Budgeting Methods

Budgeting Methods

Net Present Value (NPV)

The Net Present Value in finance is the summation of present values of the individual cash flows in one entity. It is a time series of cash flows which are both incoming and outgoing. NPV is an important tool in discounted cash flow analysis since it is a standard method for the appraisal of long term projects using time value of money. It is also used for capital budgeting throughout finance, economics and accounting. NPV measures the shortfall or excess of cash flows in terms of the present value and above the cost of funds. Therefore, the method is appropriate since it makes proper use of all cash flows and tries to incorporate the time value of money. However, some companies find this method not applicable since it requires an appropriate rate of discount, which is difficult to obtain. The rate used to discount present value to future cash flows should be appropriate since it is an important variable in this process. NPV is relatively more difficult to explain. This is because the method has many computations, which some organizations may find to be more difficult to apply (Capital, 2012).

The Net Present Value method represents the dynamic investment appraisal and a cash flow method that is discounted. The basis for this method is the assumption that today’s euro is worth that tomorrow’s. The reason being that, today’s euro can be invested somewhere to generate interest. NPV method is appropriate for assessing new investments and comparing investment alternatives. The investment with the highest net present value is a more favorable alternative. Since it is an additive process, the investments net profit value can be summed up with the discount rates that are mutually unexclusive. The Net Present Value is obtained by adding up all discounted cash flows less expenditure on investments (Economic Feasibility Studies , 2010).

In a real world situation, an organization must decide on whether to introduce a new product in the market. The product will have various expenditures on the operations and start up and will have associated the incoming disbursements and cash receipts. Therefore, the project will have an initial cash outflow, which includes cash paid to machinery, transportation costs and disbursements on training employees. The project is estimated to cover the startup expenditures and step to a break-even point at the end of ten years. The present cash is therefore important since it would be better for an organization to invest in a project that will generate revenue in the future rather than do nothing with the money (Volkman, 2012).

Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is a rate of return that is applied in capital budgeting for measuring and comparing the investments’ profitability. The calculation does not incorporate the environmental factors such as inflation and interest rate. This method is a capital budgeting technique that is mostly used by many organizations.  Business people prefer the method because they like to see their results from the calculation in annual rates rather than actual dollar returns. This enables them to make comparisons of different projects for ranking. The ranking enables them to see the project that is going to provide more bang for the buck. The project with the highest rate of return on investments is the most advantageous for the organization. However, the method is more complicated to calculate by hand. Therefore, it requires the use of a scientific calculator or application of a spreadsheet (Research and Library Services:Northern Ireland Assembly, 2010).

IRR method is time consuming since it is more difficult to calculate by hand. The financial analysts spend extra time to identify and solve problems with the IRR. This may be due to the complications that may arise out of the method utilization when there is no pattern on the conventional cash flow. However, due to the intuitive appeal of the method, it becomes the most preferred in practical application of the techniques in capital budgeting.

One disadvantage of using IRR method is that it does not account for the size of projects when doing comparison. Cash flows are compared to the outlay capital, which generate them. This can bring trouble when different projects require different amounts of capital outlay, but the smaller project brings a higher IRR.  The method also ignores future costs and concerns itself with the projected cash flows, which are generated by a capital injection. Although IRR allows one to make calculations on future cash flows, it makes a wrong assumption that the cash flows can be invested again at the IRR rate. This assumption is not real since the IRR is a high number and the opportunities, which yield the return, are significantly limited or not available at all. Therefore, the Internal Rate of Return is not suitable for making comparisons of several investment projects that vary in amounts, timing and length. It is quite possible that the investment with a lower internal rate of return has a higher net present value than an investment with a higher internal rate of return (mary, 2011).

Budgeting Methods Dissertations
Budgeting Methods Dissertations

In a real world situation, a project with high internal rate of return should have a high net present value and the vice versa is also true. Organizations should therefore consider investing in big projects, which have high internal rate of return since it would be more advantageous for the organization.

Profitability Index

Profitability index is the investment ratio to the payoff of a suggested project. The method is a useful technique in budgeting in the grading of projects. This is because it measures the value recorded by every unit of investment that is made by the investor. The profitability index of a company’s investment indicates the benefits and costs of investing in a particular capital project by the firm. It is a cost-benefit ratio used in the financial analysis of capital budgeting. The method is useful in telling whether an investment increases the value of the firm or not. If the investment increases the value of the firm, more concentration and efforts are employed on it. On the other hand, if the investment does not increase the value, the firm may be tempted to withdraw its capital from the investment. The method considers all cash flows of the project and the time value of money. It is also useful in considering the risk of future cash flows through the cost of capital. Ranking and selecting of projects is also enhanced when capital is rationed. This allows the organization know the projects, which increases the value of the firm, and revenue generating projects. The method is important as it direct organizations on the areas where they should invest their capital and the risks involved (Dra, 2013).

One of the drawbacks of this method is that it requires an estimate of the capital costs for calculating the profitability index. The method may not give a clear decision when comparing projects, which are mutually exclusive. Therefore, it is not the appropriate method to measure the investment decisions of an organization since it lacks efficiency.

Many organizations direct their profits to investments with the target of getting extra revenues from those projects. The profitability index method is crucial in identifying the projects, which add value to the organization, as well as the dormant projects. Through the application of this budgeting method, an organization is able to focus on the highest revenue generating projects and to identify areas where more capital should be employed (Economic Feasibility Studies , 2010).

Modified Internal Rate of Return (MIRR)

Modified Internal Rate of Returns (MIRR) is a financial measure of the attractiveness in an investment. It is a useful measure in capital budgeting to rank various investments of equal size. Also, the method is a discount rate that equates the present value of outflows to the future inflows value. This is a modified method of Internal Rate of Returns, and as such, its aim is to resolve the problems of the IRR. While the Internal Rate of Return assumes the projects’ cash flows are invested again at the IRR, the Modified Internal Rate of Returns assumes that positive cash flows are invested again at the cost of capital for the organization and the firm’s financial cost finances the initial outlays. Therefore, MIRR is a more accurate measure that reflects the costs and profitability of an organization’s project (Capital, 2012).

One of the advantages of this method is that it tells whether an investment increases the value of the firm. This is important for organizations to focus on the weaknesses of its investments. MIRR considers all cash flows in the project and puts in consideration the money time value. Just like other methods of budgeting, MIRR considers the future cash flows riskiness through the capital cost in the rule of decision. The Modified internal rate of return cannot be used for ranking order projects with different sizes. This is because a project with a larger modified internal rate of return may have a lower present value and vice versa. However, there are some variants, which exist for the modified internal rate of return that can be used to compare such projects (Research and Library Services:Northern Ireland Assembly, 2010).

One of the drawbacks of the Modified Internal rate of returns is that it requires the cost of capital estimates in order to make a decision. This may not be practical in an organization. The method may also not give the value maximizing decision when comparing projects, which are mutually exclusive. Lastly, the method may not give a decision when used to select projects in case of capital rationing.

Discounted Payback Period (DPP)

Discounted Payback Period is a procedure for determining the profitability of a project in a certain organization. In comparison to NPV analysis, which gives the project’s overall value, a discounted payback period indicates the length of time in years an organization would take to break even from the initial expenditure undertaken. Future cash flows are assumed to be discounted to time zero. This method has many similarities to payback period. However, the payback period is a measure of how long the initial cash flow would take to be paid back without taking into account the money time value. Discounted payback period is the time taken for the cash flows present value to recover the initial investment (Rogers, 2011).

This method is important since it puts into consideration the time value of money. Also discounted payback period considers the riskiness of cash flows of organization’s projects through the cost of capital employed. However,  there are no concrete criteria of making a decision which would indicate whether the investments increases the value of the firm. This means that the firm cannot identify the projects which adds value to the organization and might end up funding all projects including the dormant ones. The method also requires the capital costs to make payback calculations, which may not be available. Discounted Payback Period method ignores the cash flows that are beyond the payback period (Dra, 2013).

Projects with a negative net present value will lack a discounted payback period because the initial outlay will never be repaid fully. This is unlike the payback period the inflow from future cash flows could exceed the initial outflow. However, when inflows are discounted, a negative NPV is recorded.

Conclusion

NPV is a better and popular theoretical approach to capital budgeting based on several factors. Most important is that the Net Present Value use assumed that any cash flows that are intermediate generated by an investment are reinvested at the cost of capital for the firm. Due to the reasonable estimate of the cost of capital, at which the firm could invest its cash inflows, the use of NPV becomes a more realistic and conservative reinvestment rate in the preferred theory. In addition, certain properties of mathematics may cause a project with zero conventional cash inflow to have more than one IRR. The NPV approach does not have this problem (Capital, 2012).

References

Capital. (2012). Comparing Budgeting, 1-50.

Dra, P. P. (2013). budgetary methods. Advantage and disadvantages of, 1-2.

Economic Feasibility Studies . (2010). Capital Budgeting Techniques . Capital Budgeting Techniques , 1-8.

Mary, s. m. (2011). worklife resource ministry. budgeting methods, 1-3.

Research and Library Services:Northern Ireland Assembly. (2010). Research and Library Services. Northern Ireland Assembly, Research and Library Service, 1-30.

Rogers, M. (2011). Comparing Budgeting. Comparing Budgeting, 1-7.

Volkman, D. A. (2012). Journal Of Financial And Strategic Decisions. A Consistent Yield-Based Capital Budgeting Method, 1-88.

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Balance of Payment

Balance of Payment and Multinational Corporations

Introduction

Over the last two decades, the world economy has been changed to an extent on which the nations are interconnected with each other in terms of commerce and financial relationship. This circumstance is popularly known as globalization (Vinals, 2004). This interconnection not only helps to exchange goods or service but also force to keep account of financial payment between two countries (Dabrowski, 2006). This record is known as balance of payment. Generally, a multinational corporation has a strong relationship with the balance of payment between two countries (Stein, 1984). The multinational corporation may be affected positively or negatively in the host or home country by the balance of payment (Wilamoski and Tinkler, 1999). The positive relation between MNCs and Balance of Payment creates many opportunities for the multinational corporation. A manager of multinational company must take necessary steps to grab those nice opportunities.

What is Balance of Payment?

Balance of payment is a process of keeping record of transaction of a country with the rest of the word. It includes not only payment for goods and services but also all others payment over the border (Chamberlin, 2009). According the Sloman John, Balance of payment is an account that contains all monetary transaction of a country with the other countries of the world (1998). The transactions contain exports, import, incoming payment and transfer of finance. The balance of payment is usually evaluated based on certain period such as year.  It is also calculated on a single currency, normally US dollar (Mcbride, 2007). Sources of money are considered positive and deployed of funds is negative items. According to Investopedia, the balance of payment generally should be zero to be optimum (2013). However, it does not happen most of the time. The balance of payment is normally surplus or deficit for maximum country. A surplus balance of payment is said to be exist when the incoming payment is higher than total transfer.  On the other hand, a deficit balance of payment is said to be exist when the transfer payment is higher than the incoming payment.

What is Multinational Corporations or MNCs?

A multinational corporations or MNCs, also known as Multinational enterprise (MNE), is a company that operates is business or produce and sale product in more than one country (Daniels, Radebaugh and Sulivan, 2001). According to Van De Kuil, a multinational corporation follows the internationalized philosophy and operates its business both home and host country (2008). He also added that to be a multinational corporation, a company must have the assets and facilities outside the border of national country. The host country, home country and the multinational company get benefits from a multinational trade (Kokko, 2006). The host country gets higher tax or vat, the home country get foreign currency and the multinational company get profit. Here is some example of well-known multinational company Honda, Toyota, Google, HSBC, Wal-Mart, Samsung and chevron etc.

Relevance of Balance of Payment to Multinational Corporation

There is a strong relationship between the balance of payment and Multinational Corporation. A multinational corporation helps both host and home country to increase their balance of payment. In the contrary, the balance of payment situation of a country impact the operation of a multinational corporation by changing the rules and regulation based on country specific needs (Ker and Yeates, 2013). Let us look the relevance of balance of payment to Multinational Corporation in terms of different situation.

Relevance Based on “Direct impact”

 A country in which a multinational company is located tends to be get higher balance of payment. It experiences capital inflow when a multinational company get started with a certain fee. It also gets funds or money from the portion of profit of that Multinational Company (Shoo, 2005). On the other hand, the multinational company helps to improve the balance of payment of home country. The home country gets funds when the MNC make profit and return the money to the home country.

Relevance Based on “Regulatory Relation”

Another positive or negative relation between balance of payment and the MNCs is regulatory relationship. The balance of payment represents the foreign reserve of a country. The trade policy of a country changes with the changes on balance of payment position. If a country has negative balance of payment, it tries to hold the money by encouraging more export than import (Hale, 2013). It also tries to get more tax or VAT from the normal sources. This tighten money policy affects the business flow of multinational companies. They have to give more tax to the government. The sales volume of MNCs may rise because the local producer is busy to export in other countries. The MNCs can be the market leader. It may not happen all time. The rules and regulation may be strict for both domestic and multinational companies. On the other hand, if a country more reserve or balance of payment, it tries to deployed money. It encourages import than import or it invests money to another country as FDI or foreign direct investment. It may reduce the tax burden for MNCs (Bhusnurmath, 2011). By this way, the MNC can get maximum profit. The host country may be benefited from this policy by getting portion of profit when it will get back to it.

Relevance Based on “Measurement Challenge”

The MNC puts a measurement challenge of balance of payment for both home and host country. The goal of a Multinational company is to maximize the profit in after tax all over the world. To do this, they allocate resources, make mixing price system and make extra bill. These conducts is very difficult to measure for the regulatory bodies (Landefeld, Moulton, and Whichard, 2008). There are some good reasons behind this; the resources of production are not same in all countries and the price too. Therefore, it is very tough to evaluate the perfect amount of balance of payment. The mix price is also difficult to detect. Therefore, the proper amount of payment is in question in all countries due the inappropriate recording of MNCs transactions.

Relevance Based on “Foreign Exchange”

The balance of payment is a better indicator of country’s financial status. It helps to evaluate the foreign exchange rate of a country. This exchange rate has direct or indirect effect to the multinational corporation (Wang, 2005). When a currency of a country is strong, the import will cheaper and the export will less competitive. This situation puts pressure to the MNCs to adjust the situation. At that price of goods tends to be cheaper so that the multinational corporation must adjust their price level. Again, when the exchange rate of a country is weaker, the import will expensive and export will high competitive because of inflation. This situation makes higher price level within the country and the MNC have to adjust their price in a high level.

Relevance Based on “Asset Reserve”

The balance of payment also consists of asset such as gold reserve. The higher gold reserve means country has higher trade surplus and thus the higher money supply. This tends to create inflation within the country. Therefore, the MNCs can make higher profit by raising their price level. Conversely, when there is a trade deficit means low assets reserve. This makes the price lower because there is a low money supply. Therefore, the MNCs must adjust their prices level to cope up with host country’s policy.

Relevance Based on “Decision Making”

The balance of payment statistics is very important for all kinds of decision makers. The authority of a country looks carefully the flow of balance of payment. The balance of payment generally is a great indicator of future exchange rate of a country. This put pressure to the monetary authority to take necessary steps to control the money supply. Again, the balance of payment indicates the proper amount of assets reserve for a country. This makes concern for the fiscal authority. They should determine the trade policy, VAT, income taxes and the policy for the multinational corporation. Therefore, we can say, balance of payment accounts are closely related to the overall saving, investment and price policy of a country.

Relevance Based on “Business Policy”

The MNCs are also a good user of balance of payment statistics. They must assess the balance of payment both host and home country for their business policy. The policy of a MNC much depends on the balance of payment flow because change in balance of payment also changes the rules and regulations. When a multinational company try to start their business in another country, they must assess the domestic balance of payment. Because the domestic balance of payment, indicate the permission. If the host country has surplus balance of payment, the MNC can start their operation. Conversely, if the balance of payment is in deficit position the MNC may not get the foreign investment permission. Again, the MNC must assess the host country’s balance of payment. If the host country has already huge surplus balance of payment, it may not give permission to a new MNC because it tries to invest their money not get money. Conversely, if the balance of payment is in deficit position in the host country, they may welcome new money flow to their country. Thus, the balance of payment position in host and home country affect the decision of business start up. The MNC should also asses the foreign exchange rate position in home and host country. The weaker currency in home country means the multinational company have to pay more to start their business in another country. Conversely, if the exchange rate is weaker in host country, the Multinational Corporation can start their business cheaply in the host country. Balance of payment also influence the interest rate because of high bank reserve, the MNC also have to consider the interest rate in the host country. The higher the interest rate means the higher business cost for MNC in the host country.

Finance Essays Balance of Payment
Finance Essays

Changes in Balance of Payment and Management Actions

What is change in balance of payment?

Balance of Payment should be equal in all time. However, in reality, it does not happen. The balance of payment is continuously fluctuating all time. This is called disequilibrium of balance of payment. According to TR Jain, disequilibrium payment is a situation when the balance of payment fluctuates from zero (2008). Another author Cherunilam argues that a country’s balance of payment is disequilibrium when there is surplus or benefit (2010). There are three types of changes in balance of payment favourable, unfavourable and balance. Favourable balance of payment means surplus balance of payment. Unfavourable balance of payment means deficit balance of payment. Balance in BOP means equal incoming fund and outgoing funds.

Causes of Changes in Balance of Payment

There are various causes of change in balance of payment. From them, Raj Kumar, author of international economics pointed out three main reasons such as economic, political and natural (2008). He said that if a country is in developing position it must be in deficit balance of payment. The reasons behind economic cause are huge economic development in infrastructure, inflation or deflation, cyclical fluctuation and changes in foreign exchange rates. Again, the reasons behind political cause in balance of payment are political instability and international relations. The natural consequences such as earthquakes, hurricane and others are the reason for natural cause in balance of payment.

Result of Changes in Balance of Payment

The changes in balance of payment may affect positively or negatively to the economy. Here are some Results of changes in Balance of payment:

  • Positive effects of Changes in BOP increase the creditability of a country. Conversely, Negative changes in BOP lower the international creditability.
  • Positive changes decrease the foreign dependency in terms of financial help. Conversely, Deficit changes in BOP increase the foreign economic dependency.
  • Surplus changes increase the foreign exchange reserve. Conversely, Negative changes in BOP deplete the foreign exchange reserve.
  • Reserve of gold is increase in the case of surplus balance of payment. Conversely, the reserve of gold decreases and goes away in negative BOP situation.
  • Negative balance of payment hampers the economic development. Conversely, positive balance of payment improves the economic condition.
  • Surplus balance of payment increases the global market leadership for the home multinational company. Conversely, Deficit balance of payment hampers to get global market leadership position.

Opportunities for MNCs Revealed by Changes in Balance of Payment

The changes in balance of payment position affects positively and negatively for a country’s economy. As the MNCs are one of the important parts of economy, it also gets affected due to changes in balance of payment. Here are some opportunities for MNCs revealed by the changes in balance of Payment.

Business Growth: A multinational company can get business growth advantages in both home and host country. If the home country has surplus balance of payment, the authority approves MNC to start their business internationally. It means they do not mind in capital outflow from the nation as they have surplus funds to invest. On the other hand, a MNC can expand their business to a host country if they have negative balance of payment. They must try to grab money from the other national to increase their business infrastructure. For this reason, MNC is the best way to get finance.

Low start-up cost: A multinational company can start their operation cheaply in host country due to changes in balance of payment. If the host country has deficit balance of payment, they must encourage funds flow from MNC with low regulations and cost. Again, if the home country has high balance of payment, they allow MNC to start its business with lower fees.

Tax benefits: An MNC can also get tax benefits both home and host country due to fluctuation of balance of payment. The home country encourages FDI when it has surplus balance of payment. For this reason, the tax tends to be lower than deficit BOP to encourage foreign direct investment. Again, in the host country the MNC gets lower tax benefit due to deficit balance of payment (Robert, Dunn and Mutti, 2009). The MNC can also get the lower tax benefit, when the country tries to increase their export and reduce import.

Exchange rate benefits: The fluctuation of exchange rate is highly related to balance of payment. This exchange rate or balance of payment affects the operation cost positively or negatively to a multinational corporation. The MNC pay less if the home country has higher balance of payment or strong exchange rate. Here, they get exchange rate benefits due to weak currency in host country. This strong exchange rate also reduces the resources costs in the host country. Moreover, the MNC can get bill paying benefits due to change in balance of payment system.

Low cost of operation: A multinational corporation can experience low cost of operation due changes in balance of payment in both home and host country. It can get factors of production such as land, labour, machinery and others tools at low prices where the balance of payment is lower. Because, lower balance of payment indicates high rate of unemployment in the host country.

Higher Sales: A multinational corporation can increase their sales due to impact the balance of payment in the host countries. When a country experience lower balance of payment, it tries to increase the export and reduce import to get higher balance of payment. To do this, the country should ensure high production unit. The domestic producer may unable to cope up this policy. Therefore, the MNC get the opportunity to sales more during the recovery situation in balance of payment.

Higher Profit: A multinational corporation can make higher profit due to changes in balance of payment. As we discuss earlier MNC can sale higher volume in the host country in the recovery situation. By this, it can make higher profit because higher sales means higher profit (Deresky, 2009). On the other hand, the MNC can make higher profit if the currency of host country is devaluated. For example, European MNC operates its business in US. If the US dollar is weaker than Euro, the European countries will get higher value of money when they convert the money into their own currency.

Measures to exploit opportunities revolved by changes in BOP

As a MNC operates internationally, it must cope up with the changes on balance of payment in both home and host country. The manager of MNC should be careful to grab every opportunity provided by the BOP. The management measures have been given below:

Seek for growth: A manager of Multinational Corporation should always seek for business growth in home, host or any other country. To seek the business growth opportunity the MNC have to assess the balance of payment position. If the balance of payment is favourable, the manager should grab the opportunity for growth.

Alert all time: The manager should be alert all time to grab the best opportunity for business. As there are various obstacles for a multinational business, the manager have to overcome the obstacle by grabbing the best available opportunity.

Acquire new technology: New technology is very important for a business to get the competitive advantages. A company can implement a new technology to track the balance of payment related data to know the future trend of exchange rate, business cost and tax rate.

Hire business analyst: The manager can hire a business analyst to analyze the balance of payment data and recommend the best opportunity. The analyst also may responsible for making quick and instant decision regarding balance of payment trend.

Implementing short and long-term strategy: The manager can implement a short and long-term strategy for grabbing the opportunity of balance of payment. The short-term strategy may be for less than one year and the long-term strategy may be for above the one year. In addition, this strategy should include the yearly business strategy.

Conclusion

Due to high impact of globalization, every country must engage business internationally through Multinational Corporation. The multinational corporation contribute in the economy of related party’s as well whole world. This report describes that there is a strong relevance of balance of payment to Multinational Corporation. They are related to each other’s in terms of direct impact, regulatory relation, assets measurement, foreign exchange, business policy and decision-making. This report also describes that the changes in balance of payment creates some opportunities for MNC such as business growth, low start up cost, exchange rate, higher sales and higher profit benefit. Moreover, this report suggests that a manager of a company should take some important measures such as implementing new technology, higher business professional and hiring business analyst to grab the best available opportunity revealed by changes in balance of payment.

References

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Cherunilam, F. 2010. International business. New Delhi: PHI Learning Private Limited.

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Daniels, J., Radebaugh, L. and Sulivan, D. 2011. International business. Boston: Pearson.

Deresky, H. 2011. International Management. Boston, Mass.: Pearson.

Eicher, T., Mutti, J., Turnovsky, M. and Dunn, R. 2009. International economics. London: Routledge.

Essay.uk.com. n.d.. Negative and positive impact of globalisation

Hale, G. 2013. Federal Reserve Bank San Francisco | Research, Economic Research, Europe, Balance of Payments, European Periphery

Investopedia.com. 2013. What Is The Balance Of Payments?

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Asset Price Bubbles

Central Bank Response to Asset Price Bubbles

Recent research in the area of macroeconomics has been focused on trying to identify the causes of the 2007 – 2008 global financial crisis and determining best central bank monetary policies to prevent future crises. A debate that has for the last few decades been settled is now being revived; “lean” versus “clean” handling of asset Price bubbles.

The prevailing consensus of central bank monetary policy has followed the “Greenspan Doctrine” established in the 1970’s for dealing with asset price bubbles. Alan Greenspan, who was the chairman of the U.S. Federal Reserve from 1987 to 2006, believed that cleaning up after an asset bubble burst was less costly and damaging to the economy than allowing central banks to burst bubbles; attempting to “Lean Against The Wind (LATW) (Wadhwani, 2008)” on rising asset bubbles to prevent a bigger burst. This perspective was widely accepted by central banks around the world.

There are mainly four arguments against LATW monetary policy. First, bubbles are difficult to predict; the market would likely detect asset bubbles before regulators would and the market would be able to orderly deflate those bubbles through natural market processes. Secondly, there is evidence that raising interest rates (a central bank strategy for determent) doesn’t reduce the inflation of bubbles since investors are likely to take the risk on high interest rate assets in the midst of an asset bubble based on the expectation of high returns on those assets. Third, the Fed is incapable of isolating dangerous asset bubbles from normal rising asset prices; monetary policy could ham-handedly attempt to prevent asset bubbles but have the effect of harming normal asset prices. Lastly, proactively bursting asset bubbles could make the burst harsher than if the bubble were allowed to burst on its own.

Those cautions have kept the Greenspan Doctrine in place since the late 80’s, but in the aftermath of the 2007 – 2008 crisis, many economists are beginning to wonder if the “lean” strategy may actually be cleaner than the Greenspan Doctrine. Not to mention, the Greenspan Doctrine assumed that bubbles could not be as destructive as the most recent housing bubble. Could central banks develop monetary policy strategies that are more precise in detecting and deterring asset bubbles?

Combating Price Bubbles

Clearly, setting aside the lean versus clean debate, there are standard monetary principles that have not always been followed or enforced. Namely, regulators should demand more transparent disclosure, require more capital and liquidity, apply stricter monitoring of risk, stronger enforcement of compliance, and more accountability for regulators charged with overseeing the financial stability of markets. These policies need to be either reinstated and or reinforced to help stabilize the markets during asset bubbles or otherwise.

But for central banks to devise better strategies for combating bubble driven asset pricing, it is necessary to rethink the Greenspan Doctrine considering how ill-prepared the central banks were for dealing with the crisis in the financial markets. Or, perhaps both strategies have a time and place in setting monetary policy. Frederic Mishkin argues that there is a way to apply the LATW strategy to the financial markets if first central banks understand that there are two different types of bubble driven assets and each one requires a different monetary strategy.

Asset-pricing bubbles are divided into “credit bubbles” – like the housing bubble – and “irrational exuberance bubbles” – like the dot-com bubble (Mishkin, 2011).” He argues that because credit bubbles are so destructive to the economy and so hard to clean up that it would be appropriate for central banks to focus their monetary policies on predicting and deflating credit bubbles before they grow too large. Credit bubbles are linked to the financial markets so intricately that whenever there is a credit bubble like the one just experienced, its bursting usually leaves in its wake a deep recession, a financial crisis and a long period of slow growth and high unemployment.

Asset Price Bubbles
Asset Price Bubbles

Unlike normal recessions, there was no sharp recovery after the last three big asset bubbles. Because it is so hard to recover from credit bubbles, trying to head them off and prevent them is necessary. The LATW can be applied and should factor in to central bank policy because credit bubbles are much easier to identify. Each credit bubble shares certain symptoms that could alert regulators to the problem: lower lending standards, premiums on risk become abnormally low and credit is being extended at a much faster and higher rate (Mishkin, 2011).

The central bank targets these credit bubbles by slowly raising interest rates to discourage excessive risk taking in the credit markets. By inflating the interest rates on these assets, central banks can tamp down exuberance as well as spark growth in a slowing economy (The Financial Times LTD, 2014). This requires central banks to turn their focus more sharply and aggressively towards monitoring and reacting to irregularities in asset pricing more than the traditional singular focus on controlling inflation (Wadhwani, 2008) (Gambacorta & Signoretti, 2013). Lastly, this type of proactive monetary policy could have the effect of reducing moral hazard through proactive responses to booms as opposed to the reactionary approach to booms after the bust; this could discourage the reckless risk taking that typifies credit bubbles (The Financial Times LTD, 2014).

While economists are still debating the merits of the LATW strategy of curtailing asset price bubbles, it is without question that the traditional standards of monetary oversight have been too lax over recent decades and reinforcing those policies will go a long way to restoring healthy checks and balances to the world market. However, it has also become very clear that these boom and bust cycles threaten financial stability in such a way that central banks can no longer ignore fluctuations in credit markets. While focusing on controlling inflation is still a target for central bank monetary policy, central banks must now focus efforts on developing Bubble Policies (Rudebusch, 2005) that can prevent or deflate asset price bubbles before they can do real damage to the economy

References

Brittan, S., Meltzer, A. H., Wolf, M., Smaghi, L. B., Schlesinger, H., Mayer, M. Frankel, J. (2009, Fall). Should, or Can, Central Banks Target Asset Prices? A Symposium of Views

Gambacorta, L., & Signoretti, F. M. (2013, July). Should monetary policy lean against the wind? – an analysis based on a DSGE model with banking.

Mishkin, F. S. (2011). How Should Central Banks Respond to Asset Price Bubbles? The ‘Lean’ versus ‘Clean’ Debate After the GFC. Reserve Bank of Australia June Bulletin, 59-67.

Rudebusch, G. D. (2005, August 5). Monetary Policy and Asset Price Bubbles.

The Financial Times LTD. (2014, April 16). Definition of leaning against the wind. Retrieved from Financial Times Lexicon: http://lexicon.ft.com/term?term=leaning-against-the-wind

Wadhwani, S. (2008). Should Monetary Policy Respond to Asset Price Bubbles? Revisiting the Debate. National Institute Economic Review, 25 – 34.

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