External economic influences on business behaviour

Transcription

1 7 External economic influences on business behaviour A Activity 7.1 (page 115): De Smit sees recession haven in safari parks 1 Explain the terms: recession [2] economic boom. [2] Definition of recession: Two consecutive quarters in which there is a fall in real gross domestic product (GDP). This means that economic activity is declining and the output of the economy is falling. Definition of economic boom: A period of rapid economic growth when real GDP is rising at a high annual rate. 2 Analyse why the number of tourists and the type of holiday they buy depends on whether economies are in recession or growing rapidly. [8] The level of economic activity has a significant impact on the pattern of spending within an economy as it has a direct effect on people s incomes. Thus, in a recession, unemployment is rising and workers are concerned about losing their jobs. Consequently, there is a decline in expenditure on luxury goods. This will affect tourism as consumers try to save money, leading to a fall in the number of holidays abroad which are booked. Households are more likely to holiday in their own country and choose less-expensive holiday options. The reverse is true of an economic boom, as unemployment falls and households are more confident about the future. In these circumstances, the demand for foreign holidays will grow as people have more money to spend. 3 Evaluate Mr De Smit s strategy of business expansion during a period of rising inflation and slower economic growth. [10] In a time of rising inflation and slower economic growth, many businesses would be advised not to pursue expansion due to the falling real disposable incomes of consumers. Consumers will be looking to save money by reducing purchases of luxuries and are more likely to focus on necessities. The tourist industry, in general, may be adversely affected. However, there are a number of reasons, suggested in the case, for believing that Mr De Smit s strategy of business expansion has merit; these include: 1

2 In a recession, as inefficient businesses face bankruptcy due to declining sales and a failure to control costs, there will be opportunities for takeover at low cost. Thus, Mr De Smit will be able to acquire businesses at very competitive prices. The case refers to Mr De Smit having been able to take over another business cheaply in the last recession. Mr De Smit is also considering the wider market for his safari parks; that is, even if southern Africa faces a recession, there may still be demand from non- Africans with appropriate promotion these tourists can be attracted. It is suggested that the safari parks are not expensive holidays, and, therefore, as incomes fall people may switch to these cheaper holidays. However, growth may be a high-risk strategy because: Taking over businesses which are failing due to poor management will increase his borrowing and lead to increased interest payments. If Mr De Smit is unable to turn these businesses around, then they will remain unprofitable. He must choose takeover targets very carefully to ensure that they really do have the potential for profit. If the world economy is facing recession, then tourists from outside southern Africa will face declining disposable incomes. It may, therefore, be difficult to attract tourists to the safari-park business. The business will also be affected by the response of competitors to rising prices and a recession. Competitors may increase their marketing activity to protect demand. They may limit price increases to remain competitive in the market, even though this will lower profit margins. Much will depend on the position of the firm in the market is it really a low-cost alternative to expensive hotels? The severity of the recession will also be significant. Holidays are a luxury, so even low-cost options will suffer if there is a significant downturn in economic activity. The income elasticity of demand will be important; if it is negative, then a decline in income will lead to an increase in demand. Activity 7.2 (page 119): China to take action against inflation 1 State two reasons for the reported increase in inflation in China. [2] the increase in oil and petrol prices excess demand due to increased wealth in the economy 2 Are these causes of inflation cost push or demand pull pressures? Explain your answer. [4] The increase in oil prices is an example of cost push inflation. Oil is an important input into business activity; as its price increases this represents an increased cost to businesses for energy and transportation. Thus, they are forced to increase prices to recover these additional costs. Excess demand causing the price of pork and vegetables to increase is an example of demand pull inflation. High levels of consumer demand relative to the 2

3 economy s ability to supply leads to price increases as consumers are effectively competing for limited supply. 3 If the Chinese government increased interest rates again, explain what impact this could have on: consumer spending on luxury goods spending on new investment projects by Chinese businesses the external value of the Chinese exchange rate. [9] Consumer spending on luxury goods as the cost of borrowing rises, consumers will face higher interest charges on any new borrowing. Therefore, they will reduce their expenditure on luxury goods that require finance to purchase. New investment projects by Chinese businesses as higher interest rates will reduce the growth of consumer spending, this will reduce the potential returns from new investment. Thus, investment will fall. Further, as some investment is financed from borrowing, an increase in interest rates will reduce the potential profit of investment due to the increased repayments needed to service debt. The external value of the Chinese exchange rate two forces will influence the exchange rate. The increase in interest rates will encourage currency flows into the Chinese financial sector, attracted by the higher rates of interest available. This will create a demand for the yuan, leading to an appreciation of the exchange rate. However, the deflationary impact of increased interest rates will reduce import growth into the Chinese economy; this will cause further upward pressure on the exchange rate. 4 Examine the long-term problems for Chinese businesses if inflation is not brought under control. [10] This question requires an analysis of the costs of high rates of inflation. You should develop a number of the following issues and identify which are the most significant. There is greater uncertainty about the future. High rates of inflation make it more difficult to predict the revenues and costs associated with long-term investment. Thus, investment is discouraged. The government may be forced to increase interest rates to control inflation. This will lead to a decrease in demand in the economy. Employees will demand higher wages and there may be an increase in industrial unrest. A wage price spiral may result. However, this is less likely in China due to strong centralised control of the economy. Workers may have less influence than in mixed economies. If inflation is higher in China relative to its competitors, then, over time, the competitive position of Chinese firms will be eroded. This will lead to a reduction in exports and an increase in imports. 3

4 5 China has experienced rapid economic growth in recent years. Discuss the likely effects of this on Chinese manufacturing businesses. [10] Manufacturing business will benefit from increasing demand due to rising incomes. This will lead to higher levels of profit and reduced pressure to be price competitive. There may be a shortage of key skilled workers, leading to higher wage costs. Although China has significant labour resources working on the land, which can be transferred to the manufacturing sector, this labour may lack the skills needed by industry and thus require training. If growth is a consequence of the relative competitiveness of Chinese industry, then there will be an increase in demand for Chinese exports. The economy may overheat, that is, the growth rate is unsustainable. This will lead to increasing costs for businesses as they compete for resources. Increased growth leading to higher profits will lead to increased investment and technological change. Thus, Chinese industry will become more competitive on world markets. Evaluation may consider: If rapid economic growth leads to an economic boom and high inflation, then Chinese manufacturing firms will lose competitiveness. Activity 7.3 (page 123): Tobago City industrial estate 1 If Renard imported 30,000 of jewellery from Germany, what would have been the cost in dollars at the original exchange rate? [2] At a :$ exchange rate of 3:1 if Renard imported 30,000 of jewellery from Germany, then the dollar cost is: 30,000/3 = $10,000 2 What would the cost of the same order be at the new exchange rate? [2] At the new exchange rate of 2.70:1 then dollar cost is: 30,000/2.70 = $11, State two ways in which Renard could respond to this change in the price of its imports. [2] Renard might respond by: passing the cost increase on to customers by increasing the price absorbing some or all of the cost increase by accepting a lower profit margin seeking new German suppliers offering more competitive prices. 4 Calculate the euro cost of a typical monthly order from Foxbore at the original exchange rate. [2] 15,000 3 = 45,000 4

5 5 What is the new euro price once the value of the dollar has depreciated? [2] 15, = 40,500 6 Explain why the depreciation could be beneficial to Foxbore. [5] If Foxbore leaves the dollar price of its exports unchanged, then the euro price paid by the German importer will be less. Thus, Foxbore may benefit from increased sales, as there is an inverse relationship between price and quantity demanded. Alternatively, Foxbore could actually increase the dollar price to the German importer and enjoy a higher profit margin without reducing demand. For example, a price of $16, would leave the euro price unchanged at 45, Would the depreciation have been more or less beneficial to Foxbore if many of their raw materials and machinery were imported from Germany? Explain your answer. [5] If Foxbore imports raw materials from Germany, then the depreciation would be less beneficial as it would now be paying more for the raw materials, that is, the costs of production would be higher. Activity 7.4 (page 129): BMW strategies to deal with economic changes 1 Explain why BMW is badly affected by the depreciation of the US dollar. [4] BMWs are exported to the USA, therefore a depreciation of the dollar will raise the dollar price of a BMW. This will lead to a reduction in demand for BMWs unless BMW is willing to accept a lower euro price for its cars. However, a lower euro price will reduce BMW s profit margins. 2 What advantages does BMW gain from selling many cars to EU countries that use the euro as their common currency? [6] No fluctuations in the exchange rate this reduces uncertainty about future sales and revenues. BMW will be able to estimate more easily the likely revenues generated from exports. A reduction in transaction costs for the importer e.g. a French importer can pay BMW in euros and will not have to pay any commission to financial institutions to acquire the currency for paying BMW. This will increase demand for BMWs relative to cars imported from outside the euro area. 5

6 3 Evaluate the long-term impact on BMW s profits of any three of the strategic decisions that the company has made. [12] Decision Beneficial impact Adverse impact Increase production by 60% in US factory Expand marketing of its products in non-us and non-eu markets, such as China Cut back on its expensive German workforce This will protect BMW from dollar exchange rate fluctuations affecting sales/ profit. If the dollar continues to depreciate, then BMW will benefit from higher profits. Increased US production will encourage Americans to purchase BMWs. This will increase profits. A reduction in transport costs to market will benefit BMW s profits. This will reduce reliance on US and EU markets, which are mature markets and have less potential for sales growth. Entering markets such as China with high potential growth will be of long-term benefit. Cost savings will make BMW more price competitive in the future. Increased sales and/ or higher profit margins will improve profitability. Increased levels of automation will require significant investment and, therefore, lead to an increase in debt finance. This will add to costs of interest payments. Introducing automated processes may cause short-term disruption to production. However, labourcost savings in the long term will outweigh any increased short-term costs. BMW will not benefit as much from any long-term appreciation of the dollar. If the dollar appreciates, then BMW will be relatively worse off as a result of increased US production. Sales growth may initially be low as BMW is not an established brand in these markets. Average incomes are still low, so few can afford such a luxury brand. Establishing a presence in these new markets will initially be expensive and, therefore, place a strain on cash flow, and the marketing costs will reduce short-term profit. If production is transferred away from Germany, this may affect the company s image, which feeds on the perception of German engineering excellence. In the short term, redundancy will add to the costs of the business due to employment laws in Germany. Potential industrial unrest could disrupt production and affect quality. This will negatively affect sales. 6

7 Activity 7.5 (page 133) Three products A, B and C have very different income elasticities of demand. The income elasticities are: A = 2; B = 1; and C = Identify which is a normal good, which an inferior good and which a luxury good. [3] A is a luxury good. This is indicated by the relatively high income elasticity of demand. B is an inferior good. This is indicated by the negative income elasticity of demand. C is a normal good. This is indicated by the positive low income elasticity of demand. 2 If consumer incomes were to rise by 10% on average, calculate the expected change in demand for these three products. [6] Remember that income elasticity of demand is calculated as follows: YED = %ΔQ d %ΔY Expected change in demand for A: 2 = %ΔQ d = %ΔQ d = 20% Expected change in demand for B: 1 = %ΔQ d = %ΔQ d = 10% Expected change in demand for C: 0.2 = %ΔQ d = %ΔQ d = 2% 3 The three products are, in no particular order, white sliced bread, personal computers and aspirin tablets. Explain which letter you think best identifies each of these products. [6] White sliced bread is the inferior good. Bread is a staple food and, as incomes rise, consumers will switch to preferred, but more expensive, alternatives. Personal computers are the luxury good. Personal computers are not a necessity and are relatively expensive. As incomes rise, there will be an increase in demand as more consumers can now afford a personal computer. Aspirin is the normal good. Increasing incomes will lead to a small increase in quantity demanded. People can now afford to buy aspirin more frequently. If incomes fall, the decline in demand for aspirin would be limited as it is seen as a necessity. 7

8 Activity 7.6 (page 133): Excel Hi-Fi 1 Calculate the income elasticity associated with both models of console. [4] Remember: YED = %ΔQ d %ΔY Income elasticity of demand for the standard model: YED = 5% 2% = 2.5 Income elasticity of demand for the superior model: YED = 20% 2% = 10 Top tip When calculating YED, remember that the sign matters. If your answer is negative, this indicates that the product is an inferior good. 2 How would you explain why the income elasticity was greater for the more expensive model? [5] As consumers have less discretionary income after the increases in interest rates, they will be less likely to purchase luxury items, particularly those for which they need to borrow money. This will have a more significant impact on the superior model due to its much higher retail price of $500. Hence, the superior model is more sensitive to changes in income. 3 How would you expect Excel s product mix strategy to change during a period when interest rates fell substantially? [6] As interest rates fall, there is likely to be a relative increase in demand for more expensive options within markets. Thus, Excel Hi-fi is likely to favour moving its product mix strategy upmarket and supply more exclusive and expensive consoles. There will be fewer low-cost items in its product portfolio. Revision case study 1 answer provided on Student s CD-ROM. Revision case study 2 (page 135): Hotels offering steep discounts to Jamaicans 1 Explain why hotels in Jamaica have announced price reductions for local residents. [4] This is due to low occupancy rates (hotel rooms not being full all of the time) as a result of a drop in the number of American tourists to Jamaica. Americans are cutting back on holidays abroad due to their high levels of debt and the recession. Price reductions will, other things being equal, boost demand. 8

9 2 Discuss two other strategies that the Jamaican hotels could take to try to increase tourist numbers if there is a global recession in [12] Strategy Advantages Disadvantages This will attract Additional cost may not be customers. justified unless it is possible This may avoid having to attract significant to reduce prices new custom. Promotion any further price elasticity of demand will be reductions erode important. profit margins. It may be difficult to attract Increase promotional activity abroad. This is something the government is already doing. There could be discussion of the different ways in which the hotels could promote themselves. Increase promotional activity in Jamaica Move hotels upmarket, improve facilities Price reductions are being offered already to local residents. Promotion may be necessary to raise awareness of the availability of discounted rates. If Jamaicans are having to reduce expenditure, then they may be attracted by local holidays rather than travelling abroad. Improving facilities and refurbishing hotels will make them more attractive and enable them to compete more effectively with leading resorts around the world. Higher prices may be charged. US citizens due to the severity of the recession. Promotional activity will cause cash outflows and may not lead to cash inflows for some months; therefore, this will put pressure on the liquidity of Jamaican hotels. There are the extra costs of promotion. The strategy depends on the extent to which Jamaicans are being affected by the global recession and whether they will consider holidays in their own country. It is expensive to refurbish hotels and takes time. This is a long-term investment and it may take time for it to have an effect on demand. Will it increase tourist numbers? Luxury hotels may be more income elastic in demand. 3 Outline two measures that the Jamaican government could take to assist Jamaican hotels at this difficult time. [8] Two measures are identified in the text. Tax reductions for small hotels that are expanding/refurbishing will have the effect of making refurbishment more attractive to small hotels. Refurbishment will make the hotels more attractive to visitors and help maintain occupancy levels during the recession. The government is spending millions of dollars on an overseas promotional campaign. This should counter the impact of the recession to some degree. 9

10 Other measures that would help include: Depreciation of the Jamaican dollar will make holidays to Jamaica relatively cheaper for foreign tourists. Income tax cuts would boost consumer spending in Jamaica and give local residents more disposable income, which they might spend in the hotels. Revision case study 3 (page 136): Prospects for the Malaysian economy 1 What data are given in the article to suggest that the Malaysian economy was in recession in 2001? [3] There have been two successive quarters of negative economic growth. In Q1 of 2001, GDP fell 2.8% and then in Q2 it fell a further 6.8%. A recession is defined as two consecutive quarters in which GDP is falling. GDP is a measure of the value of the output of an economy over a specific time period. 2 Explain how a recession might lead to the bankruptcy of many Malaysian businesses. [6] A recession will involve a reduction of demand in the economy. Lower sales will put downward pressure on prices and may mean that businesses are no longer able to cover costs, thus leading to losses, which, if prolonged, will cause bankruptcy. A recession will also lead to some customers defaulting on payments for goods and services bought on credit. This will cause cash-flow problems for businesses and can lead to bankruptcy as businesses will be unable to pay their debts. 3 Explain how the three decisions taken in 2001 helped to achieve economic growth in Malaysia. [6] Interest rate cuts this is reflationary monetary policy. The reduced cost of borrowing will boost consumer spending on products for which borrowing is required. The fall in interest rates will also reduce the mortgage payments of some households and thus increase their discretionary income. This will lead to increased consumption. The increase in demand will raise the rate of economic growth. Tax cuts and increased government spending this is expansionary fiscal policy. The cut in tax rates will increase household disposable income and, therefore, increase consumer spending. This increases demand for the goods and services of businesses, which will increase output, thus increasing economic growth. Increased government spending gives a direct boost to demand in the economy some of the money will be spent on the goods and services of businesses and will, therefore, increase economic growth. Depreciation of the ringgit this will make Malaysian exports more price competitive, leading to an increase in demand. Imports will become more price uncompetitive and, therefore, consumers will switch to Malaysian-produced goods. 10

11 4 Evaluate, using numerical illustrations, the impact of the 2008 ringgit appreciation referred to in the passage on: Malaysian manufacturers of electronic goods [6] Malaysian importers of foreign goods. [6] Assume that at the start of the period, the exchange rate (Malaysian ringgit:us dollar) is 3.50:1 and at the end of the period it is 3.00:1. A Malaysian manufacturer of electronic goods charges a price of RM500. The cost to an American importer is, at the start of the period 500/3.5 = $ Following the appreciation of the ringgit, the dollar price will now be 500/3 = $ This represents a price increase of over 16%; other things being equal, demand will fall. Alternatively, the exporter will have to accept a lower profit margin in order to counteract the effect of appreciation. The overall impact will depend on the price elasticity of demand for Malaysian electrical products; this will be affected by the quality and reputation of the products. Assume that a Malaysian importer buys American goods at a dollar price of $200. Before the appreciation of the ringgit, the cost will be = RM700. After appreciation, the price will be = RM600. The Malaysian importer will benefit from a lower price, which may be passed on to the consumer, leading to increased demand. Alternatively, the importer may enjoy a higher profit margin by leaving the price charged to consumers unaltered. The overall impact on the importer is dependent on the price elasticity of demand for imports in Malaysia. This will depend on the closeness and number of substitute products produced in Malaysia. 5 Discuss two possible strategies a Malaysian exporting business might take in response to the recession in the USA. [10] Strategy Alter marketing mix to maintain sales in the USA Increase focus on alternative markets Commentary Cutting prices will reduce profit margins, but will help maintain sales in the USA. The price elasticity of demand will determine effectiveness in maintaining sales. Increasing promotional activity will increase costs, but should help stabilise sales in the USA. Reduce specification of products to reduce costs of production and target lower-price markets in the USA. Such markets may be very competitive as other firms look to compete in this way. Increase in marketing expenditure may be necessary. This will increase costs, but if the marketing campaign is successful, then sales will increase. However, a recession in the USA may well affect economic growth in other countries; the American recession may be exported to other economies. Changing focus to other markets may require distribution networks to be set up, if not already established. This will be expensive and potentially sales may take time to materialise. 11

12 Revision case study 4 (page 136): Coaching Inns plc 1 Discuss the likely reasons for the company s increasing difficulty in recruiting new staff. [4] The economy has expanded in recent years. Economic growth will have created jobs and reduced unemployment; thus, it will become increasingly difficult for all businesses to recruit staff. This may be a particular problem for hotels if that type of work is perceived to be low paid. Coaching Inns prefers to recruit qualified staff from other hotels. Due to the increase in employment throughout the economy, other hotels may have taken positive action to retain the services of their staff by paying better wages and/or offering better working conditions. It will, therefore, be more difficult for Coaching Inns to poach staff. 2 Analyse the impact this problem might have for the future expansion strategy of the business. [4] As Coaching Inns expands, it will need increasing numbers of employees. Failure to recruit suitably qualified staff may derail their expansion plans. Without suitable staff, the business will not be able to expand and efforts to do so may threaten the quality of service offered within the hotel chain. 3 Evaluate two ways the directors could attempt to overcome this problem. [4] A long-term solution is to offer good-quality training and clear career paths to make employment within the company attractive. Training will be more expensive than recruiting qualified staff and will take time to solve the labour shortage. Inexperienced staff during training may lead to a reduction in the quality of customer service. A short-term solution is to increase wages to attract staff from other hotels. This is costly and once wages have increased they are likely to remain high and will thus be a burden in the future. Other hotels may respond by matching the increased wages to prevent higher labour turnover. 4 Discuss the impact that higher interest rates could have on the future prospects of Coaching Inns plc. [9] As a premium hotel, Coaching Inns plc may be adversely affected by increased interest rates as tourists and businesses switch to cheaper alternatives. Coaching Inns plc may have to offer more discounted packages to maintain occupancy levels. This will negatively affect profits and there will be less retained profit for reinvestment into the business. Further expansion will be made more difficult due to the higher cost of borrowing. If expansion requires additional borrowing, then increased repayments will make expansion less attractive. Further, the increase in interest rates will dampen demand and thus make expansion less desirable. 12

13 The business has borrowed heavily to purchase suitable properties in the past. Higher interest rates may increase the cost of servicing their existing debt (i.e. paying the interest on the debt they already have). Interest payments represent an expense to the business and, therefore, any increase will reduce profit. 5 Assuming that interest rates did rise significantly for a considerable time period, evaluate alternative strategies the business could adopt to respond to this change in policy. [9] Strategy Focus expansion downmarket Consolidation Restructure debt Commentary The premium end of the market may be adversely affected by higher interest rates, so Coaching Inns plc could consider opening lower-priced hotels. However, this may require establishing a new brand name to avoid contamination of the existing brand; this may be expensive. The lower end of the market may already have wellestablished brands and already be highly competitive. The budget end of the market is a segment that Coaching Inns may have little knowledge of, so recruitment of suitable managers will be important. Put expansion on hold and focus on the existing 23 hotels. Expansion is expensive and places a strain on resources, particularly if funds are borrowed. Coaching Inns may benefit from focusing its resources on its current hotels. Higher interest rates may cause a reduction in aggregate demand and a slowdown of economic growth; thus further expansion will be more risky. Coaching Inns plc has borrowed heavily to finance expansion. Therefore, with higher interest rates, it will face higher interest payments. The business could consider raising more equity finance through issuing shares this would be particularly relevant if expansion remains a key objective. Coaching Inns may be able to renegotiate the terms of its existing debt with financial institutions to reduce the interest burden it faces. Extending the length of commercial mortgages/loans will reduce interest payments, but will cost the business more in the long term. Essay 1 a Outline the most important macro-economic objectives of the government of your country. [7] Answer will be country specific, but should outline some of the following macroeconomic objectives: 13

14 Macro-economic objective Low and stable inflation Low unemployment / full employment Balance of trade Economic growth Commentary Inflation a sustained increase in the general price level or a fall in the purchasing power of money. Why is it an important macro-economic objective? High rates of inflation relative to other countries decrease the international competitiveness of a country s economy. This leads to an increase in imports and a decrease in exports. Volatile inflation undermines business confidence and reduces investment. It becomes more difficult to predict the future value of investments, therefore causing businesses to reduce their investment. Inflation imposes costs on business, such as the need to update price lists. Inflation increases the costs of business, leading to a decrease in profitability if the costs cannot be passed on to consumers. Unemployment where those wanting to work at the prevailing wage rates are unable to find employment. Why is low unemployment desirable? Unemployment leads to an increase in government expenditure on benefits. This money could be spent more usefully elsewhere, e.g. improving education. Unemployment represents a waste of resources and lost output in the economy. There is a loss of income and reduction in the quality of life for the unemployed. There may be an increased incidence of crime in society. As the unemployed have no earned income, there will be a reduction in demand in the economy, causing a loss of sales for firms. Balance of trade exports of goods and services, less imports of goods and services. The balance of trade is part of the balance of payments. Why is the balance of trade important? To some extent, it represents the ability of an economy to pay its way in the world economy. Exports are needed to generate foreign currency to pay for imports. Trade is important to increase the living standards within an economy as it brings greater choice to consumers and the opportunity to consume goods that could not be produced economically within the country. A persistent deficit on the balance of trade would put downward pressure on the value of an economy s currency, which would lead to an increase in the price of imports. Economic growth an increase in real GDP. Why is it important? It leads to an increase in living standards and material wealth. Higher levels of GDP mean that households are able to enjoy higher levels of consumption, considered by many to be an important element of living standards. It should help take people out of poverty. Increasing levels of demand for business will increase profits. It creates jobs. It enables governments to provide more goods that are considered socially desirable, such as education and healthcare. 14

15 The relative importance of the above macro-economic objectives will depend on a number of factors including: the political objectives of the government the position of the economy in its economic cycle, e.g. in a recession with high levels of unemployment, this may become a government priority. b Examine in detail how the following policy measures are likely to affect businesses in your country: an increase in interest rates an expansionary fiscal policy. [18] Increase in interest rates An increase in interest rates represents an increase in the cost of borrowing to businesses and households. An increase in interest rates may be used by governments / central banks to control inflationary pressure in the economy, i.e. to reduce the rate of growth of demand in the economy. The full effect of an interest rate rise takes up to two years to be felt in the economy. An interest rate rise will affect businesses in the following way: Households will be encouraged to save more. This will reduce spending in the short term. Households will find new borrowing more expensive as loan repayments will be higher. This will lead to a reduction in demand for goods/services which are more expensive and for which loans are needed, e.g. new car sales, property extensions and holidays abroad. Households will face an increase in the cost of existing borrowing, such as variable rate mortgages. This will reduce households discretionary income and, therefore, lead to a reduction in demand for non-necessities. Businesses will, therefore, face a decrease in demand. However, the impact will be much greater on those firms that sell luxury goods, such as cars. Businesses will reduce investment expenditure, because the cost of borrowing is higher and because they will be concerned about future reductions in consumer spending. Businesses are more likely to face cash-flow problems due to the reduced consumer spending and the increase in their own borrowing costs. An increase in interest rates will, other things being equal, lead to an appreciation of an economy s currency. This will be a disadvantage to exporting firms, but an advantage to importing firms. Evaluation may consider: Businesses are not equally affected those selling luxuries will be worse hit. Those firms selling necessities may be relatively unaffected. Businesses that sell inferior goods will benefit as a decrease in discretionary income will lead to an increase in sales for these goods. Short-term impact is largely negative, but the long-term impact may be beneficial as increasing interest rates may help bring inflation under control. Importing businesses may find that the cost of their purchases falls due to an appreciation of the currency. This will help them remain price competitive and counteract the effect of falling consumer spending. 15

16 The impact depends on by how much interest rates rise. There will be a greater impact on businesses with high levels of debt to service. Expansionary fiscal policy An expansionary fiscal policy could take the form of an increase in government spending or a reduction in taxation (e.g. income tax, corporation tax or VAT). It is described as expansionary fiscal policy because its effect is to expand the economy. There will be a stimulation of demand in the economy. This will be beneficial to many businesses. Examples are given below: A cut in corporation tax will enable businesses to retain more profit. This should stimulate investment spending and raise business competitiveness in international markets. An increase in government spending on e.g. building new railways will directly increase demand to private-sector firms that build the railway. It will also benefit businesses indirectly as the wages paid to construction workers will be spent in the wider economy, generating demand for retail business. A reduction in income tax will increase the disposable income of households and lead to an increase in consumption. This will increase the demand for the products of businesses. Increased spending will mean that businesses need to recruit staff and may have to increase capacity. Wages may rise due to the increase in demand for labour. The increased levels of demand will lead to demand pull inflation if there are supply constraints within the economy; that is, if the economy is near its capacity, then increases in demand will just pull prices up. Increased borrowing by the government to pay for the tax cuts may lead to upward pressure on interest rates. Evaluation may consider: The impact will depend on: whether it is an increase in government spending or a reduction in taxation how the government spends its money, e.g. on infrastructure that benefits the whole economy or on goods that benefit particular firms which taxes are cut corporation tax will encourage investment directly; reduced income tax will increase demand for goods and services. 16