1.2.5 The wider economic environment


    Businesses are affected by what goes on in the economy and by the actions of the government:

    • Interest rates
    • Unemployment
    • Inflation
    • Exchange rates
    • Taxation


    Interest rates – the percentage rate charged on a loan and paid on savings (price                                        charged for borrowing money)


    • The Bank of England is a business to business bank which lends to the high street banks who have accounts.
    • High Street banks will lend to consumer and smaller businesses, usually at a higher rate of interest than they have been charged by the B of E.




    When interest rates rise it cause the following things to happen:

    • When interest rates go up, it means that for consumers who have a variable mortgage, their monthly repayments will increase, reducing their disposable income. They will cut back on luxury or unnecessary goods. Also house prices fall.
    • It also discourages borrowers as the interest paid back on the loans becomes quite expensive, and it becomes riskier to take out a loan as it is harder to pay back. This is detrimental to small businesses trying to start up as they may not be able to pay back the lender.
    • As for larger businesses, they will suffer from the increased interest they have to pay back on their loans. This, as well the fact that they are likely to be selling less gods/services due to decreased demand from consumers, means that they will have lower profit margins and less sales. This means they are less likely to expand and may reduce the size of the workforce or lower wages. Another way they are losing profit is through the increased cost of production.
    • The positives of rising interest rates are for the savers. They will get more money from their savings’ as increasing interest rates encourage saving.
    • The overall impact of this will be reduced economic growth due to lower consumer demand and lower inflation as prices will go down and consequently the value of money will increase. It will also cause a fall in investment.


    • When interest rates fall, it causes monthly mortgage payments to be lower and consumers will have a higher disposable income, meaning that they are more likely to spend more, especially large purchases like cars or holidays. This increases net consumer spending and therefore there is higher consumption.
    • It encourages borrowing as with lower interest rates, it means that loans are easier to pay back but may be harder to obtain as banks are not as willing to give out loans as they do not gain as much from this as before. However, generally borrowing is encouraged.
    • On the other hand, savers are discouraged, as they gain less from their savings and are now more likely to go out and spend what they would have saved, on large purchases such as cars or holidays.
    • Larger businesses will see an increase in sales and are also more likely to take out loans in order to expand, as low interest rates encourage businesses to invest, expand and create jobs with their raised profits.
    • Overall, lower interest rates increase inflation but also cause increased economic growth as well as increased consumption causing a higher GDP.


    Unemployment – The number of people able and willing to work but not able to find a paid



    Employment – Being financially active.


    Underemployment – When people who want to work fulltime can only find part time work.


    • With higher rates of unemployment, there is a larger supply of labour to employ from. This also means that as people are more desperate for jobs, it means the firms can pay lower wages.
    • Also with high levels of unemployment, it means there is less consumer spending due to consumers having less disposable income leading to firms losing profits.
    • Producers which sell inferior goods may see a rise in sales.
    • With lower rates of unemployment, there is pressure on firms from employees to get higher wages.
    • It also becomes harder recruit new workers without offering better packages or wages than competitors



    • It is an opportunity cost (the alternative being employment)
    • There is a loss of output, growth and income.
    • Retraining for the unemployed to find a job is very expensive.
    • Negative multiplier effects – the loss of jobs in one area can lead to less spending and cause others to also lose out.
    • Social costs as rising unemployment is linked to social deprivation,
    • Fiscal costs as the government earns less tax revenue as people are earning less.



    Inflation – a persistent rise in the average price level and a corresponding fall in                                the value of money.


    Prices of all products and services tend to rise in times of inflation. UK inflation is currently 3% and the government target is 2%.


    Hyperinflation – inflation at a very high rate


    Deflation – when there is no inflation and the average price level is decreasing


    Disinflation – a reduction in the rate of inflation


    How is inflation measured?

    1. uses a weighted average of price changes over a range of 700 goods and services (based on a basket of goods a typical family would buy)
    2. Starts with a base year of 100, the following years the % change is compared to the base year.


    There are 2 main measures of inflation: The Consumer Price Index (CPI) and Retail Price Index (RPI). They contain different items, but both use the basket of goods method. The government chose to use the CPI as it has less uncertainty than the RPI and made markets easier to compare when joining the EU as buying houses was not as common a practice.


    CPI:      the headline rate and is the one used to measure general inflation, but it excludes certain items.

    RPI:      this also includes house costs such as mortgage repayments, council tax as well as petrol costs.

    There are also two main types of inflation: demand pull inflation and cost push inflation


    Demand pull inflation        

    –        This is caused by a rise in aggregate demand (overall demand) that is slower that the increase in aggregate supply.

    –        This is when consumers compete to buy limited amounts of goods and services causing the prices to be driven.

    This can be known as “too much money chasing too few goods”.


    Cost push inflation

    –        Prices have been pushed up due to increases in any of the factors of production and when companies are already running at maximum.

    –        To maintain their profit margins, companies will pass on their higher prices to their customers.

    –        This may also cause them to attempt to cut costs or search for cheaper suppliers if that is where the increased price has come from.


    Menu costs

    • The cost caused by quickly changing prices i.e. changing price lists and updating costs on Website.

    Wage Pressure

    • Workers ask for higher wages to cover the cost of inflation which can lead to trade unions negotiating.
    • This increases business costs and cuts down the profit margin.
    • This can be expensive for the company as they cannot always afford to pay the higher prices.

    Raw Materials

    • When raw material costs increase, businesses increase their prices to keep profit margins stable.
    • This rise in price from suppliers may be caused by a rise in their own costs, e.g. increased petrol costs has increased price of delivery.

    Consumer spending

    • In times of inflation, people are uncertain about what they can afford so they are cautious and cut back on spending.
    • This ‘save not spend’ mentality causes a decrease in business profits.

    Business debt (Loans)

    • Inflation decreases the value of debt with the real value (proportionally), the debt is less than it was.
    • This is only true if high inflation does not cause high interest rates which lead to increasing costs again.

    Economic Growth

    • High inflation is often a sign of a prospering economy, it often occurs when people are spending more in the community and is an indicator.

    Exchange Rates – the price of one currency expressed in terms of another e.g. £1 = $1.5


    Who is affected by exchange rates?

    • Tourists
    • Businesses who import and export
    • International investors


    Exporting – selling goods abroad


    Importing – buying goods from abroad


    Causes of change in exchange rates

    • Due to demand and supply (market forces) which causes a floating exchange rate (constant fluctuations).
    • The more the currency is demanded, the more the price of it rises and vice versa.


    Appreciation – when one currency rises in value against another. E.g. the pound becomes                         stronger or buys more dollars.


    Depreciation – when one currency falls in value against another. E.g. the pound becomes                          weaker or buys less dollars.

    Effects on business

    • Causes uncertainty as if money is not exchanged before exchange rates change, it causes the profit margins to change completely.
    • They cannot be certain of their revenue for their exports.
    • Thousands of pounds can be lost if the exchange rate changes.
    • Businesses that export will want a depreciating/weaker pound as it will make them more competitive in foreign markets.
    • Businesses that import will want an appreciating/stronger pound as their costs will fall and they can reduce prices and make more profit. (Both above points are summarised in the acronym below)


    Stronger Pound Imports Cheaper Exports Dearer

    Direct taxation – tax which is charged on earnings, such as corporation tax or income tax


    Indirect taxation – tax which is charged on things other than income or profits, for example                           VAT, car tax, insurance tax and others

    Government expenditure needs to be paid for, most of the money for which comes from tax revenue. The remainder for this comes from borrowing from other countries and/or the Bank of England.


    Corporation tax – a tax on the profits that a business makes


    Effects on businesses

    • Direct taxation is charged (levied) on earnings. A change in the rate of income tax will affect the amount of disposable income that consumers have. An increase in taxation will reduce demand for most goods and services (apart from essentials).
    • Indirect taxation such as VAT will cause prices of many goods and services which reduces consumer spending.
    • Businesses that provide goods with excise duties (fuel and alcohol) will suffer from a decrease in demand if the government decides to raise these taxes.
    • Decreases in corporation tax allow businesses to keep more of their profits, which encourage them to invest it for future growth.

    Too high a corporation tax may deter foreign companies from basing in the UK.


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