A2 Business Studies – External Influences

Economic opportunities and constraints

Implications for business strategy of macroeconomic variables

This area of the economic opportunities and constraints section of external influences will look at areas covered in AS but in more detail. The areas covered will be:

Interest rates Exchange rates Inflation Unemployment The business cycle The labour market

Implications for business strategy of changes in interest rates

Interest rates - the cost of borrowing money and the return for lending

Interest rates measure the opportunity cost, to both individuals and firms of spending money rather than saving it and receiving interest.

Interest rates are currently 0.5%

Monetary Policy

Changes in the rate of interest to help control the level of expenditure in the economy and therefore the level of inflation

The Monetary Policy Committee – (MPC) of the Bank of England sets interest rates in the interests of the UK economy

Effects of a fall in interest rates

1. Increase in demand for consumer goods

Saving money is less attractive as less interest received

Cost of goods brought on credit lower. Luxury goods which are income elastic may particularly grow in demand e.g.cars and holidays as people feel they can now afford it.

Variable-rate mortgage payments and loan repayments will fall, meaning homeowners have more discretionary income

2. Increase in demand for capital goods

It becomes cheaper to purchase expensive capital equipment on credit. Firms may therefore bring forward intended purchases and projects.

Links with investment appraisal. Discounting rates in NPV method are determined by interest rates.

3. Fall in export prices and rise in import prices

Fall in interest rates means a fall in value of the pound

Leads to a fall in export prices and a rise in import prices

Should result in increased demand for UK goods at home and abroad if the good/service is price elastic

Domestic goods are priced more competitively (cheaper) than foreign imports

Foreign exports are cheaper than goods sold abroad

4. Fall in costs and rise in profits

Highly geared firms will benefit from lower unit costs and lower break-even point

Firms will be able to reduce prices and be more competitive and receive higher demand

or receive higher profit margins from lower unit costs with same selling price

May need more staff therefore more wages which may also result in a labour shortage in the market

Effects of a rise in interest rates

Savings are more attractive so consumer spending falls

Demand for consumer goods bought on credit falls

People borrowing have less discretionary income

Investment in capital projects falls as harder to finance

Value of the pound rises = adverse effect on competitiveness on domestic firms

Overall costs will rise

Businesses have to be more efficient to remain competitive

A2 Business Studies – External Influences

Interest rates and Exchange rates

Starter (10 minutes)

What happens in the market if interest rates rise?

What happens in the market if interest rates fall?

Consider: Consumer spending Purchases on credit Discretionary income for mortgage holders Attractiveness of saving Demand of capital goods from firms Value of the pound

Interest rates rise

Consumer spending - falls

Purchases on credit - fall

Discretionary income for mortgage holders - falls

Attractiveness of saving - improves

Demand of capital goods from firms - falls

Value of the pound - increases

Consumer spending - increases

Purchases on credit - increase

Discretionary income for mortgage holders - increases

Attractiveness of saving - falls

Demand of capital goods from firms - increases

Value of the pound - decreases

Interest rates falls

Student Activity (20 minutes)

Complete worksheet on interest rates

Interest rates and their influence on exchange rates

Interest rate changes influence the demand for pounds sterling for foreign investment

High and low interest rates have the opposite impacts

High interest rates

Capital flows into the country to take advantage of greater benefits from saving.

Therefore demand for currency goes up which pushes the price up (exchange rate rises)

This will see export prices higher

E.G. £1 = $4 after interest rate increase rather than $2. A good sold in the US for £3 will be $12 rather than $6. More expensive = sales fall

Import prices are cheaper

E.G. $1 = £2 after increase in interest rather than £4 .A US product worth $2 will be £4 rather than £8 before rise.

Low interest rates

Attracts less investment capital from abroad

Demand for pounds sterling falls = price down (the exchange rate falls)

Export prices fall = sales rise in foreign markets

e.g. £1 = $1 rather than $2. If a good worth £2 sold in US it will be $2 rather than $4

Import prices sales fall as buyers attracted by cheaper domestic products.

e.g. £1 now worth $1.50 rather than $2.00 so a US good worth $6 will cost £4 rather than £3. Therefore less competitive.

Interest rates and exchange rates

See demonstration for details at:

http://www.bized.ac.uk/learn/economics/govpol/macropolicies/interest/exchange/interest_rate_4.htm

As interest rate goes up exchange rate goes up and exports are more expensive in foreign markets.

Student Activity (15 minutes)

An interest rate rise result in the exchange rate going from £1 = $2 to £1 = $4.

How will this impact on:

A US TV manufacturer selling its goods in the US and in the UK at $100.

A UK TV manufacturer selling its TV for £80

If interest rates drop and the exchange rate changes to £1 = $0.50. How will this impact on the two firms in both markets.