AS Economics and BusinessThe Current Economic Climate

Unit 1By Mrs Hilton for revisionstation

Lesson objectives

• To be able to discuss the implications for business in a change in the interest rates

• To be able to discuss the effect of government spending or taxation on business

• To be able to discuss the potential consequences for business of unemployment, inflation and changes in the exchange rate.

• To be able to answer a past paper questions on the current economic climate

Starter

• What effect do you think that local unemployment has on demand for products and services? Is there a link?

Implications of government decisions on business

• Governments can control the rate of interest and the amount of money circulating in an economy.

• Government can also affect the amount of borrowing or credit available from financial institutions like banks.

• This is called MONETARY policy and they manipulate these variables to achieve their political party’s objectives

• The rate of interest is the price of money and the key instrument of monetary policy

Government policy continued

• The government may change the way that it spends and this may effect business

• The government may change the tax that it charges in the UK and this may effect business

• There are consequences for business of unemployment and inflation

• Business will be effected by changes in the exchange rate

• Changes in economic indicators such as unemployment will have a knock on effect to business (such as demand or larger pool of applicants for vacancies )

Glossary• Interest rates – cost of borrowing, the price of money• Inflation rates – rise in cost of goods and services to

buy (persistent increase in costs)• Unemployment rates – rise in numbers not in

employment• Tax – monies demanded from the government so they

have money to spend elsewhere like the NHS and on roads and education

• Exchange rate – the rate at which one currency can buy another £1 = $1.67

Changes to interest rates – effect on business

• What is the impact on the cost of borrowing to business?

• If interest rates rise then the cost of borrowing will rise and this will mean that the cost of supplies for a business may increase

• A fall in interest rates means that the cost of servicing debt falls which may lead to an increase in profits (costs less to borrow so less to pay back)

Changes in taxation – effect on business

• If the % of VAT goes up a business will have to pass this cost on to the consumer so if makes goods more expensive to buy

• The alternative is that the business absorbs this extra costs and the price of the goods remain the same to the customer – therefore lowering profit margins

• http://www.bbc.co.uk/news/business-12099638

Consequences for business of unemployment

• If the government tightens monetary policy by raising interest rates this will lead to a decrease in demand therefore an increase in unemployment

• High unemployment in an area will mean reduced demand for normal goods and services and an increase in demand for inferior goods

Inflation

• Inflation is a rise in the price of goods and services we buy • The annual rate of inflation shows how much higher or lower prices are

compared with the same month a year earlier. It indicates changes to our cost of living

• So if the inflation rate is 3% in January, for example, prices are 3% higher than they were 12 months earlier. Or, to look at it another way, we need to spend 3% more to buy the same things

• We compare this to the annual change recorded in the previous month to get an idea of whether price rises are getting bigger or smaller

• If the annual rate has risen from 3% to 4% from one month to the next, prices are rising at a faster rate

• Bank of England ideal is 2%• Source: http://www.bbc.co.uk/news/10612209

Inflation videos from bbc

Consequences of changes in inflation on business

• What impact will a change in inflation rates have on the cost of supplies?

• As inflation rises so does the cost of products and services

• Cost of supplies, ingredients and raw materials will go up• Suppliers likely to be also within UK so will also be

suffering from a rise in prices• Business owners may need to increase their prices to

maintain profitability• Profit margins will be squeezed

• What impact will a change in inflation rates have on labour wages?

• As inflation rises then this lowers the real wage rate, increases the demand for labour and lowers unemployment

• As inflation lowers this raises the real wages, reduces the demand for labour and increases unemployment

Consequences of changes in inflation on business

Lower real wages as inflation

rises

As the cost of goods rise this means if your wages stay the same you may

not be able to buy as much…

Consequences of changes in exchange rates on business

• What impact will a change in exchange rates have on the cost of supplies? It depends if they were purchased from abroad. If our pound increased (or appreciates) against another currency this will make imported supplies cheaper:

• Strong• Pound• Imports• Cheaper• Exports• Dearer

Today’s market data for currencies

• http://www.bbc.co.uk/news/business/market_data/currency/default.stm

Try looking at this website every day – it

changes with the fluctuating exchange rates. You can track

prices over a week and see how much they

change.

Sample question 1

[8]

• [8]

Answer question 1

Sample question 2

• Between 2009 and 2011, the annual rate of CPI inflation was above the UK government’s target range.

• Which one of the following could be an effect of higher inflation rates for UK manufacturer’s, such as JCB Ltd?

• A Fall in cost of supplies• B Reduction in real wages for its staff• C Increase in exports• D Increase in recruitment• [4]

Answer question 2

• Answer option B – reduction in real wages- Inflation is a persistent increase in the aggregate/general level of prices in an

economy (1 mark)- Which can cause the cost of living to increase because less can be bought for

the same amount of money (1 mark)- So unless wages are increased in line with prices, consumer purchasing

power will fall (1 mark)- Cost of supplies is likely to increase during inflation because the stock may

be purchased from within the UK from suppliers charging higher prices (1 mark)

- Exports may fall because UK goods may become less price competitive given inflation (1 mark)

Sample question 3 (from second half of the paper)

• Exchange rates and interest rates are economic external influences.

• Assess their likely significance to Cebu Home. [12]

Answer question 3Level of answer

Marks (per factor)

Level 1 1 e.g. the exchange rate is the price of one currency in terms of another, or interest rates are the price of money paid to lenders or by borrowers

Level 2 2 e.g. higher interest rates may cause a reduction in the demand for Cebu Home furnishings.

Level 3 3

4

e.g. exchange rates may affect cost of importing products, e.g. a fall in costs if the pound strengthens might lead to an increase in profit.

e.g. increases in interest rates could cause a reduction in disposable incomes, which will mean spending on luxuries such as home furnishings might fall, so Cebu Home’s sales/stock turnover will fall.

Level 4 5

6

e.g. Cebu Home imports its stock from the Philippines so the cost of stock is likely to be affected by fluctuations in the exchange rate because a strong £ will make furniture purchasing cheaper. However, quality may be moreimportant than price, in which case the strong £ will not be significant.

e.g. if interest rates fall this may lead to an increase in consumer borrowing like mortgages which may increase the demand for Cebu Home furniture. However, the changes in interest rate may not actually affect her typical customers (thespians) because they will not need to borrow to buy the products, in which case demand for Cebu Home homeware may not decline if interest rates increase.

Sample question 4

• Throughout 2007, the UK experienced a gradual decline in interest rates.

• Which of the following is the most likely consequence for a small electrical retailer?

• A Spending on stock decreases• B Staff wages are increased• C Borrowing increases• D Average cost of stock increases• [4]

Answer to question 4

• Answer C – borrowing increasesInterest rates are the price of borrowing money (1 mark

knowledge/understanding), so a reduction in interest rates effectively means a reduction in the cost of borrowing (1 mark analysis), which, other things being equal, should lead to an increase in the demand by businesses for investment funds not an increase in bank deposits (1 mark evaluation).

• A fall in interest rates means that the cost of servicing debt falls (1 mark knowledge) which may lead to an increase in profits (1 mark analysis) which will not necessarily be spent on increasing the wages of staff (1 mark evaluation).

Sample question 5

• The value of the £ (pound sterling) fell against the euro in late 2008 and 2009.

• This change would have most likely benefited British:

• A tourists holidaying in France and Spain • B exporters who sold their products in countries using the

euro • C consumers, because overall the inflation rate fell as a result • D importers, because they were able to improve their profit

margins

Answer to question 5

• Answer option B - exporters• Definition of exchange rate, i.e. the price of one currency

in terms of another (1 mark); • - Because the relative price of British exports will fall as a

result (1 mark); • - Which, providing competitiveness is based on price, will

increase demand (1 mark) • - British tourists abroad will get less foreign currency for

their £ sterling which will make things more expensive (1 mark)

• Spiced / wpidec

Revision Video