Economic forces have an enormous impact on both business and customers. They influence
a business’s capacity to compete and customer’s willingness and ability to spend. The
following figure shows the impact of each phase of the economic cycle on a business’s
performance. Information on economic growth, inflation trends, average weekly earnings,
consumer confidence, interest rates, consumer spending and unemployment provide
businesses with insight into economic trends. This information on the level of economic activity
allows businesses to predict possible threats to, and opportunities for, business activity.
The most important economic influence from the external environment can be attributed to
the economic cycles. Economic cycles are a feature of the economies businesses operate in.
Economic cycle refers to the predictable long-term pattern of changes in the national income.
In the traditional business cycle, there are four stages: expansion, prosperity, contraction and
recession.
After a recessionary phase, spending gradually increases as people become more confident
about the future. When people are confident that their income will be maintained or improved
in the future, they spend more on things like cars, furniture and whitegoods. In turn, more
people are employed to provide the extra goods and this leads to even more income. The
pattern of spending continues to climb. This period of growth in spending can last for a
considerable time.
Boom: The peak of the cycle is called a boom. During a boom GDP is growing fast because
the economy is performing well. Existing firms will be expanding and new firms will be entering
the market. Demand will be rising, jobs will be created, wages will be rising and the profits
made by firms will be rising. However, prices may also be rising. For example, in the UK, the
price of houses rose sharply when GDP was growing rapidly in the 1990s and 2000s.
Downturn: A boom will be followed by a downturn. The economy is still growing, but at a slower
rate. Demand for goods and services will flatten out or begin to fall, unemployment will start to
rise and wage increases will slow down. Many firms will stop expanding, profits may fall and
some firms will leave the market. Prices will rise more slowly.
Recession or depression: At the bottom of the business cycle GDP may be flat. If GDP starts
to fall, the bottom of the cycle may be referred to as a slump or depression. Such a period is
often associated with hardship. Demand will start to fall for many goods and services –
particularly non-essentials. Unemployment rises sharply, business confidence is very low,
bankruptcies rise and prices become flat. The prices of some things may even fall. A less
severe version of a depression is a recession.
Recovery: When GDP starts to rise again there is a recovery or an upswing in the economy.
Businesses and consumers regain their confidence and economic activity is on the increase.
Demand starts to rise, unemployment begins to fall and prices start to rise again.
The impact of the business cycle on business
The uneven pattern of growth, shown by the business cycle, can have an impact on
businesses. However, the size of the impact will depend on the financial position of the
business and what it produces.
● Output. During a boom, businesses increase output to meet rising demand. Some will
increase capacity. Businesses providing non-essential products and luxury items will benefit
more than those that produce necessities. Businesses operating in the holiday, restaurant, air
transport, jewellery and fashion industries are likely to benefit most. In contrast, during a
recession or a depression output will fall. Businesses respond by reducing output and cutting
capacity. Businesses that trade in essential items, such as supermarkets, will avoid the worst
of the downturn.
● Profit. During a boom business profits are likely to rise. This is because demand is rising
and it is easier to raise prices. However, when national income starts to decline, it is harder to
make a profit. Businesses may cut their costs to maintain profit levels. Many will have to
tolerate lower profits and some will make losses.
● Business confidence and investment. During an economic recovery and into a boom,
business confidence is high. Business owners are optimistic about the future and are prepared
to take more risks. For example, they are more inclined to launch new products, enter new
markets and expand. In contrast, during a recession business confidence is low and business
owners are pessimistic, cautious and anxious about the future. Consequently, they are not
likely to take risks and are more inclined to contract their businesses. Investment is likely to
fall. For example, instead of replacing outdated machinery they will make do with what they
have.
● Employment. During a boom unemployment falls because businesses are taking on more
workers to cope with rising demand. Sometimes firms might struggle to recruit the quantity
and quality of staff that they need as there are fewer people seeking work available. However,
during a recession the opposite happens. Businesses lay off workers and unemployment rises.
● Business start-ups and closures. In a boom more people are prepared to set up a new
business. This is because demand is rising and it is easier to make a profit. Business
confidence will be high so new entrepreneurs will be more enthusiastic. However, a recession
is not a good time to start a new business. Business closures will be rising and inefficient
businesses, those with cash flow problems and those producing non-essential products, are
most at risk
Inflation
A government will want to keep prices stable in the country’s economy. This means that
inflation must be kept under control. Inflation is when the general price level is rising. For
example, if a basket of goods cost £100 on 1.1.2013, and the same basket cost £103 on
1.1.2014, prices have gone up by three per cent. This means that the inflation rate is three per
cent. If inflation is too high it can harm the economy. Figure 2 shows inflation rates in the UK
between 2004 and 2014. The graph shows that the rate of inflation has been quite low,
fluctuating between one and five per cent. Inflation rates at these levels are not really
troublesome. However, in the 1970s, inflation reached levels of 25 per cent, which was a
serious threat to businesses and the economy.
How is inflation measured?
A common approach to measuring inflation is to calculate changes in the consumer price index
(CPI). This involves gathering information about the prices of goods and services in the
economy. Each month the government records price changes of about 600 goods and
services. From these records an average price change is calculated and converted into an
index number. The month’s figures can then be compared with the previous month’s, or that
of 12 months ago, to calculate the percentage change in prices (i.e. the inflation rate) over the
time period.
How does inflation affect businesses?
Inflation rates between one and five per cent, like those in the UK between 2004 and 2014 in
Figure 2, are not likely to have a big impact on businesses. However, once the CPI gets into
double figures and beyond, inflation can have some damaging effects on businesses. High
and particularly fluctuating inflation is likely to be damaging to business for a number of
reasons.
Increased costs: High or fluctuating inflation imposes a variety of costs on businesses.
● With suppliers’ prices rising all the time, but at different rates, time must be spent researching
the market for the best deals. Equally, more time has to be spent tracking the prices of
competitors to decide when and by how much to increase your own prices. These costs are
called shoe leather costs, because before the age of the telephone and the Internet,
businesses would have to send their employees round on foot to gather this information.
● Raising prices costs money. Customers have to be informed of the new prices. Brochures
might have to be reprinted and sent out. Websites might have to be updated. The sales force
has to be made familiar with new prices. These costs are called menu costs because, for a
restaurant, increasing prices means that it has to reprint its menus.
● Management is likely to have to spend more time dealing with workers’ pay claims. Instead
of being able to sign a two or three year deal, annual pay negotiations are likely to be the
norm. If there is hyperinflation, where inflation is running into 100 per cent per annum or over,
pay negotiations may have to take place each month. There is also a much larger risk of
strikes because workers and managers will probably have different views of future inflation
rates. Workers will be worried that any deal they make will leave them worse off after inflation.
So they might be more willing to take industrial action to get high pay settlements.
Uncertainty: With high and fluctuating inflation, businesses don’t know what prices will be in
three or six months’ time, let alone in one or five years. But decisions have to be made now
which will affect the business in the long term. For example, businesses need to invest to
survive. But how much should they invest? The price of a new machine, a shop or a new
computer system will probably be higher in six months than today. But are they worth buying
if interest rates are at very high levels? What if the new machine is bought, financed by very
high cost borrowing and there is a recession, where demand for goods and services falls?
Another problem with uncertainty is linked to entering longterm contracts. A customer might
approach a business wanting to buy products on a regular monthly basis for the next two
years. How can the supplier put a price on this contract if it doesn’t know what the inflation
rate will be over the next 24 months?
Borrowing and lending: Borrowing and lending becomes an opportunity and a problem for
businesses. On the one hand, the real value of debts incurred in the past can become quickly
eroded by inflation. If inflation is 100 per cent per annum, the real value of money borrowed a
year ago is halved in one year. Inflation initially benefits borrowers and harms lenders. But in
an inflationary environment, interest rates rise to match inflation. If inflation is 100 per cent,
interest rates might be 110 per cent. If there is prolonged inflation, interest rates are likely to
become index linked – linked to the index of prices. So interest might be charged at the rate
of inflation plus 5 per cent or plus 10 per cent.
Consumer reactions: Consumers react to inflation as well as businesses. Prolonged inflation
tends to lead to more saving. Inflation unsettles consumers. They become less willing to
borrow money, not knowing what will happen in the future. The value of savings tends to fall
as inflation erodes their real value. So people react by saving more to make up savings to
their previous real value. Increased saving means less spending and so businesses will sell
less. If inflation is very high, consumers will adopt different spending patterns which may affect
businesses. For example, if there is hyperinflation, prices will be changing by the day.
Consumers will then tend to spend wages or interest as soon as they receive them. On ‘pay
day’ there can be huge activity in shops. Supermarkets have to be geared up to selling most
of the weekly or monthly turnover in just a few hours. Suppliers of fresh produce to
supermarkets have to be geared to delivering most of their goods on one day a week.
International competitiveness: High inflation can have an impact on businesses that import or
export goods and services. For example, if the UK has higher inflation rates than its trading
partners, UK businesses will become uncompetitive. As result they are likely to lose sales and
shares in overseas markets. Also, UK businesses facing competition from overseas will lose
out because imports become relatively cheaper. For example, consumers in the UK may buy
foreign goods instead of UK goods because their prices are rising less quickly than those in
the UK. The impact of changes in the price of imports and exports are discussed in more detail
later in this unit.
Deflation
Some countries in the world have experienced deflation. This is where the general price level
starts to fall and can also be a problem for businesses. This is mainly because deflation is
usually associated with a fall in demand. When prices are falling consumers may delay
spending because they think they can make purchases in the future at lower prices. As a result
businesses postpone investment and may lay off workers due to the need to cut production.
Businesses may also have to lower their prices, which can reduce their profits. In 2014, there
were some deflationary pressures in the EU when the oil price fell sharply, inflation was very
low and a number of countries were in recession.
Exchange rates
Different countries in the world have their own currencies. For example, the USA uses the
dollar, Japan uses the yen, many EU countries use the euro and the UK has the pound. When
countries use different currencies transactions between people and businesses are affected.
For example, an Indian visitor to the UK cannot use rupees, they would have to buy some
British pounds. How many pounds would the Indian visitor get for 150,000 rupees? This
depends on the exchange rate between the pound and the rupee. If it were £1 = Rs100 the
visitor would get £1,500 (Rs150,000 ÷ Rs100). The exchange rate shows the price of pounds
in terms of rupees. When businesses buy goods and services from other countries payments
are usually made in the supplier’s currency. Some examples are given below.
For UK exports rises, there will be an increase in the demand for pounds. This is because
foreigners need pounds to pay for exports. The increase in demand for pounds will raise the
exchange rate (i.e. raise the value of the currency, the pound, against that of another
currency). When it rises, the exchange rate has appreciated. Changes in the exchange rate
can have an impact on the demand for exports and imports. This is because, when the
exchange rate changes, the prices of exports and imports also change. Worked example 1
How much will it cost a French business to buy goods from a British business which cost
£400,000 if £1 = €1.25? The cost to the French business in euros is: 400,000 × 1.25 =
€500,000 2 How many US dollars will it cost a British business buying £55,000 of goods from
an American business if £1 = US$1.50? The cost to the British business in US dollars is:
£55,000 × $1.50 = $82,500 3 How much will it cost a British business in pounds to buy
$300,000 of goods from a US business if £1 = US$1.50? The cost in pounds is: $300,000 ÷
$1.50 = £150,000 4 How many pounds can a Japanese business person buy with ¥100,000
when visiting London if £1 = ¥190? The quantity of pounds that can be bought is: ¥100,000 ÷
¥190 = £526.32
The impact of an appreciation in the exchange rate on imports and exports
The exchange rate is the price of one currency in terms of another. Like all prices they can
change. This is because prices are determined by market forces and supply and demand
conditions can change at any time. For example, if the demand for UK exports rises, there will
be an increase in the demand for pounds. This is because foreigners need pounds to pay for
exports. The increase in demand for pounds will raise the exchange rate (i.e. raise the value
of the currency, the pound, against that of another currency). When it rises, the exchange rate
has appreciated. Changes in the exchange rate can have an impact on the demand for exports
and imports. This is because, when the exchange rate changes, the prices of exports and
imports also change.
How are businesses affected by exchange rates?
The examples above show what happens to the prices of imports and exports when exchange
rates appreciate and depreciate. Sometimes these changes will benefit a business, other
times they will not. For example, if the value of the rupee falls, Indian exporters will benefit
because the price of exports falls and demand should increase. However, Indian importers
will lose out because their purchases will be more expensive. Fluctuating exchange rates
cause uncertainty. Businesses do not know what is going to happen to exchange rates in the
future. This means that it is difficult to predict demand for exports and the cost of imports. This
makes planning and budgeting more difficult. Another problem is that it costs money to switch
from one currency to another. There is a usually a commission charge of around two per cent.
This represents a cost to importers and therefore reduces profit.
Interest rates
If a business or an individual borrows money, they usually have to pay interest on the loan.
Equally, if they put their savings into a bank or building society, they expect to receive interest.
The interest rate is the price of borrowing or saving money. For example, if a small business
borrows £10,000 from a bank for one year, and the interest rate is 7 per cent, it has to pay
£700 in interest. Equally, if a business has £1 million in the bank for a year which it uses as
working capital, and the rate of interest the bank offers is 3 per cent, it will earn £30,000 in
interest The impact of low interest rates on businesses has been generally helpful. Figure 3
shows the level of interest rates in the UK between 1984 and 2014. Since 2008 the base rate
has been 0.5 per cent. However, previously to this in the late 1980s, rates were much higher
reaching a peak of 15 per cent. Rates this high can have damaging effects on businesses as
outlined below. Finally, the use of interest rates to help control the economy is called monetary
policy. For example, the government might raise interest rates to dampen demand in the
economy if they though that inflation was being caused by demand rising too quickly.
Effect of interest rates on costs
Changes in interest rates are likely to affect the overheads of a business. Interest charges are
part of overhead costs. If interest rates rise, businesses are likely to have to pay higher interest
payments on their borrowing.
For example, a business might borrow £10,000 on overdraft. The annual payments on this
would rise from £600 to £700 if the rate of interest rose from 6 to 7 per cent a year.
Not all borrowing is at variable rates of interest. Variable rates mean that banks or other
lenders are free to change the rate of interest on any money borrowed. Many loans to
businesses are at fixed rates of interest. This is where the bank cannot change the rate of
interest over the agreed term (the time over which the loan will be paid off) of the loan. A rise
in interest rates in the economy won’t affect the overheads of a business with only fixed term
loans. But, if a business wanted to take out new loans, it would have to pay the higher rates
of interest the bank or other lender was now charging. So overhead costs would rise.
Effect of interest rates on investment Changes in the rate of interest affect the amount that
businesses invest, for example in new buildings, plant and machinery. There are four main
reasons for this.
The cost of loans
Investment projects are often financed through loans. A rise in interest rates increases the
cost of borrowing money. So projects financed this way will find that the total costs have risen,
reducing profitability. This might be enough to persuade some businesses to shelve their
investment plans. Total investment in the economy will then fall.
Attractiveness of saving
Businesses have the alternative of putting their funds into savings schemes rather than
investing in machinery or buildings, for example. A rise in interest rates makes putting money
into financial assets relatively more attractive. For example, if interest rates rise from 5 to 8
per cent, a business might decide to shelve an investment project and save the funds instead.
Paying off existing loans
A rise in interest rates will increase the cost of existing variable rate borrowing. A business
could choose to pay off existing loans rather than increase its investment. This will reduce its
costs. It also reduces the risk associated with borrowing. A fall in demand A rise in interest
rates is likely to reduce total spending in the economy, as explained below. This might affect
the profitability of many investment projects. For example, a business might forecast that an
investment project would be profitable with 20,000 sales a year. But if sales were projected to
be only 15,000 a year because of a downturn in demand, then the investment project could
be unprofitable and might not go ahead.
Effect of interest rates on demand
The level of interest rates affects aggregate demand (i.e. total demand) for goods and services
in the economy. A rise in interest rates will tend to push down aggregate demand. A fall in
interest rates will tend to increase demand. Businesses are directly affected by changes in
demand. When demand falls, their sales go down because less is being bought. If demand
rises, businesses receive more orders and more sales. There are many different ways in which
changes in interest rates lead to changes in the sales of businesses.
Domestic consumption
Consumers will be hit by a rise in interest rates. The cost of loans will rise. This will deter
consumers from buying goods bought on credit, such as cars, furniture and electrical
equipment. These goods are known as consumer durables because they are ‘used up’ over a
long period. In the UK, people who have a mortgage (a loan to buy a house) are also likely to
see their monthly repayments rise because most mortgages are variable rate loans. Existing
mortgage holders will then have less to spend on other goods and services. Some potential
new home buyers will be put off because they can’t afford the repayments, directly hitting the
new housing market. If unemployment begins to rise because of less spending, consumer
confidence will fall. This will make consumers even less willing to take out loans and spend.
Domestic investment
As explained above, businesses are likely to cut back plans for new investment if interest rates
rise. Investment goods, like new buildings or machines, are made by businesses. So these
businesses will see a fall in their demand.
Stocks
Businesses keep stocks of raw materials and finished goods. Stocks cost money to keep,
because a fall in stock levels could be used to finance a fall in borrowing and interest
payments. So a rise in interest rates will increase the cost of keeping stock. This will encourage
businesses to destock, i.e. reduce their stock levels. This will be especially true if the rise in
interest rates has hit demand in the economy. With fewer sales, less needs to be produced.
So less stock needs to be kept. But cutting stock reduces orders for businesses further up the
chain of production. For example, a retailer cutting stocks affects demand from its suppliers.
Destocking due to higher interest rates will therefore cause a fall in demand throughout much
of industry
Exports and Imports
A rise in interest rate tends to lead to a rise in the value of one currency against others. A rise
in the pound, for example, will make it harder for UK businesses to export profitably. At the
same time, foreign firms will find it easier to gain sales in the UK domestic market because
they will be able to reduce their prices. The result is likely to be a fall in exports and a loss of
sales to importers in the domestic market. Both will reduce demand and hit UK businesses.