions, (6th Ed.). Cengage Learning EMEA. Pp. 790. Elliott, L. & Atkinson, D. (2012). Why Britain Will Have a Third World Economy by 2014. Palgrave Macmillan. Pp. 1-389 Encyclopaedia Britannica, Inc., (2014). Britannica Book of the Year 2014. Encyclopedia Britannica, Inc. Pp. 1- 882 pages Ferrero, A. (Jan 15th, 2014). Desperate Times, Desperate Measures. University Of Oxford. Retrieved on 31st December 2014 from. Floud, R., Humphries, J. & Johnson, P. (2014). The Cambridge Economic History of Modern Britain. UK: Cambridge University Press. Pp. 1-560. Gay, R. D. (2008). Effect of Macroeconomic Variables on Stock Market Returns for Four Emerging Economies. ProQuest. Pp. 1-120. Granville, B. (2013). Remembering Inflation. Princeton University Press. Pp. 1-296 Great Britain: H.M. Treasury, (2013). Review of the Monetary Policy Framework. The Stationery Office. Pp. 12-64 Holmes, D.R. (2013). Economy of Words. University of Chicago Press. Pp. 1-264. International Monetary Fund. Research Dept., (2014). World Economic Outlook, October 2014. International Monetary Fund. Pp. 1-242 Khan, M. (04 Nov 2014). Does the UK have a £70bn deficit problem? The Telegraph. Retrieved on 31st December 2014 from Lipsey, R. &Chrystal, A. (2011). Economics, (12th Ed.). Oxford University Press. Pp. 1-677. NPR, (October 31, 2014). "Why Deflation Is Such A Big Worry For Europe" Retrieved on 31st December 2014 from Office for National Statistics, (2014). United Kingdom Balance of Payments. Retrieved on 31st December 2014 from Powell, D. J. (Aug 14, 2013). The Traders Guide to the Euro Area. Wiley. Pp. 1-216. Sloman, J. & Hinde, K. & Garratt, D. (2010). Economics for Business. Financial Times/Prentice Hall. Pp. 1-840 Smith, P. (2014). As Deflation Looms, It’s Europe’s Moment of Truth the Fiscal Times. Retrieved on 31st December 2014 from Trading Economics, (2014). United Kingdom GDP Growth Rate. Retrieved on 31st December 2014 from Read More