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Class 3

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13 views7 pages

Class 3

fm notes

Uploaded by

cca.bishwaraj
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Class-3

The Financial Management Environment

One of the main areas of importance for the financial manager is the raising
of finance. In this chapter we look at the framework within which he operates
and the institutions and markets than can help him in this respect

Financial intermediation
Financial intermediaries – organisations which bring together potential
lenders and potential borrowers.
Companies need to raise money in order to finance their operations.
However, it is often difficult for them to raise money directly from private
individuals and therefore they often turn to institutions and organisations
that match firms that require finance with individuals who want to invest.
One example of a financial intermediary is a bank. They make loans to
companies using the money that has been deposited with them by
individuals.

The features of the service that they are providing are as follows:

(a) Aggregation:
Individuals are each depositing relatively small amounts with the bank, but
the bank is able to consolidate and lend larger amounts to companies.
(b) Maturity Transformation:
Most individuals are depositing money for relatively short periods, but the
bank is able to transform this into longer term loans to companies in the
knowledge that as some individuals withdraw their deposits, others will take
their place.
(c) Diversification of risk:
Many individuals may be scared of lending money directly to one particular
company because of the risk of that company going bankrupt. However, a
bank will be lending money to many companies and will therefore be
reducing the risk to themselves and therefore to the individuals whose
money they are using.

(d) Liquidity: providing a liquid market with flexibility and choice for
lenders and borrowers.
(e) Hedging: providing businesses with instruments for hedging risk (e.g.
forward contracts, options and swaps).

Ordinary banks (or clearing banks) are one example of a financial


intermediary, as explained above.

Other examples of financial intermediaries include:

๏ Pension funds

๏ Investment Trusts / Unit Trusts

๏ State Savings Banks

Macroeconomics

Macroeconomic policy– the setting of economic objectives by the


government (e.g. full employment, economic growth, the avoidance of
inflation) and the use of control instruments to achieve those objectives (e.g.
fiscal policy and monetary policy).

Monetary Policy
The set actions taken by the government or the central bank to achieve
economic objectives using monetary instruments.
Monetary policy actions may either:
 directly control the amount of money in circulation (the money
supply); or

 attempt to reduce the demand for money through its price (interest
rates). For example, increasing interest rates increases the cost of
borrowing, decreasing the demand for goods and the inflation rate.
By exercising control in these ways, governments can regulate the level of
demand in the economy. Those who see monetary policies as crucial to
managing macroeconomic activity are called monetarists.

Direct Control of the Money Supply


Governments or central banks can directly control the money supply in the
following ways:
1. Open market operations
 If the central bank sells government securities, the money supply is
contracted, as some of the funds available in the market are "soaked
up" by purchasing the government securities.
o The sale of government securities will reduce bank deposits due
to the level of funds that have been soaked up.
o This in turn can lead to a further reduction in the money supply,
as the banks' ability to lend is reduced. This is known as
the multiplier effect.
 Equally, if the central bank were to buy back securities, funds would be
released into the market.
2. Reserve asset requirements (cash reserve ratio): the central
bank can set a minimum level of liquid assets which banks must
maintain. This limits their ability to lend and thereby reduces the
money supply.
3. Special deposits: the central bank can have the power to call
for special deposits. These deposits do not count as part of the bank's
reserve base against which it can lend. They have the effect, therefore,
of reducing the bank's ability to lend and thereby reducing the money
supply.
4. Direct control: the central bank may set specific limits on the amount
banks lend. Credit controls are challenging to impose as, with fairly
free international movement of funds, they can easily be
circumvented.
Fiscal policy
Government actions to achieve economic objectives through the fiscal
instruments of taxation, public spending and the budget deficit or surplus.
Governments can use public expenditure and taxation to regulate the level
of demand within the economy.

Keynesian Approach
Those who view fiscal policy as crucial in controlling macroeconomic
activity are called Keynesians (after the economist John Maynard Keynes).
If the economy is in recession, fiscal policy can be used to reflate the
economy by taking the following actions:
 Increase government spending to increase the level of demand in the
economy directly (e.g. if a government initiates large road-building
projects or establishes training schemes for sections of the population,
the demand for goods and services in the economy is increased).
 Reduce taxation to boost both consumption and investment.

Supply-side policies – policies which focus on creating the right conditions


in which private enterprise can grow and raise the capacity of the economy
to provide the output demanded.
Supply-side Policy Examples
For supply-side policy adherents, the private sector (being driven by the
profit motive) is deemed more efficient at providing the output required than
the public sector.
Supply-side policies include:
 low corporate tax rates to encourage private enterprise;
 promoting a stable, low inflation economy with minimal government
intervention;
 limited government spending;
 a balanced fiscal budget;
 deregulation of industries;
 a reduction in the power of trade unions;
 an increase in the training and education of the workforce;

Exchange rate policy – how a government manages its currency in relation


to foreign currencies.

1.5.1 Reasons for Controlling Exchange Rates


 To rectify a balance of trade deficit. If inflation in one country is higher
than in others, its export prices will become uncompetitive in overseas
markets so its trade deficit will grow. Therefore the government may
try to bring about a fall in the exchange rates to make exports less
expensive.
 To prevent a balance of trade surplus. A government may try to bring
about a limited rise in exchange rates to make imports less expensive.
 To stabilise the exchange rate. If importers and exporters face less
exchange rate risk, confidence in the currency will improve, facilitating
international trade.

Floating Exchange Rate


A "freely floating" exchange rate means that the currency's value is allowed
to move freely with supply and demand market forces.
Floating exchange rates tend to correct a trade surplus or deficit. If imports
exceed exports, the supply of the home currency will exceed demand and
the home currency will depreciate, boosting demand for exports and
correcting the trade imbalance.
A "managed float" means that the exchange rate is allowed to float but the
central bank intervenes to prevent major fluctuations.

Fixed Exchange Rate


A fixed exchange rate ("fixed peg") regime is one in which the rate is kept
fixed against that of another currency, or basket of
currencies. No fluctuations are permitted; the central bank intervenes to
maintain the exchange rate.

Inflation – the rate of increase of the general level of prices in the economy.

Inflation is usually measured by the Consumer Price Index (CPI). The CPI
relates to retail goods and services and indicates how fast average prices are
rising across the economy generally. (The inflation of specific goods and
services may be higher or lower than the CPI.)

Causes of Inflation
Keynesians consider there to be two major causes of inflation:
1. Demand-pull inflation: inflation arises due to demand exceeding the
maximum output of the economy with full employment.
2. Cost-push inflation: increases in the cost of raw materials or the cost
of labour lead to increases in the unit costs of production,
which inevitably lead to price increases as higher costs are passed on
to the consumer. The term "imported cost-push inflation" is used if
the increased costs arise on imported goods.

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