BEC - Notes Chapter 2

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Business Cycles and Reasons for Business Fluctuations
GDP - the total market value of all final goods and services produced within the borders of a nation in a
particular time period. (GM has a factory in China, doesn't count in GDP, Toyota has a factory in US,
counts as GDP)

Nominal GDP - unadjusted, measures the value of all final goods and services in current prices

Real GDP - adjusted to account for changes in the price level by removing inflation by using a price index
(called GDP deflator)

Real GDP = (nominal GDP ÷ GDP deflator) * 100

Business cycle phases: Expansionary, Peak, Contractionary, Trough and Recovery

B2-5 chart of the business cycle

Recession - the economy experiences negative real economic growth (declines in national output) for two
consecutive quarters
Depression - a sever recession, long period of stagnation in business activity and high unemployment rates

Leading indicators tend to predict economic activity

- Avg new unemployment claims
- New housing
- Money supply
- Order for goods
- Price changes in materials

Lagging indicators tend to follow economic activity

- Prime rate charged by banks
- Avg duration of unemployment
- Bank loans outstanding

Coincident indicators tent to occur during economic activity

- Industrial production
- Manufacturing and trade sales

Draw supply & demand curve (do you remember how to label the graph, which goes where?)

Increase demand (shift right)

- Increase in wealth
- Decreased in interest rates
- Currency depreciates
- Increase in government spending
- Decrease in taxes

Decrease demand (shift left)

- Decrease in wealth
- Increase in interest rates
- Currency appreciates
- Decrease in government spending
- Increase in taxes

Increase supply (shift right)

- Decrease in raw materials/wages
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- Excess supply
- Increase in subsidies

Decrease supply (shift left)

- Increase in raw materials/wages
- Supply shock
- Increase in taxes

The multiplier effect - increase in spending generates income for firms, which in turn spend that income, which
gives other firms or households income and so on. This results from the marginal
propensity to consume (MPC), The MPC is the change in consumption due to $1 increase
in income,

Multiplier = [1 ÷ (1 - MPC)] * change in spending

Economic measures and reasons for changes in the economy

The combined economic output of these four sectors comprise the GDP
- Households (consumers)
- Businesses
- Federal, State and local governments
- The Foreign sector

There are two ways to measure GDP

1. Expenditure Approach - calculates the sum of the four components (GICE)
Government Purchases of goods and services
+ Gross private domestic investment
+ Personal consumption expenditures
+ Net Exports
= GDP

2. Income Approach - sum of resource costs and incomes (IPIRATED)

Income of proprietors
+ Profits on corporations
+ Interest (net)
+ Rental income
+ Adjustments for net foreign income and miscellaneous items
+ Taxes
+ Employee compensation
+ Depreciation
= GDP

Either approach will yield the same GDP

Net Domestic Product (NDP) - is GDP minus depreciation

Gross National Product (GNP) - includes goods and services produced overseas by U.S. firms and excludes
goods and services that are produced domestically by foreign firms. (GM has a factory in China, counts as
GNP, Toyota has a factory in US, does not count in GNP)

Disposable income (DI) - personal income less personal taxes. It is the amount of income households have
available to either spend or save

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To be counted as unemployed a person must be actively looking for work

Unemployment rate = (number of unemployed ÷ total labor force) * 100

Types of Unemployment
• Fictional unemployment - normal unemployment resulting from workers changing jobs or being
temporarily laid off
• Structural Unemployment - Jobs available do not correspond to the skills of the work force, or workers
do not live where the jobs are located
• Seasonal unemployment - is the result of seasonal changes in the demand and supply of labor
• Cyclical unemployment - amount of unemployment resulting from declines in real GDP during a
contraction or recession

Fictional, structural and seasonal will always occur regardless of the economic state.

Natural rate of employment - normal rate of employment around which the unemployment rate fluctuates due
to cyclical unemployment

Full employment - there is no cyclical unemployment

Inflation is defined as the sustained increase in general prices of goods and services

Consumer Price Index (CPI) - measure of the overall cost of fixed basket of goods and services purchased by
an avg household

Inflation rate = [(CPI this period - CPI last period) ÷ CPI last period] * 100

Demand-pull inflation is caused by increases in aggregate demand

Cost-push inflation is caused by reductions in short-run aggregate supply

Inflation causes purchasing power to decrease. Inverse relationship

Monetary assets and liabilities (cash, A/R, Notes payable, etc) are fixed in dollars and are not affected by
inflation

Non-monetary assets and liabilities (buildings, land, machinery, etc) will fluctuate with inflation and deflation

During a period of inflation, those receiving money (its worth less) will be hurt because purchasing power as
eroded. Firms that lend money at fixed interest rates will be hurt by inflation

During a period of inflation, those with a fixed amount of debt will be aided because they will repay the debt
will inflated dollars. Thus inflation tends to benefit firms with a large amount of outstanding debt

Stagflation - falling national output and inflation

The Phillips curve - illustrates the inverse relationship between inflation and the unemployment rate

B2-22 graph of Phillips curve

Makes sense because high unemployment means low demand so prices should fall

Cyclical budget deficit - caused by temporary low activity (poor economy means less income for people so
government gets less in revenues)
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A structural budget deficit - caused by a structural imbalance between government spending and revenue

Nominal interest rate - interest rate in current prices

Real interest rate - is defined as the nominal interest rate minus the inflation rate

Real interest rate = nominal interest rate - inflation rate

M1 and M2 are the most common measures of money supply

M1 - money used for purchases of goods and services (coins, currency, deposits)
M2 - M1 + liquid assets that can be converted easily into M1

Monetary policy is the use of the money supply to stabile the economy. The fed controls the money supply
through 3 main ways:
1. Open Market Operations - purchase (increase M1) and sale (decrease M1) of government securities
(T-bills and bonds)
2. Discount rate - the rate the fed charges banks. Raising rates discourages borrowing and decreases
money supply and visa versa
3. Required Reserve Ratio (RRR) - fraction of total deposits banks must hold in reserve. Raising the
RRR decrease money supply

Money demand and interest rates are inversely related. 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

An increase in money supply will cause interest rates to fall, leading to increase in investment, increasing
demand, causing GDP to increase, unemployment to fall and price level to rise

Market influences on business strategies

Mission statement - one or two line descriptions of what the organization is in business to do

SWOT - Strength and Weakness are internal, Opportunities and Threats are external

Implementing a plan can occur on various levels; Corporate lvl, Business lvl, Functional lvl, Operating lvl.
[Strategic] ----------------------------------- [Tactical]

The market demand curve for a good is the sum of all the individual demand curves

B2-34 graph illustrating individual demand curve summed to market demand curve

A change in price results in a change in quantity supplied/demanded

A change in anything other than price results in a change in supply/demand

B2-36 graph on surplus and shortage

If price is set above the equilibrium (price floor), it will create a surplus, quantity supplied exceeds quantity
demanded
If price is set below the equilibrium (price ceiling), it will create a shortage, quantity demanded exceeds
quantity supplied

Elasticity - measure of how sensitive the demand for, or supply of, a product changes to changes in price
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Price elasticity is measured in 2 ways:

• Point method - measures price elasticity at a particular point of the demand curve
Price elasticity = % change in quantity demanded ÷ % change in price

• Midpoint method - measures price elasticity of demand between any two points on a demand
curve
Price elasticity = [(Q2 - Q1) ÷ (Q2+Q1)] ÷ [(P2-P1) ÷ (P2+P1)]

Price Inelastic < 1

Price Elastic > 1
Unit Elasticity = 1

More the substitutes more elasticity

Longer the time period the more elasticity

Cross elasticity - the % change in the quantity demanded (or supplied) of one good caused by the price change
of another good

Cross elasticity = % change in number of units of X demanded (or supplied) ÷ % change in price of Y
If the coefficient is positive, then the two goods are substitutes
If the coefficient is negative, then the commodities are complements

Explicit costs - are documented out-of-expenses (wages, materials and utilities)

Implicit costs - opportunity costs, the profits that are lost from following one business strategy vs another

Accounting costs - measure the explicit costs of operating a business

Economic costs - accounting (explicit) costs plus opportunity (implicit) costs

Accounting profits - difference between total revenue and total accounting costs
Economic profits - difference between total revenue and total economic costs, which include opportunity costs

Marginal costs (incremental cost) - is the change in total cost associated with a change in output quantity over a
period of time

MC = change in total costs ÷ change in quantity

Economies of scale - are reductions in unit costs resulting from increases size of operations
Diseconomies of scale - size becomes inefficient and they are no longer cost productive

Perfectly competitive market

- A larger number of suppliers and customers
- Little product differentiation (homogenous products)
- No barriers to entry
- B2-49 graph of this

Monopolistic competition
- Many firms with differentiated products
- Few barriers to entry
- Ability to exert some influence over the price and market
- Competition to increase brand loyalty
- B2-52 graph of this

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Oligopoly
- Few firms with differentiated products
- Fairly significant barriers to entry
- Ability to fix prices
- B2-53 graph of this

Monopoly
- A single firm with a unique product
- Significant barriers to entry
- The ability of the firm to set output and prices
- No substitute products
- B2-50 graph of this

Regardless of the model, the firm will operate best/ maximize short run profits, Price = Marginal Revenue =
Marginal Cost (P=MR=MC)

B2-50 comprehensive chart showing differences between the market structures

Cartels - a group of firms acting together to coordinate output decisions and control prices as if they were a
single monopoly

Boycotts - organized group of refusals to conduct market transactions with a target group

Factors of production
- Land (natural resources)
- Labor (human capital)
- Capital (non-human physical capital accumulated through past investment)

Minimum wage causes a surplus of workers because a firm can't or don't want to pay works (minimum wage is
set above equilibrium price). So it increases unemployment.

Best cost provider combines the cost leadership strategy benefits with the differentiation strategy

Implications of dealing in foreign currencies

3 types of exchange rate risks
Transaction risk - single transaction
Economic risk - government instability, nationalization
B2-74 chart of currency effect on foreign currency inflows and outflows
Translation risk - translation of financial statements
- Temporal method (remeasurement method) - assumes function currency of the sub is that of
parents
- translation gains and losses flow through the income statement
- if we are converting from the 3rd currency to functional, those gains flow through I/S
- Current method (translation method) - functional currency of the sub is different from parent
- translation gains and losses flow through other comprehensive income
- if we are converting from functional to reporting currency, those gains flow through
other comprehensive income

Factors influencing exchange rates

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• Relative inflation rates - when country A inflation exceeds country B inflation, country B currency
appreciates as country A residents try to protect their money from eroding
• Relative income levels - when country A's income increases compared to country B, country B
currency appreciates as country A residents buy more of B's goods and services
• Government controls - Tariffs or taxes on country B's goods will decrease the demand for B's currency,
depreciating it compared to A
• Relative interest rates - when country A's interest rates are lower than country B's, country B's currency
appreciates as country A residents seek better returns in country B

There are 3 theories explaining exchange rate risk

• Purchasing Power Parity - the price of identical goods should cost the same in two different countries
when measured in the same currency
- Absolute form - prices will be exact between countries
- Relative form - prices will be approximately equal (accounts for transportation and govt reg)
• International Fischer effect - explains the fluctuation in FX rates through analysis of interest rates.
• Interest Rate Parity - holds that foreign and domestic interest rates will reach equilibrium once covered
interest arbitrage is no longer possible

Types of hedges
• Futures - trade on an exchange, smaller transaction and are denominated in standard amounts
• Forwards - trade over-the-counter, larger transaction and denominated in standard amounts
• Money Market Hedge - uses domestic currency to purchase a foreign currency at spot rates and invest
them in securities times to mature at the same time as the payable is due
B2-79 example of money market hedge

Transfer pricing - transaction between subsidiaries to minimize taxation while still being legal

Other

SCOR Model (Supply Chain Operations Reference)

• Plan – consists of developing ways to balance demand and supply
(planning inventory levels, purchase of raw materials, etc)
• Source – procure the resources required to meet and manage the infrastructure for the sources
(selecting vendors, collecting vendor payments, quality assurance, etc)
• Make – all activities that turn raw materials into finished products
(manufacturing the product, changes in engineering, performing quality assurance tests)
• Deliver – all activities that get the product to the consumers
(managing orders, forecasting, pricing, A/R, shipping)