MBA Notes: Economics

Key Topics:
- Schools of economic thought
- Market structures and competition
- Managing growth
- Understanding business cycles
- Fiscal and monetary policy considerations
- Assessing economic success

Economics has been something of a backwater subject but the crisis that hit the global economy at the end of the first decade of the 21st century changed all that. There is hardly anyone in business who hasn't heard and felt the clash between the Keynesian view that economies need occasionally to be kick started and that of the Monetarists who claim most problems with economies can be solved with a liberal injection of cash – quantitative easing.

In fact, as by 2010/11 it had become evident from the contrasting behaviour of governments around the world all heavily armed with schools of their own economist, there is no conclusive universally applicable strategy for managing economies.

Gordon Brown, then British Prime Minister who claimed to have banished boom and bust, was proved decisively wrong. Perhaps the best way to appreciate why economists never agree lies in this quote by Maynard Keynes: 'When the facts change I change my mind.'

The jury is out on who the got the whole subject of economics under way, but two serious contenders are Aristotle (382–322 BC) who, in his work Topics, got the subject of human production under way, and Chanakya, whose treatise Arthasastra (economics), written in the period 321–296 BC, laid out a framework for the economic management of India's agriculture, forestry, wildlife, mining, transport and trade.

Alfred Marshall, the dominant figure in British economics until his death in 1924, defined economics in his influential textbook Principles of Economics as: 'a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well-being. Thus it is on one side a study of wealth; and on the other, and more important side, a part of the study of man.'

Today that definition has been shortened in most textbooks on the subject to: 'Economics is the social science which examines how people choose to use limited or scarce resources in attempting to satisfy their unlimited wants.'

The dismal science, as economics is often referred to, reveals something of the contradictions inherent in the subject itself. Science to most people means a subject comprising fundamental truths that hold good under all conditions and forever.

Two and two equals four, or the area of a circle = πr2, work equally as well as propositions in Mongolia and on the Moon. But put two economists together and you will get three economic theories. Worse still, if you put three together you could end up with six!

Schools of economic thought
Groups of economists who broadly share the same views are collectively known as schools. Thinking of these as places where people are learning about a constantly changing dynamic subject is a more useful concept than considering economics to be a science.

With Buddha seeking to eliminate want, Malthus who was sure that human populations grew faster than food production and so charity was self-defeating, Marx and Keynes who for different reasons saw the state's role as central and Adam Smith whose 'Invisible Hand' saw all economic activity as being subject to the law of unintended consequences, there has been and is some scope for diversity.

The two economic theories that every self-respecting MBA must have an appreciation of are:

- Keynesian: A theory of macroeconomics developed by British economist John Maynard Keynes and documented in his book The General Theory of Employment, Interest and Money, published in 1936. He argued that low demand is the primary cause of recessions and that government fiscal policies (see below) should be the method employed to create employment, control inflation and stabilize business cycles. This work initiated the modern study of macroeconomics and guided economic thinking, only diminishing in popularity in the 1970s when violent shocks to economies, caused particularly by escalating oil prices, simultaneously led to high unemployment and high inflation rates. This challenged the central implications of Keynesian economics.
 

- Monetarist: First put forward by the economist Milton Friedman and the Chicago school of economists. Friedman and Anna Schwartz (an economist at the US National Bureau of Economic Research) in their book A Monetary History of the United States 1867–1960 argued that 'inflation is always and everywhere a monetary phenomenon'. Friedman advocated that a country's central bank should pursue a monetary policy (see below) such as to keep the supply of and demand for money at equilibrium. By 1990 monetarism was being challenged as it could not be reconciled with, among other things, the inability of monetary policy alone to stimulate the economy in the 2001–03 period.

Marxism: 'Das Kapital, Kritik der politischen Okonomie' (Capital: Critique of Political Economy), published in 1887 in its first English edition is a critical analysis of capitalism as an economic force. It set out to show that the economic laws of the capitalist mode of production were basically flawed. In the second best-selling book of all time, The Communist Manifesto, Marx and his co-author Engels wrote: 'What the bourgeoisie therefore produces, above all, are its own grave-diggers. Its fall and the victory of the proletariat are equally inevitable.'

Marxism claims that labour is the only economic factor entitled to earn money and that those with capital should not be able to receive an income as interest on their savings or investments. In any period of history, dominant and subservient classes, according to Marxism, can be identified by their inequality in wealth and power. Marx saw this as a fundamental moral problem and argued that while capitalism continued to operate, some groups would dominate others and take for themselves the lion's share of the society's wealth, power and privileges. The ultimate goal of Marxism is a classless society where everyone is equal. Marx believed that history is in essence concerned with the struggle between classes for dominance: 'The history of all hitherto existing society is the history of class struggles.'

While conventional economics, that is the capitalist versions of the subject, believe Marxism is dead and buried in Highgate cemetery, the citizens of the most populous and successful nation on earth in economic terms at least – the Chinese – may beg to disagree. They are not alone. A recent Reuters reports cited a survey of east Germans found that 52 per cent believed the free-market economy was 'unsuitable' and 43 per cent said they wanted socialism back.

You can find out more about how economic thought has developed over the years at these websites: http://en.citizendium.org/wiki/History_of_economic_thought and www.timelinesdb.com/listevents.php.

Micro vs macroeconomics
Microeconomics is the study of economics as it affects small units such as individuals, families, firms and industries.

Macro is a study of the forces that affect a whole economy. The main concept used in microeconomics, and one that underpins almost the whole subject of economics, is that of the price elasticity of demand. The concept itself is simple enough. The higher the price of a good or service the less of it you are likely to sell. Obviously it's not quite that simple in practice; the number of buyers, their expectations, preference and ability to pay, the availability of substitute products also have an effect.

Figure below  is that of a theoretical demand curve.

FIGURE: The demand curve

The figure shows how the volume of sales of a particular good or service will change with changes in price.

The elasticity of demand is a measure of the degree to which consumers are sensitive to price.

This is calculated by dividing the percentage change in demand by the percentage change in price. If a price is reduced by 50 per cent (eg from $/£/€100 to $/£/€50) and the quantity demanded increased by 100 per cent (eg from 1,000 to 2,000), the elasticity of demand coefficient is 2 (100/50). Here the quantity demanded changes by a bigger percentage than the price change, so demand is considered to be elastic. Were the demand in this case to rise by only 25 per cent, then the elasticity of demand coefficient would be 0.5 (25/100). Here the demand is described as being 'inelastic' as the percentage demand change is smaller than that of the price change.

Having a feel for elasticity is important in developing a business's marketing strategy, but there is no perfect scientific way to work out what the demand coefficient is; it has to be assessed by 'feel'. Unfortunately, the price elasticity changes at different price levels.

For example, reducing the price of vodka from $/£/€10 to $/£/€5 might double sales, but halving it again may not have such a dramatic effect. In fact it could encourage one group of buyers, those giving it as a present, to feel that giving something that cheap is rather insulting.

Market structures
The whole of the subject of economics as practised in advanced economies is predicated on the belief that market forces are allowed a large degree of freedom. New firms can set up in business, charging the price they see fit, and if their strategy is flawed they will be allowed to fail (Entrepreneurship). Price is allowed to send important signals throughout the economy, apportioning demand and resources accordingly. But perfect competition, where price is allowed such freedom, is only one of four prevailing market structures; although market economies are dominated by near-perfect competition, that is not maintained without a struggle.

The following are the four market structures that are at work in economies.

Monopoly
Monopolies exist where a single supplier dominates the market and so renders normal competitive forces largely redundant. Price, quality and innovation are compromised, so deliver less value to the end consumer than they might otherwise expect. Microsoft has a near-monopolistic grip on the operating system market, as has Pfizer, the pharmaceutical giant, through its patent on the drug Viagra; and British Airports Authority (BAA), which runs Heathrow, Gatwick and Stansted, has a similar hold on London airports' traffic.

Monopolies claim that without being allowed to dominate their market it would be impossible to get sufficient economies of scale to reinvest. That was the argument of the early railway companies and it was BAA's argument in 2008 in defending itself against the prospects of a government-enforced break-up.
 

In countries where monopolies are seen as being detrimental, bodies exist to regulate the market to prevent them becoming too powerful. The UK has the Competition Commission (www.competition-commission.org.uk), the United States the Federal Trade Commission (www.ftc.gov) and the EU has The European Commission (http://ec.europa.eu/comm/competition/index_en.html), all keeping monopolies in check. A duopoly is, as the name would suggest, a particular form of monopoly with only two firms in the market.

Oligopoly
This is where between 3 and 20 large firms dominate a market, or where 4 or 5 firms share more than 40 per cent of the market. The danger for consumers and suppliers alike is that these dominant firms can control the market, to their disadvantage. Supermarket chains in the UK, airlines, oil exploration and refining businesses the world over operate as virtual oligopolies. Frequently the temptation to act in a cartel to fix prices is too great to resist. BA had colluded with Virgin Atlantic on at least six occasions between August 2004 and January 2006, the Office of Fair Trading said.
Between August 2004 and January 2006, British Airways and Virgin Atlantic, the dominant players on the route from London to US cities, colluded with each other to fix the price of fuel surcharges. During that time, surcharges rose from £5 to £60 per ticket. British Airways had to set aside £350 million to deal with fines in the UK and United States.

Perfect competition
This is a utopian environment in which there are many suppliers of identical products or services, with equal access to all the necessary resources such as money, materials, technology and people. There are no barriers to entry, so businesses can enter or leave the market at will and consumers have perfect information on every aspect of the alternative goods on offer.

Competitive markets
Sometimes referred to confusingly as monopolistic competition, this rests between oligopoly and perfect competition, but is closer to perfect competition. Here a large number of relatively small competitors, each with small market shares, compete with differentiated products satisfying diverse consumer wants and needs.

Essential economics
Despite the competing schools of thought on how business and the economy interact, there is at least general agreement on the most important factors. True, there is much disagreement on how important these factors are and even on how they can be influenced, but on the factors themselves there is a measure of agreement. MBAs will need a grasp of these key issues in order to play a full role in shaping the strategy of their organization.

Economic growth
Government's role in economic policy is generally accepted as being to steer a path that ensures long-term growth without leading to a general rise in prices (see Inflation, below). The underlying belief is that growth in goods and services leads to a happier, more satisfied population, while spreading democracy, diversity, social mobility and greater all-round tolerance. Also, the bigger the gross domestic product (GDP) the more guns and bombs a country can afford, both to defend itself and to impose its will on others who are weaker. There is certainly evidence that people judge their well-being by comparing themselves to others, but unfortunately as income goes up, so do expectations.
There have been many attempts at creating a more comprehensive measure of economic health. Gross National Happiness (www.grossnationalhappiness.com) and the Genuine Progress Indicator (www.rprogress.org/sustainability_indicators/genuine_progress_ indicator.htm) are attempts to include a range of other factors such as life expectancy, crime rates, pollution, long-term environmental damage, resource depletion and income distribution, for example.
GDP is the yardstick taken to measure the economy, even though that doesn't necessarily say much about the level of happiness in a country. There are a number of ways of comparing GDP both between countries and between time periods and, needless to say, economists can't agree which is best.

Gross domestic product
GDP is the total market value of all final goods and services produced in a country in a one-year period. A country's balance sheet, like that for a business, shows the sources and uses of funds.

A country's GDP is usually arrived at using the expenditure method, using the equation GDP = consumption (spending by consumers) + gross investment (spending by business) + government spending + (exports – imports).

Each component of expenditure plays a part in helping increase GDP and hence economic growth. (See Keynes above.)
The rate of growth of GDP matters greatly.

The UK and Europe's long-run GDP growth rate of around 2.5 per cent will lead to a doubling of the countries' wealth in around three decades. China and India, whose growth rate routinely exceeds 8 per cent, will see average wealth double in less than one decade. All other things being equal, companies looking to set up overseas will head for the countries with rapid growth in GDP.

Gross domestic product per person
Measuring a country's total GDP misses an important consideration – the population. If the growth in both GDP and population were uniform there would be no problem, but that is not the case. Britain's country GDP grew at 2.75 per cent between 2003 and 2007, but as the population grew sharply too, GDP per person grew at a rather slower 2.1 per cent. Japan with its shrinking population also grew its GDP per head by 2.1 per cent, matching that of Britain and beating the United States whose growth measured in this way was only 1.9 per cent as opposed to the 2.9 per cent the United States reported for the economy as a whole.

Gross domestic product at purchasing power parity (PPP)
GDP, usually referred to as nominal GDP, is arrived at by the simple process of adding up expenditure and does not reflect differences in the cost of living in different countries or the currency exchange rate prevailing at the time. The same amount of GDP, in other words, can buy a lot more goods and services in one country than another. China's GDP per person is about £1,000 nominal but £3,500 at PPP. Calculating PPP is fraught with problems as people buy very different baskets of goods and services. One way round the imperfections is to produce light-hearted attempts at showing PPP using an external product common to most countries. The Economist has published a Big Mac Index (BMI) since 1986, with a few variations such the Tall Latte index and a Coca-Cola map that showed the inverse relationship between the amount of Cola consumed per capita in a country and the general standard of health. In 2007, Commonwealth Securities, an Australian bank, created the iPod Index with much the same aim of calculating a proxy for PPP on a country-by-country basis.

Business cycles
Economies tend to follow a cyclical pattern that moves from boom, when demand is strong, to slump, economists' shorthand for a downturn. The death of the cycle has often been claimed as politicians believe they have become better managers of demand, but the 'this time it's different' school of thinking have been proved wrong time and time again.
 

The cycle itself is caused by the collective behaviour of billions of people – the unfathomable 'animal spirits' of businesses and households. Maynard Keynes (see above) explained animal spirits as: 'Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as the result of animal spirits – a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.'
Added to the urge to act is the equally inevitable herd-like behaviour that leads to excessive optimism and pessimism. Charles Mackay (Extraordinary Popular Delusions and the Madness of Crowds), Joseph De La Vega (Confusión de Confusiones) and the more recent Irrational Exuberance 2nd edition (Robert J Shiller) between them provide a comprehensive insight into the capacity for collective overreaction. From the tulip mania in 17th-century Holland and the South Sea Bubble (1711–20) to the internet bubble in 1999 and the collapse in US real estate in 2008, the story behind each bubble has been uncomfortably familiar. Strong market demand for some commodity (gold, copper, oil), currency, property or type of share leads the general public to believe that the trend cannot end. Over-optimism leads the public at large to overextend itself in acquiring the object of the mania, while lenders fall over each other to fan the flames. Finally, either the money runs out or groups of investors become cautious. Fear turns to panic selling, so creating a vicious downward spiral that can take years to recover from.

Categories of cycle
Economics is the science, in so far as it can be considered one, of the indistinctly knowable rather than the exactly predictable. Though all cycles, even the one you are in, are difficult to understand or predict with much accuracy, there are discernible patterns and some distinctive characteristics.

Figure below shows an elegant curve, which depicts the theoretical textbook cycle.
Four phases typically occur in each textbook cycle:

- U1, where demand is picking up and toeing the line of the long-term trend;
- U2, where demand exceeds the long-term trend;
- D1, where demand dips down to hit the long-term trend;
- D2, where demand slumps below the long-term trend.

FIGURE: Textbook economic cycle

To make things more complicated, there is not one cycle but at least four that operate, each with different characteristics yet interacting one with the others.

Kondratieff's long waves
Kondratieff (www.kwaves.com/kond_overview.htm), a Soviet economist, who fell out with Russia's Marxist leaders and died in one of Stalin's prisons, advanced the theory that the advent of capitalism had created long-wave economic cycles lasting around 50 years. His theories received a boost when the great depression (1929–33) hit world economies and resonated in Britain in 1980–81 when factory closures, high unemployment and crippling inflation devastated the country. The idea of a long wave is supported by evidence that major enabling technologies, from the first printing press to the internet, take 50 years to yield full value, before themselves being overtaken.

Kuznet's cycle
American economist Simon Kuznet, a Nobel Laureate (1971) working in the University of Pennsylvania, made a lifelong study of economic cycles. He identified a cycle of 15–25 years' duration covering the period it takes to acquire land, get the necessary permissions, build property and sell. Also known as the building cycle, this has credibility as so much of economic life is influenced by property and the related purchases of furniture and associated professional charges, for example for lawyers, architects and surveyors.

Juglar cycle
Clement Juglar, a French economist, studied the rise and fall in interest rates and prices in the 1860s, observing boom and bust waves of 9 to 11 years going through four phases in each cycle: prosperity, where investors piled into new and exciting ventures; crisis, when business failures started to rise; liquidation, when investors pull out of markets; and recession, when the consequences of these failures begin to be felt in the wider economy in terms of job losses and reduced consumption.

Kitchin cycle
In 1923, Joseph Kitchin published in the Harvard University Press an article entitled 'Review of Economic Statistics', outlining his discovery of a 40-month cycle resulting from a study of US and UK statistics from 1890 to 1922. He observed a natural cyclical path caused, he believed, by movements in inventories. When demand appears to be stronger than it really is, companies build and carry too much inventory, leading people to overestimate likely future growth. When that higher growth fails to materialize, inventories are reduced, often sharply, so inflicting a 'boom, bust' pressure on the economy.

Monitoring cycles
The National Bureau of Economic Research (www.nber.org) provides a history of all US business cycle expansions and contractions since 1854. The Foundation for the Study of Cycles (http://foundationforthestudyofcycles.org), an international research and educational institution established in 1941 by Harvard economist Edward R Dewey, provides a detailed explanation of different cycles. The Centre for Growth and Business Cycle Research based at the School of Social Sciences, The University of Manchester (www.socialsciences.manchester.ac.uk/cgbcr), provides details of current research, recent publications and downloadable discussion papers on all aspects of business cycles.

Inflation
Inflation is defined as too much money chasing too few goods and if it gets out of control it can devastate an economy. Not all goods and services have to experience price increases. The inflation rate itself is measured by defining a basket of goods and services used by a 'typical' consumer and then keeping track of the cost of that basket using such indices as the retail price index. During the upswing stage of a business cycle there is a tendency to overshoot, which can lead to the economy 'overheating'. As there is usually a lag while production struggles to catch up with demand, prices rise to 'ration' goods and services.

Inflation is generally seen being a problem for a number of reasons:

- 'Inflation makes fools of us all' is a truism about the misleading signals sent by rapid changes in price. Consumers and businesses like certainty, and fluctuating rates of inflation make planning more difficult, which in turns leads to a loss of confidence.
- Inflation redistributes wealth in a haphazard and often unfair manner. For example, savers will find their purchasing power diminish as their fixed sum saved will buy fewer goods and services in the future. Borrowers will benefit as they are effectively paying back a capital sum that is being eroded in value by inflation.
- If the inflation rate is greater than that of other countries, domestic products become less competitive, so exports will be reduced and economic growth will slow.
- High inflation can lead to high wage demands, which can in turn lead to an upward spiral in costs and so feed further inflationary pressures.

Current economic wisdom has it that a modest degree of inflation is healthy provided that everyone knows what it will be and can factor it into their decision making. That is why central banks have as one of their functions monitoring inflation rates and taking action to keep below a certain figure – in the UK this is 2 per cent. Three further aspects of inflation that need to be considered are:

Deflation
The opposite of inflation and occurs when the general level of prices is falling. This can occur after a major bubble collapses and will lead to people putting off purchasing decisions in the expectation of being able to buy later at even lower prices. Japan experienced deflation when its boom in the 1980s turned to a long, wearying bust. Two decades of near zero interest rates have yet to yield anything resembling a dynamic economy. The Nikkei Stock Market Index peaked at 38,916 on 29 December 1989 and at October 2010 was just 9,500– a measure of the country's economic morass.

Hyperinflation
This is unusually rapid self-feeding inflation; in extreme cases, this can lead to the collapse of a country's monetary system. This occurred in Germany in 1923, when prices rose 2,500 per cent in one month and in Zimbabwe in April 2008 when the annual inflation rate hit 165,000 per cent.

Stagflation
The combination of high economic stagnation with inflation, such as happened in industrialized countries during the 1970s, when OPEC raised oil prices.

Interest rates
Around half the money used to finance businesses is borrowed and private individuals use mortgages, hire purchase and credit cards to fund many of their purchases. Governments too have to use debt through the sale of bonds, when taxes are insufficient to meet their spending plans. The 'price' of borrowed money is the interest paid. Governments can stimulate both business and consumer expenditure by lowering interest rates or choke off demand (see 'Micro vs macroeconomics', above) by raising it. Interest rates are the favourite tool of central banks to control inflation as it can be used to bring supply and demand back into balance.

Interest rates also have a direct bearing on a country's exchange rate. If it is higher than that in other comparable economies it will tend to support the exchange rate at a higher rate, and if lower, the currency will tend to be weaker (see also 'The exchange rate'). There are, however, several different interest rates and governments do not directly control them all:

- Bank Base Rate: This is the interest set by governments, for example by the Bank of England's monetary committee, the US Federal Reserve and the European Central Bank. It is a reference point from which other interest rates are set, but is not the actual interest rate charged by clearing banks to their many and varied clients.
- Libor (London Inter-bank Offered Rate): This is the rate of interest at which banks borrow funds from each other, an essential activity to facilitate global trade and to settle contracts on futures and options exchanges. As such, it is the primary benchmark for short-term interest rates globally. The rate is set by a panel representing around 500 banks and depends on a number of factors, including local interest rates, expectations of future rate movements and the prevailing banking climate. Usually the Libor rate is lower than the rate set by central banks to allow banks a small margin. But if banks lose confidence in their peers' ability to repay then either they stop lending or they charge a premium over the Bank Base Rate. This was the case during the sub-prime crisis in 2007/08. Libor is both sensitive and complex. Rates are set in 10 currencies and for 15 different maturity dates, from an 'overnight' rate maturing tomorrow, a 'spot/next' rate that covers the period to the day after tomorrow, through weeks and months out as far as (but never further than) one year.
- Lending Rate: This is the rate at which banks will lend to businesses and private individuals. It can be anything from a fraction of a percent above either Bank Base Rate or Libor (whichever is the higher) for blue chip firms, a percent or two above for mortgages, and up to 15 per cent above for credit card loans; the higher the perceived risk the higher the rate.


Economic policy and tools
Keeping the economy growing, holding inflation in check and attempting to both anticipate and mitigate the worst effects of downturns in the business cycle are the primary economic goals of government. Dials showing the GDP growth rate and inflation are on every government's economy management dashboard. But these are not the only factors that affect an economy, nor is setting interest rates the only club in a central banker's locker.

Policy options
The UK's 1981 Budget, designed to remove several billion pounds from the economy when the UK was in the depths of recession, provoked an unprecedented letter from 364 economists published in The Times stating: 'There is no basis in economic theory or supporting evidence for the government's present policies.' In fact the UK economy recovered and eventually prospered. Even today, no politician, yet alone economist, can agree on whether the 364 economists were right or Lady Thatcher's then Chancellor of the Exchequer, Sir Geoffrey, now Lord, Howe. Although economists disagree on almost everything, they do accept that there are two broad categories of policy: fiscal and monetary.

Monetary policy
Monetarists, as the adherents of this school of thought are known, believe that as the economy runs on money, controlling the supply of the amount of money in circulation is the key to achieving growth without inflation. If the supply of money grows faster than the economy, inflation will rise as too much money will be chasing too few goods; too slow and growth is stifled. There are a number of difficulties in actually executing monetary policies:

- Measuring money: In the first place, agreement has to be reached on what exactly money is. There are at least five different and to some extent overlapping measurements, all attempting to measure the liquid assets at large in an economy. Designated with the prefix M, these measures range from M0, the narrowest definition which includes only the cash held in banks and in circulation, through to M5, the broadest measure which extends to a wide range of other short-term highly liquid financial assets held as a substitute for deposits. Not content with these five measures, some now have letter prefixes to subdivide further the types of liquid assets included. If you can imagine trying to drive a car with several speedometers you will get a feeling for the problem. In the world boom of 1972–73, for example, the UK's M3 and M4 grew at nearly 25 per cent per annum; M5 grew at over 20 per cent, yet M1 grew at only 10 per cent.
- Velocity of circulation: Money's use is as a medium of exchange; we swap it for goods and services, which in turn create the value in an economy that result ultimately in GDP. Over any interval of time, the money one person spends can be used later by the recipients of that money to purchase other goods and services, the suppliers of which can then themselves spend the same cash again. The more times cash circulates each year the higher the velocity and hence the money supply available to fuel GDP. To measure money supply we need to know the velocity of circulation but it is notoriously difficult to do, is different for each of the Ms and can change over time.

Central bankers have three tools to help control the amount of money in circulation:

- Open market operations are where the central bank sells government securities to banks, leaving them with less cash to lend.
- Reserve requirements are the proportion of reserves a bank must keep in relation to the amount of money it can lend. Raising the level of reserves reduces banks' capacity to lend.
- Discount rate is the interest rate the central bank charges banks. Raising that rate reduces the money available to lend.

Fiscal policy
A government's approach to tax and spending is known as its fiscal policy. Cutting taxes and so giving consumers and businesses more money to spend can stimulate an economy. Alternatively, raising taxes can cool an economy down if it looks like overheating. Governments can themselves increase spending, both by using taxes and by borrowing money raised by issuing government securities. The latter approach is termed deficit spending and has been understood and used extensively since popularized by Maynard Keynes in the 1920s. He showed how governments could use this aspect of fiscal policy either to avert a recession or to reduce its effect on unemployment.

The spending multiplier effect
Keynesian economists deduced that government expenditure multiplies through the economy having a far greater ripple effect than the initial sum involved, making such activity more important than the sums themselves may sound. Let's suppose the government decides to embark on a major programme of school building, resulting in $/£/€100 million of salaries for construction workers. The impact of their salaries on the economy depends on their marginal propensity to consume (MPC) – in other words, how much of their salary they will save and how much they will spend. If we suppose that they will save 10 per cent of salary (the approximate 20-year average, though at the time of writing it was less than 6 per cent), then they will spend 90 per cent.

That gives an MPC of 0.9, which is 90 per cent expressed as a decimal:

So the effect of £100 million of government spending on the wider economy is 10 × £100 million, or £1,000 million, because each 90 per cent of a worker's income is spent, which in turn becomes someone else's income of which they spend 90 per cent, and so on.

The tax multiplier
Tax reductions are another way in which governments can affect expenditure by giving or taking money away from consumers, and that too has a multiplier effect. This formula is almost identical to that for the spending multiplier. The only difference is the inclusion of the negative marginal propensity to consume (–MPC). The MPC is negative because an increase in taxes decreases income and hence the ability to consume. If we again assume that 90 per cent of income is spent and 10 per cent saved, we have a marginal propensity to consume of 0.9 and a marginal propensity to save of 0.1. This gives a tax multiplier of –9 (see below), which means that if taxes are raised by £100 million that will result in –9 × £100 million; in other words, £900 million will be taken out of consumption.

The converse is of course true; were taxes reduced by £100 million, consumption would rise by £900 million.

More concerns
Using tools and policies to keep an economy growing and inflation low is certainly a government's primary goal; but they do have some other parallel and interrelated outcomes in mind. These are not so much secondary objectives, but like inflation are more the effect of mismanagement, bad timing or major events in a big economy with which much business is conducted. The most important of these concerns include the following.

Employment vs unemployment
Government's stated goal in this respect is to maintain the economy at full employment. That has the benefit of keeping most citizens happy, while contributing tax to the general good. However, if everyone is in a job the only way a new or growing business can recruit additional staff is to poach from other organizations, usually by offering higher wages. That in turn feeds into inflation, as wage prices, a major component of costs, are rising without there necessarily being an increase in output. Also, high employment can lead to the 'jobs for life' attitude prevalent in Japan for so long that contributed to its market inefficiencies.
In practice, governments actually set their policies to achieve an acceptable level of unemployment. In the UK and United States that is around 5 per cent of the labour force, while in continental Europe between 9 and 10 per cent has become the norm. High unemployment reduces a country's overall GDP through having unproductive workers. If the unemployed also get state welfare, as is the case particularly in continental Europe and to a lesser extent the UK, it increases the cost for the country as a whole.
So maintaining an acceptable rather than full employment is the realistic purpose of economic policy and governments have a number of factors and figures to keep tabs on to achieve that goal:

- Cyclical unemployment: This is the rate of unemployment attributable to a stage in the economic cycle. Typically, during a downturn unemployment will be higher than the normal target rate and lower in the upswing.
- Seasonal unemployment: This occurs at certain times in the year; for example, in winter, construction and casual farm workers are more likely to be laid off.
- Frictional unemployment: This is the result of an economy or geographic area within an economy moving from one type of productive activity to another. The shift from employment in coal and steel mining to other forms of employment, usually in the service sector, is one such shift that Western economies have experienced.
- Structural unemployment: This is caused by workers not having the skills and businesses not having the technology to meet new demands being made on an economy.
- Vacancy rate: This measures the number of unfilled jobs at any one time. A high level of unemployment can be partially offset against lots of vacancies, as people take time to move from one job to another, particularly if that requires moving home.

One further measure a government can take to influence unemployment is to import labour, either through immigration or by accepting seasonal workers from overseas.

The exchange rate
The rate at which different currencies are traded is their exchange rate, with a high rate being viewed as a sign of economic virility. So-called strong rates of exchange mean that citizens and businesses find foreign goods and services relatively cheap. Unfortunately, it also means that foreigners find their goods and services expensive and will buy less and seek new suppliers in countries with more favourable exchange rates.
 

Most countries have their own currency, but not all governments pursue the same exchange rate policies and each such policy involves different costs and risks:

- Managed and 'not fully convertible' is when the government exercises political and economic control over the exchange rate and the amount of its currency that can be moved in or out of the country. China and India are among many countries that fall into this category. Such constraints can mean that a currency drops sharply in value periodically as the government of the day tries to hold back international pressures.
- Pegged: For the majority of countries which have been anxiously seeking ways to promote economic stability and their own prosperity, the most favourable way has been to peg the local currency to a major convertible currency, such as the euro or US dollar. This means that while the local currency may move up and down against all other world currencies, it will remain or at least attempt to remain stable against the one it is pegged against. In total, 22 states and territories have a national currency that is directly pegged to the euro, including 14 West African countries, 3 French Pacific territories, 2 African island countries and 3 Balkan countries.
- Dollarized: This is a slight misnomer as the term is used to describe a country that abandons its own currency and adopts the exclusive use of the US dollar or another major international currency, such as the euro. The euro, for example, is the official currency in 15 states and territories outside the European Union. In such cases the country in question takes on the risks and costs associated with the 'host' currency. Many of the economies opting for this approach already informally use the foreign currency in private and public transactions.
- Floating and 'fully convertible': These currencies fluctuate as the country in question succeeds or fails. Russia, for example, lifted currency controls in July 2006 as a sign of economic confidence, making the rouble fully convertible. Now it is more attractive to invest in Russia, while Russian businesses can freely, without worry, without any special permit or burden, participate in investments overseas. Barely eight years earlier the country defaulted on its massive domestic debt, devalued its currency and wiped out Russians' savings. Russia's macroeconomic situation had to become stable to allow this to happen, which has been achieved on the back of large gold reserves, a balanced budget and foreign investment that exceeded capital outflows largely on the basis of oil and gas exploration activity.


Balance of payments
The balance of payments is the difference between all payments coming into a country and those going out. A surplus of payments coming in over those going out is said to be favourable and the opposite is unfavourable. The balance of payments is divided into two accounts: the current account, such as payments for imports, exports, services and transfers of money; and capital account payments for physical and financial assets.
The balance of trade, which is itself a major part of the overall balance of payments, is the difference between the value of goods and services exported out of a country and those imported into the country. When imports exceed exports a country's GDP is reduced by that amount (see GDP earlier in this guide). Imports and exports are themselves influenced by a country's competitive position, which can be eroded by too high an inflation rate, for example, or by having too strong a currency, which encourages overseas purchases of goods and services, including holidays.

The broken window fallacy
In the broken window fallacy advanced by French economist Frederic Bastiat (1801–50), the argument that economies can be kick started by almost any expenditure was exposed as plain wrong.
Bastiat's example starts with a man's son breaking a pane of glass that he in turn will have to pay to replace. Onlookers considering the situation come to the conclusion that far from being a vandal the boy has actually done the community a service. His father will have to pay a glazier to replace the broken pane, who will then in turn have money to spend in the local economy. In fact, without this type of business glaziers would be in trouble and all the businesses, restaurants, garages, bookkeeping services and the like will get a shot in the arm from this additional spending too. The smashed window will go on providing money and employment in ever-widening circles.
On closer inspection this argument is shown as nonsense; breaking the window reduces the father's disposable income who in turn will now be unable to spend the exact same sum of money as the glazier will be getting. In fact by destroying something that has already been bought and is still in satisfactory working order the economy is worse off than before. Had the window not been broken the money in question could have been spent on valuable new assets.
In economic terms just spending money won't necessarily kick start the economy unless it is invested in productive assets.