External Economic influences on business activity

Economic objectives of governments

• Economic growth

• Low price inflation

• Low rate of unemployment

• Exchange rate stability

• Long-term balance of payments

• Wealth and income transfers to reduce inequalities

There may be conflicts whilst the government is trying to fulfil these objectives, so the government will have to prioritise

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Economic growth

• Measured using GDP 

• It is measured in monetary terms 

• Inflation will increase the value of GDP, which is not true economic growth 

• Economic growth occurs as a result of a rise in the real GDP of a country 

• Negative economic growth (or recession) occurs when GDP falls 

• Benefits of economic growth:

  • Increase in average living standards

  • Higher employment and consumer incomes 

  • Reduction in absolute poverty 

  • More resources available for the government 

  • Rising demand

Factors leading to economic growth

• Increases in output resulting from technological changes and expansion of industry capital 

• Increases in economic resources, such as a higher working population or discovery of new resources 

• Increases in productivity

The business cycle 

• Economies grow at different rates over time 

• Boom –

  • Very fast economic growth 

  • Rising income and profits 

  • Rising inflation 

  • Shortages of skilled labour, higher wage rates 

  • Increased interest rates

• Recession –

  • Falling demand 

  • Real GDP growth slows down 

  • House and asset prices fall 

  • Incomes reduce 

  • Profits fall 

• Slump – 

  • A serious and prolonged recession 

  • Real GDP falls substantially 

  • House and asset prices fall 

• Recovery and growth –

  • Real GDP begins to rise 

  • Rate of inflation falls 

  • Products become more competitive 

  • Rising demand

Is a recession always bad?

• During a recession, output falls, unemployment rises, incomes and demand fall. 

• Government revenues fall

• Demand for normal and income elastic goods reduces 

• Advantages of recession:

• Capital assets become cheaper 

• Demand for inferior goods rises 

• Risk of job losses may improve relations 

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Inflation

• Increase in the average price of goods and services

• Fall in the value of money

How to measure inflation

• Measured using CPI (consumer price index)

• It records average changes in goods used by consumers

• Compared with previous months prices

• Weights are added to these price changes

• Then they are averaged and given an index number

Causes of inflation

• Cost push inflation –

  • Depreciation of the currency

  • Rising wage rates

  • Rising raw material costs

• Demand pull inflation –

  • Higher consumer demand

The impact of inflation on business strategy 

• Benefits:

  • Increase costs can be passed to consumers 

  • Fall in the real value of debt 

  • Increase in value of fixed assets 

  • Increased profit margin as inventory is bought in advance 

• Drawbacks:

  • Higher wage demands

  • Consumers become more price sensitive 

  • Higher rate of interest 

  • Cash flow problems 

  • Uncertainty 

  • Unreliable forecasts 

  • Lose competitiveness overseas 

  • Reduce chances of receiving discounts and credit periods from suppliers 

Business strategies during inflation

• Reduce investment 

• Lower profit margin 

• Lower debts and borrowing 

• Reduce credit period given to customers 

• Reduce labour costs

Deflation 

• Fall in the average price of goods and services 

• Rise in the value of money

Is deflation beneficial?

• Consumers delay purchases 

• Discourage borrowing 

• Firms unwilling to invest 

• Stocked up inventory reduces in value

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Unemployment 

• Members of the working force who are willing and able to work, but cannot find a job 

Causes of unemployment 

• Cyclical unemployment 

  • This occurs during the recession stage 

  • During recession, demand falls, encouraging businesses to make employees redundant 

  • Using anti-inflationary policies may lead to cyclical unemployment 

  • If currency appreciates, demand for domestic goods will fall, leading to cyclical unemployment 

• Structural unemployment 

  • Exists during rapid growth 

  • It occurs due to structural changes in an economy, changing the demand for labour

  • Causes of structural changes:

    • Change in consumer tastes and preferences 

    • Increased use of technology, reducing the need to employ workers 

    • Deindustrialisation 

    • Increased need for multi-skilled workers 

  • Provide education and training to workers to avoid structural unemployment 

• Frictional unemployment 

  • Unemployment when a worker loses their job and are trying to find a new one 

  • May lead to cyclical unemployment 

  • Provide information about job opportunities, open job centres and recruitment agencies, reduce unemployment benefits, etc to reduce frictional unemployment 

Costs of unemployment 

• Social problems – crime 

• Loss of income and living standards 

• Inefficient economy, can produce much more 

• Tax revenue used to support unemployed, opportunity cost 

• Reduces demand 

• Skills may become outdated

Balance of payments (current account)

• Records the value of goods and services traded between one country and the rest of the world 

• Deficit – imports > exports 

• Problems of a BOP deficit –

  • Depreciation of the exchange rate 

  • Decline in currency reserves 

  • Reduced Foreign direct investment (FDI)

Exchange rates

• The price of one currency in terms of another 

• Exchange rates are determined through the forces of demand and supply 

Exchange rate fluctuations 

• Demand is greater than supply – appreciation – rise in the value 

• Supply is greater than demand – depreciation – fall in the value 

Appreciation of the currency 

• Cheaper raw materials, increased competitiveness 

• Reduce inflation 

• Cheaper imports may substitute domestic goods 

• Higher competition

Depreciation of the currency 

• Cheaper in international markets, increased competitiveness 

• Lesser price competition in domestic market

• Higher cost of imported raw materials 

International competitiveness – non price factors

• Product design and innovation 

• Quality of construction and reliability 

• Effective promotion and extensive distribution 

• After-sales service 

• Investment in trained staff and modern technology

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Macro-economic policies 

• They impact the entire economy 

• Influence the level of AD and AS 

Fiscal policy 

• Decisions regarding govt expenditure and tax rates 

• Revenue > expenditure = surplus 

• Revenue < expenditure = deficit 

• During a recession, a government will either raise government spending or lower tax rates, so that AD rises, increasing output and employment 

• During a period of economic boom, a government will either lower government spending or raise tax rates so that AD falls, lowering inflation, output and employment

Monetary policy

• Decisions regarding interest rates, money supply and exchange rate of a country

• Recession, lower interest rates, increase AD

• Higher interest rates will increase costs of production for businesses, lower demand and appreciate the country’s exchange rate

Monetary policy and the exchange rate

• Higher interest rates will lead to appreciation of a country’s currency

• Reasons:

  • Speculation

Exchange rate policy 

• Drawbacks of floating exchange rate & benefits of joining a common currency  

  • Fluctuating prices of imported raw materials 

  • Unstable demand levels 

  • Uncertainty

  • Difficult to make cost comparison as there is no price transparency 

  • Increased costs 

• Advantages of not joining a common currency  

  • Central bank can maintain its status as the interest setting authority 

  • Joining a common currency will reduce the independence of each government to control their own tax rates 

  • Interest rates can be used to achieve other objectives, rather than focusing on exchange rates 

  • Joining a common currency, conversion costs will be high

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Government policies and business competitiveness

• Supply side policies are ones that aim to increase industrial competitiveness

• These include:

  • Lower rates of income tax – encourage workers to earn more as they don’t have to pay a higher % in taxes  

  • Lower rates of corporation tax – lower tax will increase profits, increasing funds for investment, increasing efficiency and competitiveness 

  • Increasing labour market flexibility and labour productivity – 

    • Subsidize training programmes 

    • Increased funding for higher-education 

    • Lower rates of income tax

    • Encouraging immigration of skilled workers 

    • Restricting welfare benefits

Government intervention in industry

• Subsidies to lower prices

• Subsidies to help loss making businesses 

• Grants to open up in particular locations

• Financial supports for consumers

Market failure

• Market failure occurs when there is inefficiency in the market and some goods are overproduced (demerit goods) or under consumed (merit goods)

• Private costs and benefits are borne by the people directly involved in production and consumption

• External costs and benefits are borne by third partie

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Income elasticity of demand

• A numerical measure of responsiveness of demand to a change in income

• YED = % change in demand/ % change in income

• Normal goods – it is positive, between 0 to 1. It means as consumers income increases, demand for these goods rises, by a small proportion

• Luxury goods – it is positive, greater than 1. It means as consumers income increases, demand for these goods rises by a greater proportion

• Inferior goods – YED is negative. Demand for these goods falls as income rises