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2.2. Business Environment |
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Business Environment
& Concepts 2
Concepts 2
Business Environment &
1. Business cycles and reasons for business fluctuations .........................................................
3
2. Economic measures and reasons for changes in the economy ............................................
14
3. Market influences on business strategies.........................................................................
28
4. Implications of dealing in foreign currencies ....................................................................
67
5. Appendix I: Homework reading......................................................................................
80
6. Appendix II: Homework reading ....................................................................................
84
7. Appendix III: Homework reading ...................................................................................
88
8. Terminology ...............................................................................................................
97
9. Class questions ...........................................................................................................
99
BUSINESS CYCLES AND REASONS FOR BUSINESS FLUCTUATIONS
I. BUSINESS CYCLES
A. INTRODUCTION
Business cycles refer to the rise and fall of economic activity relative to its long-term growth trend (i.e., the swings in total national output, income, and employment over time). Although the economy tends to grow over time, the growth in economic activity is not stable. Rather, economic activity is characterized by fluctuations, and these fluctuations are known as business cycles. Business cycles vary in duration and severity. Some cycles are quite mild.
Others are characterized by large increases in unemployment and/or inflation. The analysis of business cycles is part of the field of macroeconomics. Macroeconomics is the study of the economy as a whole. It examines the determinants of national income, unemployment, and inflation and how monetary and fiscal policies affect economic activity. On the other hand, microeconomics studies consumers, producers, and suppliers operating in a narrowly defined market.
B. MEASURING ECONOMIC ACTIVITY: GROSS DOMESTIC PRODUCT
Because business cycles refer to the rise and fall of economic activity, it is important to first examine how economic activity is measured. The most common measure of the economic activity or output of an economy is Gross Domestic Product (GDP). GDP is the total market value of all final goods and services (the term "final goods and services" excludes used goods that have been resold) produced within the borders of a nation in a particular time period (i.e., the nation's output of goods and services). Note that GDP includes all final goods and services produced by resources
resources. Thus, U.S. GDP includes the output of foreign-owned factories in the U.S. but excludes the output of U.S.-owned factories operating abroad.
C. NOMINAL VERSUS REAL GDP
1. Nominal GDP
Nominal GDP (unadjusted) measures the value of all final goods and services in prices prevailing at the time of production. That is, nominal GDP measures the value of all final goods and services in current prices.
2. Real GDP
a. Definition
Real GDP (adjusted) measures the value of all final goods and services in
constant prices. That is, real GDP is adjusted to account for changes in the price
level (i.e., it removes the effects of inflation by using a price index). Real GDP is
the most commonly used measure of economic activity and national output (i.e.
the total output of an economy).
b. Price Index (GDP Deflator)
The price index used to calculate real GDP is called the GDP Deflator. It is a
price index for all goods and services included in GDP. Using the GDP deflator,
real GDP is calculated as the ratio of nominal GDP to the GDP deflator times
100.
Real GDP = Nominal GDP 100
GDP Deflator
×
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D. REAL GDP PER CAPITA AND ECONOMIC GROWTH
Real Per Capita GDP (Real GDP per Capita) is real GDP divided by population. Real GDP
per capita is typically used to compare standards of living across countries or across time.
Real GDP per capita is also used to measure economic growth. Economic growth is the
increase in real GDP per capita over time.
E. SUMMARY COMPOSITION OF BUSINESS CYCLES
As noted above, economic activity is characterized by fluctuations, and these fluctuations are
known as business cycles. Business cycles are typically comprised of:
1. Expansionary Phase
An expansionary phase is characterized by rising economic activity (real GDP) and
growth. During an expansionary phase, economic activity is rising above its long-term
growth trend. Firm profits are likely to be rising during an expansionary phase as the
demand for goods and services increases. Firms are also likely to increase the size of
their workforce during an expansion, and the price of goods and services is likely to be
rising.
2. Peak
A peak is a high point of economic activity. It marks the end of an expansionary phase
and the beginning of a contractionary phase in economic activity. At the peak of a
business cycle, firm profits are likely to be at their highest level. Firms are also likely to
face capacity constraints and input shortages (raw material and labor), leading to
higher costs and a higher overall price level.
3. Contractionary Phase
A contractionary phase is characterized by falling economic activity and growth and
follows a peak. During a contractionary phase, firm profits are likely to be falling from
their highest levels.
4. Trough
A trough is a low point of economic activity. At this point of the business cycle, firm
profits are likely to be at their lowest level. Firms are also likely to experience
significant excess production capacity, leading them to reduce the size of their
workforce and cut costs.
5. Recovery Phase
A recovery phase follows a trough. During a recovery phase, economic activity begins
to increase and return to its long-term growth trend. Further, firm profits typically begin
to stabilize as the demand for goods and services begins to rise.
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II. TERMINOLOGY USED IN DESCRIBING BUSINESS CYCLES
A. RECESSION
A recession occurs when the economy experiences negative real economic growth (declines
in national output). Economists define a recession as two consecutive quarters of falling
national output. During a recession, firm profits tend to fall and many firms incur losses.
Firms are also likely to have excess capacity. As a result, during a recession, resources
(including labor) are likely to be underutilized and unemployment is likely to be high.
B. DEPRESSION
A depression is a very severe recession. It is characterized by a relatively long period of
stagnation in business activity and high unemployment rates. As a result, firms will
experience significant excess capacity. Furthermore, due to the significant reduction in the
demand for goods and services, it is likely that many firms will go out of business during a
depression.
C. ILLUSTRATION
Graph A
illustrates the business cycle.
Time (Years)
Peak
Trough
Peak
Trough
Recovery
Phase
Expansionary
Phase
Graph A
Contractionary Phase
Long-term growth
trend in national output
Output (Real GDP)
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III. ECONOMIC INDICATORS
Although business cycles tend to be irregular and unpredictable, economists nevertheless attempt
to predict business cycles and their severity and duration using economic indicators. Economic
indicators (gathered by The Conference Board) are variables that have historically correlated highly
with economic activity. They can be "leading indicators," "lagging indicators," or "coincident
indicators."
A. LEADING INDICATORS
Leading indicators tend to predict economic activity. The government routinely revises the
numbers as more data becomes available. Thus, leading indicators are subject to change.
They include:
1. Average new unemployment claims
2. Building permits for residences
3. Average length of the workweek
4. Money supply
5. Prices of selected stocks
6. Orders for goods
7. Price changes of materials
8. Index of consumer expectations
B. LAGGING INDICATORS
Lagging indicators tend to follow economic activity. They give signals after the fact and
include the following:
1. Prime rate charged by banks
2. Average duration of unemployment
3. Bank loans outstanding
C. COINCIDENT INDICATORS
Coincident indicators tend to occur coincident to economic activity. They include the
following:
1. Industrial production
2. Manufacturing and trade sales
IV. REASONS FOR FLUCTUATIONS
While there are a variety of theories regarding the cause of business cycles, economists generally
agree that business cycles result from shifts in aggregate demand and/or aggregate supply.
Aggregate demand and aggregate supply curves can be used to illustrate the relationship between
a country's output (real GDP) and price level (the GDP Deflator). They are also used to examine
the causes of economic fluctuations.
A. AGGREGATE DEMAND (AD) CURVE
The aggregate demand (AD) curve illustrates the maximum quantity of all goods and services
that households, firms, and the government are willing and able to purchase at any given
price level. It shows the relationship between total output (real GDP) of the economy and the
price level. Note that this "aggregate" demand curve is the macroeconomic demand curve of
the "total" demand in the economy as a whole. This particular "line" just happens to be drawn
as a straight line; although it is often drawn as a curve. The x-axis is real GDP.
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B. AGGREGATE SUPPLY (AS) CURVE
The aggregate supply (AS) curve illustrates the maximum quantity of all goods and services
producers are willing and able to produce at any given price level. Note that this "aggregate"
supply curve is the macroeconomic supply curve of the "total" supply in the economy as a
whole.
1. Short-Run Aggregate Supply Curve
The short-run aggregate supply (SRAS) curve is upward sloping, illustrating the fact
that as the price level rises, firms are willing to produce more goods and services.
2. Long-Run Aggregate Supply Curve
The long-run aggregate supply (LRAS) curve is vertical, illustrating the fact that in the
long-run, if all resources are fully utilized, output is determined solely by the factors of
production. This curve corresponds to the potential level of output in the economy.
3. Potential Level of Output (Potential GDP)
Potential GDP refers to the level of real GDP (national output) that the economy would
produce if its resources (capital and labor) were fully employed. When real GDP is
below the potential level of output, the economy will typically be experiencing a
recession. Similarly, when real GDP rises above the potential level of output, the
economy will typically be experiencing an expansion.
C. ILLUSTRATION
Graph B
Price Level
Aggregate Demand
Long-Run Aggregate
Supply
Short-Run
Aggregate Supply
Y
illustrates the aggregate demand and aggregate supply curves for an economy.*
P
0
Graph B
The intersection of the Short-Run Aggregate Supply (SRAS) curve and the
Aggregate Demand (AD) curve determines the level of output (real GDP) and
price level in the short run. The position of the long-run aggregate supply (LRAS)
curve determines the level of output in the long run. The LRAS curve is vertical at
the economy’s potential level of output.
Y* = GDP at the potential (equilibrium) level of output.
Real GDP
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D. AGGREGATE DEMAND, AGGREGATE SUPPLY, AND ECONOMIC FLUCTUATIONS
Business cycles, or economic fluctuations, are the result of shifts in aggregate demand and
short-run aggregate supply (note that shifts in the long-run aggregate supply curve are
associated with long-run growth in the economy and do not affect business cycles).
1. Reduction in Demand
If circumstances cause individuals, businesses, or governments to reduce their
demand for goods and services, economic activity (real GDP) will decline, leading to a
contraction in economic activity and possibly a recession. As a result, a reduction in
demand tends to cause firm profits to decline. Firms are also likely to experience an
increase in excess capacity, leading them to reduce the size of their workforce.
2. Increase in Demand
In contrast, if circumstances cause individuals, businesses, and governments to
increase their demand for goods and services, economic activity will rise, leading to a
recovery or an expansion in economic activity. As a result, an increase in demand
tends to cause firm profits to rise. Firms are also likely to experience a reduction in
excess capacity, leading them to increase the size of their workforce.
3. Reduction of Supply
If circumstances cause firms to reduce their supply of goods and services, economic
activity will fall, leading to a contraction or possibly a recession. As firms reduce their
supply, they are also likely to reduce the size of their workforce, leading to higher
unemployment.
4. Increase in Supply
If circumstances cause firms to increase their supply of goods and services, economic
activity will rise, leading to an expansionary phase of economic activity. As firms
increase their supply, they are also likely to increase the size of their workforce, leading
to lower unemployment.
Graphs C and D
short-run aggregate supply.
illustrate recessions caused by shifts in aggregate demand and
Output (Real GDP)
Price Level
Output (Real GDP)
Price Level
AD
1
AD
Y
1 Y0
P
1
P
0
Y
1 Y0
P
1
P
0
A recession caused by a shift in the
aggregate demand curve
aggregate demand causes actual GDP to
fall below potential GDP. This is illustrated
as the leftward shift in aggregate demand.
As a result, real GDP falls from Y
: A decrease in0 to Y1.
A recession caused by a shift in the short
run aggregate supply curve
short-run aggregate supply causes actual GDP
to fall below potential GDP. This is illustrated
as the leftward shift in the short run aggregate
supply curve. As a result, real GDP falls from
Y
SRAS
SRAS
: A decrease in0 to Y1.1
SRAS
AD
LRAS LRAS
Graph C Graph D
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E. FACTORS THAT SHIFT AGGREGATE DEMAND
The primary factors that shift aggregate demand are:
1. Changes in Wealth
a. Increase in Wealth
An increase in wealth causes the aggregate demand curve to shift to the right.
Thus, an increase in wealth causes the economy to expand and leads to an
increase in national output (real GDP).
b. Decrease in Wealth
A decrease in wealth causes the aggregate demand curve to shift to the left. A
decrease in wealth does the opposite of an increase in wealth. For example, a
large decline in stock prices would decrease consumer wealth and therefore shift
the aggregate demand curve to the left. As a result, national output would fall,
causing a contraction and possibly a recession.
2. Changes in Real Interest Rates
a. Increase in Real Interest Rates
An increase in interest rates increases the cost of capital and, therefore, tends to
reduce consumer demand for durable goods such as new cars and homes and
firm demand for new plants and equipment.
b. Decrease in Real Interest Rates
A decrease in real interest rates does the opposite of an increase in real interest
rates. A decrease in real interest rates reduces the cost of capital, thereby
increasing the demand for investment goods and shifting the aggregate demand
curve to the right, causing national output to rise. Conversely, an increase in real
interest rates causes the cost of capital to rise and shifts the aggregate demand
curve to the left, causing national output to fall.
3. Changes in Expectations about the Future Economic Outlook (Consumer
Confidence)
a. Confident Economic Outlook
If households become confident about the economic outlook (consumer
confidence increases), the willingness to acquire investment and consumer
goods increases and the aggregate demand curve shifts right, causing national
output to rise.
b. Uncertain Economic Outlook
When the economic outlook appears more uncertain, consumers tend to reduce
current spending, shifting aggregate demand to the left and causing national
output to fall.
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4. Changes in Exchange Rates
a. Appreciated Currencies
If the currency of a country appreciates in real terms relative to the currencies of
its trading partners, its goods will become relatively expensive for foreigners,
while foreign goods will become relatively cheap for its residents. As a result, net
exports (exports minus imports) will fall, shifting the aggregate demand curve to
the left and causing national output to fall.
b. Depreciated Currencies
If the currency of a country depreciates in real terms relative to the currencies of
its trading partners, its goods will become relatively cheap for foreigners, while
foreign goods will become relatively expensive for its residents. As a result, net
exports (exports minus imports) will rise, shifting the aggregate demand curve to
the right and causing national output to rise.
5. Changes in Government Spending
a. Increase in Government Spending
An increase in government spending shifts the aggregate demand curve to the
right, causing national output to rise.
b. Decrease in Government Spending
A decrease in government spending shifts the aggregate demand curve to the
left, causing national output to fall.
6. Changes in Consumer Taxes
a. Increase in Consumer Taxes
An increase in consumer taxes (e.g., the personal income tax) reduces the
disposable income
shifts the aggregate demand curve to the left, causing national output to fall.
(gross income minus taxes) of consumers and, therefore,
b. Decrease in Consumer Taxes
A decrease in taxes increases the disposable income of consumers and
therefore shifts the aggregate demand curve to the right causing national output
to rise.
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7. Illustration: Changes in Government Spending and/or Taxes
Graph E
in taxes (known as expansionary fiscal policy), and
decrease in government spending and/or an increase in taxes (known as
contractionary fiscal policy).
illustrates the effect of an increase in government spending and/or a decreaseGraph F illustrates the effect of a
Output (Real GDP)
Price Level
Output (Real GDP)
Price Level
AD
AD
1
Y
0 Y1
P
0
P
1
Y
1 Y0
P
0
P
1
In graph E, the economy is initially in a
recession, illustrated as output level Y
0, which is
below
government can stimulate the economy by
increasing government spending or decreasing
taxes
curve to the right and causing national output
(real GDP) to rise.
SRAS SRAS
AD
LRAS LRAS
the potential level of output Y1. The(or both) shifting the aggregate demand
Graph E Graph F
In graph F, the economy is initially in an
expansionary phase, illustrated as output level
Y
Y
by decreasing government spending or
increasing taxes
aggregate demand curve to the left and causing
national output (real GDP) to fall.
AD
0, which is above the potential level of output1. The government can contract the economy(or both), shifting the1
F. THE MULTIPLIER EFFECT
The multiplier effect refers to the fact that an increase in consumer, firm, or government
spending, produces a multiplied increase in the level of economic activity. For example, a $1
increase in government spending results in a greater than $1 increase in real GDP. The
multiplier effect stems from the fact that increases in spending generate income for firms,
which in turn spend that income. Their spending gives other households and firms income,
and so on. Therefore, the effect of a $1 increase in spending is magnified by the multiplier
effect. The multiplier effect results from the marginal propensity to consume (MPC). The
MPC is the change in consumption due to a $1 increase in income. Because people tend to
save part of their income, the MPC is typically less than one. Using the MPC, the size of the
multiplier effect can be calculated using the following formula:
Multiplier 1 Change in Spending
(1 MPC)
= ×
−
Note: The examiners could refer to "1 – MPC" as the marginal propensity to save (MPS), so
be aware of this terminology as well.
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For example, suppose the MPC is 0.8 (i.e., the change in consumption due to a $1 increase
in income is 80 cents) and that spending increases by $100. Then the multiplier would be:
Multiplier 1 $100 $500
(1 0.8)
= × =
−
Thus a $100 dollar increase in spending results in a $500 increase in real GDP.
G. FACTORS THAT SHIFT SHORT-RUN AGGREGATE SUPPLY
Recall that shifts in long-run aggregate supply are associated with economic growth NOT
business cycles. Therefore, when discussing business cycles we focus on shifts in the shortrun
aggregate supply curve. The primary factors that shift short-run aggregate supply are:
1. Changes in Input (Resource) Prices
a. Increase in Input Prices
An increase in input prices (raw material prices, wages, etc.) causes the shortrun
aggregate supply curve to shift left. Thus, an increase in input prices causes
the economy to contract and leads to a decrease in national output (real GDP).
EXAMPLE
For example, a large increase in oil prices (oil is a primary input in production) would shift the short-run aggregate
supply curve to the left. As a result, national output would fall, causing a contraction and possibly a recession. This is
illustrated in Graph D.
b. Decrease in Input Prices
A decrease in input prices causes the short-run aggregate supply curve to shift to
the right. A decrease in input prices causes the economy to expand and leads to
an increase in national output (real GDP).
2. Supply Shocks
a. Supplies are Plentiful
If resource supplies become more plentiful, the short-run aggregate supply curve
will shift to the right, causing national output to increase.
b. Supplies are Curtailed
If resource supplies are curtailed (e.g., crop failures, damage to infrastructure
caused by earthquakes, etc.) the short-run supply curve will shift to the left,
causing national output (real GDP) to decline.
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B2-13
H. SHIFTS IN AGGREGATE DEMAND AND SUPPLY AND THE EFFECTS ON FIRM
BUSINESS OPERATIONS
Shifts in either the aggregate demand or aggregate supply curve affect the business
conditions of firms.
1. Example
As was discussed above, when the aggregate demand curve shifts right (an increase in
aggregate demand), firm profits tend to increase. In addition, firms are likely to
experience a decrease in excess capacity, leading them to increase the size of their
workforce.
2. Effect of Economic Events on the Firm
When economic events (such as those discussed above) cause either the aggregate
demand curve or short-run aggregate supply curve to shift, they also affect the
business conditions of firms.
a. Shifts in Aggregate Demand
Economic events that cause aggregate demand to increase (e.g., an increase in
wealth or a decrease in interest rates) tend to cause firm profits to rise. In
contrast, economic events that cause aggregate demand to decrease (e.g., a
decline in consumer confidence) tend to cause firm profits to fall.
b. Shifts in Aggregate Supply
Economic events that shift the aggregate supply curve also affect firm profits,
employment, and other conditions. For example, a rise in input costs tends to
reduce firm profits and cause firms to reduce the size of their workforce.
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ECONOMIC MEASURES AND REASONS FOR CHANGES IN THE ECONOMY
I. OVERVIEW
Economists and policy-makers rely on a host of economic measures or indicators to determine the
overall state of economic activity. Some of the most commonly cited economic measures are: (1)
real Gross Domestic Product (real GDP), (2) the unemployment rate, (3) the inflation rate, and (4)
interest rates. It is important to remember that these economic measures tend to move together.
For example, when real GDP is rising, unemployment tends to be falling. Similarly, when the
unemployment rate is rising the inflation rate tends to be falling.
II. THE NATIONAL INCOME ACCOUNTING SYSTEM
The National Income and Product Accounting (NIPA) system was developed by the U.S.
Department of Commerce in order to monitor the health and performance of the U.S. economy.
The two approaches to measuring GDP (expenditure approach and income approach, both
discussed in detail below) are calculated using NIPA. The combined economic output of the
following four sectors is called Gross Domestic Product (GDP), the total dollar value of all new final
goods and services produced within the economy in a given time period.
??????
Households (or Consumers)
??????
Businesses
??????
Federal, State, and Local Governments
??????
Remember that GDP was introduced on page B2-3 where nominal GDP and real GDP were
discussed.
The Foreign Sector
A. TWO METHODS OF MEASURING GDP
The two methods of measuring GDP are the expenditure approach and the income approach.
1. The Expenditure Approach
Under the expenditure approach, GDP is the sum of the following four components:
G
Gross private domestic
investment, and change in business inventories)
Personal
Net
overnment purchases of goods and servicesinvestment (nonresidential fixed investment, residential fixedconsumption expenditures (durable goods, non-durable goods, and services)exports (exports minus imports)
G
I
C
E
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2. The Income Approach
The income approach accounts for GDP as the value of resource costs and incomes
generated during the measurement period.
a. The income approach includes business profits, rent, wages, interest,
depreciation, and business taxes.
b. Calculate GDP through the income approach by using the following mnemonic:
I
ncome of proprietors
P
rofits of corporations
I
nterest (net)
R
ental income
A
djustments for net foreign income and miscellaneous items
T
axes (indirect business taxes)
E
mployee compensation (wages)
D
epreciation (also known as capital consumption allowance)
B. COMPARISON OF APPROACHES
The different approaches to preparing an "income statement" for the domestic economy (the
GDP) are shown in the table below.
1. The aggregate expenditures approach on the left is a flow-of-product approach (at
market prices).
2. The income approach on the right is a flow of earnings and costs approach (valueadded
items plus taxes).
Table 1
(Billions of Dollars)
Expenditures Approach Income Approach
(Flow-of-Product) (Earnings and Cost)
G
overnment purchases $1,314.7 Income of proprietors $ 450.9
I
nvestment 1,014.4 Profits of corporations 526.5
C
onsumption 4,698.7 Interest (net) 392.8
E
xports (net) (96.4) Rental income 116.6
A
income/miscellaneous 45.0
djustments for net foreign
T
axes (indirect business) 572.5
E
mployee compensation 4,008.3
D
of fixed capital) 818.8
Aggregate Expenditure
epreciation (consumption$6,931.4 Domestic Income $6,931.4
I
P
I
R
A
T
E
D
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C. OTHER MEASURES OF NATIONAL INCOME
While GDP is the most common measure of national income and an economy's output and
performance, there are several other noteworthy measures. These measures are calculated
by making specific deductions and additions to GDP and include: Net Domestic Product
(NDP), Gross National Product (GNP), Net National Product (NNP), National Income (NI),
Personal Income (PI), and Disposable Income (DI).
1. Net Domestic Product
Net domestic product (NDP) is GDP minus depreciation (the capital consumption
allowance), the expenditure necessary to maintain production capacity (or
"depreciation" to accountants).
2. Gross National Product (GNP)
GNP is defined as the market value of final goods and services produced by
residents
of a country in a given time period. GNP differs from GDP because GNP includes
goods and services that are produced overseas by U.S. firms and excludes goods and
services that are produced domestically by foreign firms. For example, if BMW
produces cars in the U.S., that production is counted as part of U.S. GDP, but it is not
counted as part of U.S. GNP because BMW is a foreign-owned company.
3. Net National Product (NNP)
Net national product (NNP) is defined as the total income of a country's residents less
losses from economic depreciation (i.e., losses in the value of capital goods due to age
and wear). Thus, NNP equals GNP minus economic depreciation. This depreciation is
not accounting depreciation, which is allocation of costs to accounting periods.
4. National Income (NI)
National income (NI) is NNP less indirect business taxes (e.g., sales tax). It measures
the income received by all factors of production within a country.
5. Personal Income (PI)
Personal Income (PI) is the income received by households and noncorporate
businesses. Specifically,
NI
Less
Net interest
Contributions for social measures (social security contributions)
Corporate income taxes
: Undistributed corporate profits (retained earnings)
Plus
Personal interest income
Business transfer payments/dividends
=
6. Disposable Income (DI)
: Government transfer payments to individualsPI
Disposable Income (DI) is personal income less personal taxes. It is the amount of
income households have available either to spend or save.
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III. THE UNEMPLOYMENT RATE
The unemployment rate measures the ratio of the number of people classified as unemployed to
the total labor force. The total labor force includes all non-institutionalized individuals 16 years of
age or older who are either working or actively looking for work. (An unemployed person is defined
as a person 16 years of age or older who is available for work and who has actively sought
employment during the previous four weeks.) Note that to be counted as unemployed a person
must be actively looking for work. The unemployment rate can be expressed as:
Unemployment Rate = Number of Unemployed 100
Total Labor Force
×
A. TYPES OF UNEMPLOYMENT
1. Frictional Unemployment
Frictional unemployment is normal unemployment resulting from workers routinely
changing jobs or from workers being temporarily laid off. It is the unemployment that
arises because of the time needed to match qualified job seekers with available jobs.
2. Structural Unemployment
Structural unemployment occurs when:
a. Jobs available in the market do not correspond to the skills of the work force, and
b. Unemployed workers do not live where the jobs are located.
3. Seasonal Unemployment
Seasonal unemployment is the result of seasonal changes in the demand and supply
of labor. For example, shortly before Christmas, the demand for labor increases and
then decreases again after Christmas.
4. Cyclical Unemployment
Cyclical unemployment is the amount of unemployment resulting from declines in real
GDP during periods of contraction or recession or in any period when the economy
fails to operate at its potential. When real GDP is
cyclical unemployment is positive. When real GDP is
output, cyclical unemployment is negative. Thus, cyclical unemployment rises during a
recession and falls during an expansion.
below the potential level of output,above the potential level of
B. NATURAL RATE OF UNEMPLOYMENT AND THE MEANING OF FULL EMPLOYMENT
1. Natural Rate of Unemployment
The natural rate of unemployment is the "normal" rate of unemployment around which
the unemployment rate fluctuates due to cyclical unemployment. Thus, the natural rate
of unemployment is the sum of frictional, structural, and seasonal unemployment or the
employment rate that exists when the economy is at its potential output level (recall
that the position of the Long-Run Aggregate Supply (LRAS) curve is determined by the
potential level of output).
2. Full Employment
Full employment is defined as the level of unemployment when there is no cyclical
unemployment. Full employment does
economy is operating at full employment, there is still frictional, structural, and seasonal
unemployment.
not mean zero unemployment. When the
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C. THE LINK BETWEEN UNEMPLOYMENT AND OUTPUT (REAL GDP)
The unemployment rate and national output (real GDP) tend to move in opposite directions.
That is, when real GDP is rising, the unemployment rate tends to be falling. Similarly, when
real GDP is falling (for example, when the economy is in a recession), the unemployment rate
tends to be rising. The reason for the link between the two variables is straightforward.
When the demand for goods and services increases (when real GDP is rising), firms typically
need to hire additional workers to produce the additional goods and services demanded and
hence the unemployment rate tends to fall. Obviously the opposite is true when the demand
for goods and services decreases.
IV. THE PRICE LEVEL AND INFLATION
A. DEFINITIONS
1. Inflation
Inflation is defined as a sustained increase in the general prices of goods and services.
It occurs when prices on average are increasing over time.
2. Deflation
Deflation is defined as a sustained decrease in the general prices of goods and
services. It occurs when prices on average are falling over time. Most economists
believe deflation is a much bigger economic problem than inflation. During periods of
deflation, firms are likely to experience significant excess production capacity. This
occurs because consumers tend to hold off purchasing goods and services during a
period of deflation because they realize the price of goods and services is likely to
continue to fall. Consequently, firm profits are likely to be falling during periods of
deflation.
3. Inflation/Deflation Rate
The inflation or deflation rate is typically measured as the percentage change in the
Consumer Price Index (CPI) from one period to the next.
a. Consumer Price Index (CPI)
The CPI is a measure of the overall cost of a fixed basket of goods and services
purchased by an average household. (The Producer Price Index (PPI) measures
the overall cost of a basket of goods and services typically purchased by firms.)
b. Formula
Using the CPI, the inflation rate is calculated as the percentage change in the
CPI from one period to the next:
this period last period
last period
CPI CPI
Inflation Rate = 100
CPI
−
×
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B. CAUSES OF INFLATION AND DEFLATION
Inflation and deflation are caused by shifts in the aggregate demand and short-run aggregate
supply curves. A shift right in the aggregate demand curve will cause the price level to rise,
leading to inflation. Similarly, a shift left in the short-run aggregate supply curve will also
cause the price level to rise, leading to inflation.
1. Demand-Pull Inflation
Demand-pull inflation is caused by increases in aggregate demand. Thus, demand-pull
inflation could be caused by factors such as:
a. Increases in government spending,
b. Decreases in taxes,
c. Increases in wealth, and
d. Increases in the money supply.
2. Cost-Push Inflation
Cost-push inflation is caused by reductions in short-run aggregate supply. Thus, costpush
inflation could be caused by factors such as:
a. An increase in oil prices, or
b. An increase in nominal wages.
3. Illustrations
Graphs G and H
demand and short-run aggregate supply curves.
illustrate demand-pull and cost-push inflation using the aggregate
Output (Real GDP)
Price Level
Output (Real GDP)
Price Level
AD
AD
1
Y
0 Y1
P
0
P
1
Y
1 Y0
P
1
P
0
Demand-Pull Inflation:
aggregate demand causes the short-run
equilibrium price level to rise from P
An increase in0 to P1.
Cost-Push Inflation:
aggregate supply causes the short-run
equilibrium price level to rise from P
SRAS
SRAS
A decrease in shortrun0 to P1.1
SRAS
AD
Graph G Graph H
4. Deflation
Deflation is also caused by shifts in aggregate demand or short-run aggregate supply.
A shift left in aggregate demand (perhaps brought about by a stock market crash or a
large increase in taxes) will cause the aggregate price level to fall. Similarly, a shift
right in the short-run aggregate supply curve will also cause the aggregate price level
to fall.
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C. INFLATION AND THE VALUE OF MONEY
Inflation has an inverse relationship with purchasing power. As the price level rises, the value
of money declines.
1. Definitions
a. Monetary Assets and Liabilities
Monetary assets and liabilities (e.g., cash, accounts receivable, notes payable,
etc.) are fixed in dollar amounts regardless of changes in specific prices or the
general price level.
b. Non-Monetary Assets and Liabilities
The value of non-monetary assets (e.g., a building, land, machinery, etc.) and
non-monetary liabilities will fluctuate with inflation and deflation.
2. Holding Monetary Assets
During a period of inflation, those with a fixed amount of money or income (e.g., retired
persons) will be hurt (i.e., their purchasing power will be eroded). Similarly, firms that
lend out money at fixed interest rates are likely to be hurt by inflation.
3. Holding Monetary Liabilities
During a period of inflation, those with a fixed amount of debt (e.g., those with home
mortgages) will be aided (i.e., the debt will be repaid with inflated dollars). Thus,
inflation also tends to be benefit firms with large amounts of outstanding debt.
EXAMPLE
OPEC and the Stagflation of the 1970s
Between 1973 and 1974, OPEC (Organization of Petroleum Exporting Countries) substantially curtailed its production of
crude oil. As a result, the price of a barrel of crude oil rose from approximately $2.00 per barrel in late 1973 to $10.00
per barrel in late 1974.
This increase in the price of crude oil had a substantial effect on the U.S. economy. Specifically, rising crude oil prices
represented an increase in input costs for U.S. firms. As a result, firms cut back production and the short-run aggregate
supply curve shifted left.
This is the situation depicted in Graph D. As the short-run aggregate supply curve shifted left, national output (real
GDP) began to decline, unemployment began to rise, and the aggregate price level began to rise (cost-push inflation).
The combination of falling national output and a rising price level is known as
74 led to a recession in the U.S. that was particularly harsh because not only was the unemployment rate rising, but the
newly unemployed were facing higher prices for goods and services due to inflation!
stagflation. The actions of OPEC in 1973-
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EXAMPLE
The Great Depression and Deflation
The Great Depression began with the stock market crash of October 24, 1929. By 1932, the Dow Jones industrial
average had fallen 89% from its peak in 1929. In addition, shortly before the stock market crash, the Federal Reserve
(the Central Bank of the U.S.) increased interest rates in an attempt to control inflation. It then increased interest rates
again in early 1931.
While the stock market crash was not the only cause of the great depression, it does mark the beginning of the
depression. The depression was caused by a number of factors including ill-timed interest rate hikes by the Federal
Reserve, the stock market crash, and protectionist trade policies. Table 1 shows what happened to real GDP, the
unemployment rate, and the price level (as measured by the CPI) between 1929 and 1933.
Table 1
Year Real GDP
(Billions of 1987 Dollars)
Unemployment
Rate
Price Level
(CPI)
1929 821.8 3.15% 17.1
1930 748.9 8.71% 16.7
1931 691.3 15.91% 15.2
1932 599.7 23.65% 13.7
1933 587.1 24.87% 13.0
As the table illustrates, the Great Depression was characterized by falling output (falling real GDP), rising
unemployment and deflation. The deflation that occurred can be seen by noting that between 1929 and 1933 the price
level fell continuously. Furthermore, at the height of the Great Depression, one out of every four workers was
unemployed!
The data suggests that the Great Depression was caused by a shift left in aggregate demand, as in
Specifically, the stock market crash reduced household wealth, which shifted the aggregate demand curve to the left.
In addition, the interest rate hikes, orchestrated by the Federal Reserve, increased the cost of capital, thereby
decreasing the demand for investment goods and shifting the aggregate demand curve even further to the left. As
aggregate demand fell, the price level also fell and the nation experienced a period of deflation.
Graph C.
V. INVERSE RELATIONSHIP BETWEEN INFLATION AND UNEMPLOYMENT
A. THE PHILLIPS CURVE
Inflation and unemployment are traditionally thought to have an inverse relationship in the
short run. The Phillips Curve illustrates the inverse relationship between the rate of inflation
and the unemployment rate. It illustrates the tradeoff that exists in the short run between
inflation and unemployment. While unemployment and inflation have historically moved in
opposite directions, during the oil shocks of the 1970s the Phillips Curve broke down.
Specifically, the oil shocks (negative supply shocks) of the 1970s led to a situation where
both unemployment and the price level were rising.
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B. ILLUSTRATION OF THE PHILLIPS CURVE
The Phillips Curve is illustrated in
Graph I.
Inflation Rate
Unemployment Rate
The Phillips Curve illustrates the tradeoff
between inflation and unemployment.
When unemployment is high, inflation
tends to be low, and when unemployment
is very low, inflation tends to be high.
Graph I
VI. BUDGET DEFICITS AND SURPLUSES
The budget is the federal government's plan for spending funds and raising revenues through
taxation, fees, and other means (and for borrowing funds if necessary). The budget deficit and the
budget surplus are important indicators of the current and future health of an economy.
A. BUDGET DEFICITS
A budget deficit occurs when a country spends more than it takes in (mostly in the form of
taxes).
1. Financing Budget Deficits
Budget deficits are usually financed by government borrowing, which affects interest
rates. The government could also finance budget deficits by printing new money.
However, financing budget deficits by printing money causes inflation.
2. Cyclical Budget Deficit
A cyclical budget deficit is caused by temporarily low economic activity. For example, a
cyclical budget deficit might be caused by a recession.
3. Structural Budget Deficit
A structural budget deficit is one that is caused by a structural imbalance between
government spending and revenue. Structural deficits are not caused by temporarily
low economic activity.
B. BUDGET SURPLUSES
A budget surplus occurs when government revenues exceed government spending during
the year.
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VII. INTEREST RATES
A. NOMINAL AND REAL INTEREST RATES
1. Nominal Interest Rate
The nominal interest rate is the amount of interest paid (or earned) measured in current
dollars. When the economy experiences inflation, nominal interest rates are not a good
measure of how much borrowers really pay or lenders really receive when they take
out or make a loan. A more accurate measure of the interest borrowers pay or lenders
receive is the real interest rate.
2. Real Interest Rate
The real interest rate is defined as the nominal interest rate minus the inflation rate. It
is a measure of the purchasing power of interest earned or paid.
Real Interest Rate = Nominal Interest Rate – Inflation Rate
EXAMPLE
For example, if you take out a loan with a 10% nominal interest rate and the inflation rate is 3%, then your real interest
rate is only 7%. That is, after adjusting for the fact that the dollars with which you will repay the loan in the future are
worth less than current dollars due to inflation, you are really only paying 7% to borrow the money!
3. Relationship Between Nominal Interest Rates and Inflation
Nominal interest rates and inflation tend to move together. When the inflation rate
increases, so does the nominal interest rate. The relationship between nominal
interest rates and inflation may be shown by rearranging the above equation for real
interest rates as follows:
Nominal Interest Rate = Real Interest Rate + Inflation
Thus, if real interest rates do not change, a 1% increase in the inflation rate will lead to
a 1% increase in nominal interest rates.
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Illustration: Nominal Interest Rates and Inflation (Graph J)
Nominal Interest Rates and Inflation
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
16.00%
18.00%
20.00%
1955 1960 1965 1970 1975 1980 1985 1990 1995
Year
Interest Rate/Inflation Rate
Nominal Interest Rate
Inflation Rate
Note the close relationship between nominal interest rates and the inflation rate. As
the inflation rate increases, the nominal interest rate also increases. Also note that
around 1974/1975 the inflation rate was actually higher than the nominal interest rate
implying real interest rates were negative!
B. DEFINITION OF MONEY AND THE MONEY SUPPLY
Money is the set of liquid assets that are generally accepted in exchange for goods and
services. The money supply is defined as the stock of all liquid assets available for
transactions in the economy at any given point in time. There are several definitions of
money supply. M1 and M2 are the most common measures of money supply and are
reported (periodically) in financial publications such as the Wall Street Journal.
M1
includes coins, currency, checkable deposits (accounts that allow holders to write checks
against interest-bearing funds within them), and traveler's checks. M1 does not typically
include savings accounts or certificates of deposit (CDs).
is defined broadly as money that is used for purchases of goods and services. It typically
M2
but that can be converted easily into checkable deposits or other components of M1. These
include time certificates of deposit less than $100,000, money market deposit accounts at
banks, mutual fund accounts, and savings accounts.
is defined broadly as M1 plus liquid assets that cannot be used as a medium of exchange
M3
includes all items in M2 as well as time certificates of deposit in excess of $100,000.
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C. MONETARY POLICY AND THE MONEY SUPPLY
Monetary policy is the use of the money supply to stabilize the economy. The Federal
Reserve uses monetary policy to increase or decrease the money supply in an effort to
promote price stability and full employment. Understanding the effects of changes in the
money supply is important because changes in the money supply lead to changes in interest
rates, changes in the price level, and changes in national output (real GDP). The Fed
controls the money supply through:
1. Open Market Operations (OMO)
Open Market Operations (OMO) consist of the purchase and sale of government
securities (Treasury Bills and bonds) in the open market.
a. Increase in the Money Supply
When the Fed purchases government securities, it increases the money supply
(i.e., puts money into circulation to pay for the securities).
b. Decrease in the Money Supply
When the Fed sells government securities, it decreases the money supply
(i.e., takes money out of circulation).
2. Changes in the Discount Rate
The discount rate is the interest rate the Fed charges member banks for short-term
(normally overnight) loans.
a. Member banks may borrow money from the Fed to cover liquidity needs,
increase reserves, or make investments.
b. Raising the discount rate discourages borrowing by member banks and
decreases the money supply.
c. Lowering the discount rate encourages borrowing by member banks and
increases the money supply.
3. Changes in the Required Reserve Ratio (RRR)
The Required Reserve Ratio (RRR) is the fraction of total deposits banks must hold in
reserve.
a. Raising the reserve requirement decreases the money supply.
b. Lowering the reserve requirement increases the money supply.
D. INTEREST RATES AND THE SUPPLY OF AND DEMAND FOR MONEY
1. Demand for Money is Inversely Related to Interest Rates
Changes in the money supply have a direct effect on interest rates because interest
rates are determined by the supply of and demand for money. The demand for money
is the relationship between how much money individuals want to hold and the interest
rate. The demand for money is inversely related to the interest rate—as interest rates
rise, it becomes more expensive to hold money (because holding money rather than
saving or investing it means you do not earn interest), thus reducing the demand for
money.
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2. Supply of Money is Fixed at a Given Point in Time
As noted above, the supply of money is determined by the Federal Reserve and is
therefore fixed at any given point in time at the level set by the Federal Reserve.
Graph K
money demand curve and the money supply line determines the interest rate.
a. An increase in the money supply will cause interest rates to fall.
b. Conversely, a decrease in the money supply will cause interest rates to rise.
illustrates the demand for and supply of money. The intersection of the
Interest Rate
Quantity of Money
Demand for Money
MS MS
1
Equilibrium
interest rate;
I
0
I
1
Graph K
The Money Market
The Money Market:
money intersects the supply of money. The money supply curve is vertical since
the Federal Reserve controls the supply of money (thus it is independent of the
interest rate). If the Fed increases the money supply, interest rates will fall, as
illustrated by the fall in interest rates from I
The equilibrium interest rate is found where the demand for0 to I1.
VIII. MONETARY POLICY AND ITS EFFECTS ON INTEREST RATES, THE PRICE LEVEL, OUTPUT
(REAL GDP) AND UNEMPLOYMENT
When the Federal Reserve increases or decreases the money supply it has a direct effect on
interest rates and an indirect effect on the price level, real GDP, and the unemployment rate.
Specifically, when the Fed changes the money supply, it causes interest rates to either increase or
decrease. As we saw earlier, changes in the interest rate directly affect the cost of capital and thus
shift the aggregate demand curve. Finally, shifts in aggregate demand cause changes in the price
level, real GDP, and the unemployment rate.
A. EXPANSIONARY MONETARY POLICY (INCREASES IN THE MONEY SUPPLY)
Expansionary monetary policy results when the Fed increases the money supply.
Expansionary monetary policy affects the economy through the following chain of events:
1. An increase in the money supply causes interest rates to fall.
2. Falling interest rates reduce the cost of capital and hence stimulate the desired levels
of firm investment and household consumption.
3. Increases in desired investment and consumption cause an increase in aggregate
demand.
4. Aggregate demand shifts to the right, causing real GDP to rise, the unemployment rate
to fall, and the price level to rise.
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B. CONTRACTIONARY MONETARY POLICY (DECREASES IN THE MONEY SUPPLY)
Contractionary monetary policy results when the Fed decreases the money supply. The
effect of contractionary monetary policy is the exact opposite of expansionary monetary
policy. Specifically:
1. A decrease in the money supply causes interest rates to rise.
2. Rising interest rates reduce the desired levels of firm investment and household
consumption.
3. Decreases in desired investment and consumption cause a decrease in aggregate
demand.
4. Aggregate demand shifts to the left, causing real GDP to fall, the unemployment rate to
rise, and the price level to fall.
EXAMPLE
The 2001 Recession and Monetary Policy
After growing steadily for almost a decade, the U.S. economy started to slow down at the end of 2000. The slowdown
in the economy was accompanied by a large drop in stock prices that marked the end of the bull market of the late
1990's. In 2001, the U.S. economy experienced two consecutive quarters of negative real GDP growth implying the
economy had slipped into a recession. As the economy began to falter, Alan Greenspan, the Chairman of the Federal
Reserve, initiated expansionary monetary policy. Specifically, the Federal Reserve began lowering interest rates by
increasing the money supply. Lower interest rates helped keep the economy from slipping even further into a
recession. Specifically, lower interest rates led to a large increase in home purchases starting in 2001 and continuing
through 2002. In addition, lower interest rates made it possible for the auto industry to offer attractive financing rates,
including zero-percent financing! This helped increase consumer purchases of automobiles and overall demand for
goods and services in the economy. The recession of 2001 and the actions taken by the Federal Reserve are
illustrated in Graphs L and M.
Graph L Graph M
M
o M1
P
1
MS
0
Money Demand
MS
1
I
0
I
1
Interest Rate
LRAS
Price Level
SRAS
Y
0
P
0
AD
0
AD
1
Y
Quantity of Money
1 Real GDP
Graph M illustrates the recession of 2001. During the recession, output (real GDP) is at Y
potential level of output Y
monetary policy of the Federal Reserve. By increasing the money supply, the Federal Reserve caused interest rates to
fall from I
such as automobiles. The increased consumption and investment led to a shift right in aggregate demand as depicted
in graph M. As aggregate demand shifted right, real GDP began to increase and the economy began to recover from
the recession.
0, which is below the1, indicating a recession. Graph L illustrates the money market and the expansionary0 to I1. Lower interest rates spurred new home investments and consumer consumption of durable goods
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MARKET INFLUENCES ON BUSINESS STRATEGIES
I. INTRODUCTION
The strategic goals of a firm are influenced by the market in which the firm operates. The ability of
a firm to achieve success is a direct result of how well the strategic plan fits the market in which the
firm operates and how well the firm carries out its strategic plan. The firm must create an overall
plan (a strategic plan) to assist in combating competition and helping it to develop an approach to
achieve its objectives (in line with the firm's vision and mission statement).
Strategic thinking encompasses a wide variety of issues with various types of benefits, such as the
unification of organizational and operational decisions, goal-orientation toward the desired company
achievements, directed focus on planning for flexible responses for new developments in the
market, the creation of bases for evaluation, and the overall company focus on the vision, mission
statement, and objectives of the firm.
A. STEPS IN STRATEGIC MANAGEMENT (STRATEGIC POSITIONING)
Strategic management (positioning) normally involves defining the mission, identifying the
strategy, identifying the critical success factors, and analyzing those success factors by
recognition of strengths, weaknesses, opportunities, and threats.
1. Define the Firm's Vision and Mission Statements
Organizational mission statements usually represent one or two line descriptions of
what the organization is in business to do. Ultimately, however, mission philosophies
fall into one of three basic categories that impact the overall manner in which the
organization carries out its business.
a. Build Missions
Build missions are for organizations that accommodate a volume or range of
work as a means of accomplishing organizational objectives. Organizations with
build missions tend to take a long-term view and are likely to invest in significant
capital projects.
b. Hold Missions
Hold missions are for organizations that maintain their current competitive
position.
c. Harvest Missions
Harvest missions are for organizations that reap immediate benefits from the
organization. Organizations with harvest missions tend to have a short-term
view, are less likely to invest in significant capital projects, and are more likely to
focus on net income, cash flows, and immediate return.
2. Set the Goals of the Firm
Organizations can choose any number of ways to achieve their missions. Generally,
however, there are two broad and distinct paths for achieving organizational goals: cost
leadership and differentiation. Each path has its own characteristics and implications
for operational planning, budgeting, and corporate culture and will be discussed in
detail later in this lecture.
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3. Define the Objectives of the Firm
a. Financial Objectives
Financial objectives are the improvement of the overall financial outcomes of a
firm's strategy.
b. Non-Financial Objectives
Non-financial objectives are the improvement of the overall ability of the firm to
compete in the market in the long run, which is the ultimate focus for overall
shareholder wealth maximization.
4. Decide What to Measure and Take a Baseline Measurement
Organizations use various measures of success to determine the achievement of
strategic objectives. These measures are generally referred to as critical success
factors, which may be either financial or non-financial.
a. Financial Measures (Financial)
Financial measures of success are generally derived from the financial reporting
system of the organization or the marketplace. Examples of financial measures
include sales or earnings growth, dividend growth, and growth in the market
value of the organization's stock, credit ratings, cash flows, etc.
b. Internal Business Processes (Non-Financial)
Internal business process measures of success generally relate to non-financial
measures of efficiency or production effectiveness derived from internal records.
Internal business process measures of success include quality measures, cycle
time computations, yields, reduction in waste, etc.
c. Customer Measures (Non-Financial)
Customer measures of success are non-financial measures of organizational
effectiveness derived from information provided directly or indirectly by
customers or from data derived from responses to customers. Customer
measures of success include market share data, customer satisfaction data,
brand recognition information, on-time delivery data, etc.
d. Advance Learning and Innovation (Non-Financial)
Learning and innovation measures of success are internal measures of effective
use of human resources including morale and corporate culture, innovation in
new products and methods, education and training, etc.
5. Strategic Analysis (SWOT)
Organizations use strategic or SWOT (
Strengths, Weaknesses, Opportunities, and
T
organization will measure. Factors internal to an organization that impact strategy are
the sources of strengths and weaknesses. Outstanding skills that represent strengths
in relation to competitors are referred to as core competencies. Factors external to the
organization are the sources of opportunities and threats. As managers review these
factors, the organization builds clarity regarding the mission, consensus as to strategy,
critical success factors, and the impact of internal and external factors on the business.
hreats) analysis to ascertain the overall strategy and critical success factors that the
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