External Influences Unit 2.3.5 Flashcards

Question

**41 External Influences** *How Might Businesses Respond to a Change in Exchange Rates? - Conclusion*

Answer 1

Exchange rate fluctuations can significantly impact a business’s costs, revenues, and competitiveness. ✅ When a currency **appreciates**, exporters suffer from reduced demand while importers benefit from lower costs. ✅ When a currency **depreciates**, exporters enjoy improved competitiveness while importers face higher expenses. Therefore, businesses must develop flexible strategies such as adjusting prices, seeking new markets, or changing suppliers. This allows them to **minimise risks**, **protect profit margins**, and **maintain competitiveness** in an uncertain international environment.

Answer 2

Interest rates represent the cost of borrowing money or the reward for saving it. When individuals or businesses take out loans, they are required to pay interest, usually expressed as a percentage of the borrowed amount. Conversely, when they deposit money into a savings account, they earn interest as a return on their funds. For instance, if a business borrows $10,000 at an interest rate of 7% for one year, it will have to repay an additional $700 in interest. Similarly, if the same business deposits $1 million in a bank account that offers 3% interest, it will earn $30,000 in return after one year.

Answer 3

Governments and central banks use interest rates as a tool to regulate the economy—a policy known as **monetary policy**. If inflation is increasing because demand in the economy is growing too quickly, the central bank may raise interest rates to reduce consumer and business spending. Higher interest rates discourage borrowing, as loans become more expensive, and they encourage saving, as the return on savings increases. This reduction in spending and borrowing helps slow down inflation. If the government raises interest rates → then borrowing becomes more expensive for businesses → this increases the cost of loans used to fund investment → as a result, some businesses may delay or reduce investment in new equipment, staff, or expansion → this can lead to slower business growth → and overall economic demand may decrease → helping to reduce inflationary pressures.

Answer 4

Interest rates represent the cost of borrowing money or the reward for saving. When businesses borrow funds, they are typically required to pay interest on the amount borrowed. This interest forms part of a business’s **overhead costs**—the regular and ongoing expenses required to operate.

Answer 5

An increase in interest rates leads to **higher borrowing costs** for businesses. For instance, if a business has a loan of US$10,000 and the interest rate rises from 6% to 7%, the annual interest payment increases from US$600 to US$700. This additional cost affects cash flow and can reduce overall profitability.

Answer 6

Not all borrowing is affected equally by interest rate changes: - **Fixed Interest Rates**: These do not change over the loan period. If a business has fixed-rate loans, its interest payments remain the same regardless of whether interest rates rise in the wider economy. Therefore, the business is shielded from rising interest rates during the fixed term. - **Variable Interest Rates**: These can change at the lender’s discretion or based on market conditions. If a business has loans with variable rates, it will experience immediate increases in its interest payments when interest rates rise.

Answer 7

If interest rates increase, businesses with variable-rate loans will face higher interest payments. This raises their overall costs (overheads), which reduces profit margins. In response, the business may need to cut other expenses, raise prices, or delay investment plans to manage the additional financial burden. Even if the business currently holds fixed-rate loans, any **future borrowing** will likely be more expensive. As a result, planning for growth becomes more challenging, and financial risk increases. Therefore, changes in interest rates directly impact both current operating costs and future financial decisions for businesses.

Answer 8

Changes in interest rates can significantly influence the level of investment undertaken by businesses. Investment refers to spending on capital goods such as buildings, machinery, and technology, and it is often a key driver of long-term business growth. When interest rates rise, there are several reasons why businesses may reduce or delay investment.

Answer 9

**Firstly**, higher interest rates increase the cost of borrowing. Since many investment projects are financed through loans, an increase in interest rates raises the total cost of financing. This reduces the expected profitability of the investment. As a result, some firms may decide that certain projects are no longer financially viable and cancel or postpone them. Therefore, total investment in the economy may fall.

Answer 10

**Secondly**, higher interest rates make saving more attractive. Instead of investing in new projects, businesses may choose to place their funds in financial savings or investment accounts, where they can earn a relatively high return. This opportunity cost of investment rises, which may discourage firms from committing to long-term capital expenditure.

Answer 11

**Thirdly**, businesses with existing loans on variable interest rates will experience increased repayment costs. This rise in costs may encourage businesses to prioritise repaying debt rather than taking on additional investment. By doing so, they aim to reduce financial risk and maintain cash flow stability.

Answer 12

**Finally**, a rise in interest rates often leads to reduced consumer and business spending across the economy, as borrowing becomes more expensive and disposable income falls. In this environment of lower aggregate demand, businesses may forecast lower sales. If the projected revenue from a potential investment decreases, the investment may no longer be considered profitable, leading firms to delay or abandon the project.

Answer 13

**In conclusion**, a rise in interest rates increases the cost of borrowing, makes saving more attractive, raises debt repayments, and lowers expected demand. Together, these factors reduce the incentive for businesses to invest, which can lead to a slowdown in capital spending across the economy.

Answer 14

Interest rates play a crucial role in influencing **aggregate demand**—the total demand for goods and services within an economy. When interest rates change, they impact consumer behaviour, business investment, stockholding decisions, and international trade. These changes directly affect the level of sales, production, and profitability of businesses.

Answer 15

When **interest rates increase**, the cost of borrowing rises. This means that consumers who wish to finance purchases using credit—such as buying durable goods like cars, furniture, or household appliances—face **higher monthly repayment costs**. As a result, many consumers are **discouraged from borrowing and reduce their spending**. In addition, households with **existing variable-rate mortgages** will see an increase in their monthly repayments. This reduces their **disposable income**, which in turn limits their ability to purchase non-essential goods and services. A rise in interest rates → Higher cost of borrowing and mortgages → Lower consumer disposable income → Reduced consumer spending → Fall in aggregate demand → Lower business sales and profits.

Answer 16

Interest rates also affect business investment decisions. Many firms rely on **external finance** to fund capital investment, such as purchasing machinery, upgrading equipment, or expanding facilities. When interest rates rise, **the cost of financing investment through loans increases**, which reduces the expected return on investment projects. In some cases, this reduced profitability may lead firms to **delay or cancel investment plans** altogether. Moreover, higher interest rates make **saving money more attractive** than investing in riskier capital projects, further discouraging investment. A rise in interest rates → Higher cost of borrowing for investment → Reduced expected returns on projects → Decrease in business investment → Fall in demand for capital goods → Lower aggregate demand and business activity.

Answer 17

Holding inventory—whether raw materials or finished goods—incurs costs. If a business has borrowed money to finance inventory, a rise in interest rates makes **holding stock more expensive**. Businesses may respond by **reducing their stock levels** (destocking) to cut costs and free up cash. This reduction in stock leads to **lower orders placed with suppliers**, which affects other businesses further up the supply chain. Additionally, if demand is already falling due to reduced consumer spending, there is even **less need to maintain high stock levels**. A rise in interest rates → Higher cost of holding stock → Businesses reduce inventory levels → Lower demand from suppliers → Fall in production across the supply chain → Reduced aggregate demand.

Answer 18

Higher interest rates tend to attract **foreign investment**, leading to an **appreciation of the domestic currency**. When the value of a country's currency rises, **exports become more expensive** for foreign buyers, while **imports become cheaper** for domestic consumers. This can lead to a **decline in demand for domestic exports** and an **increase in demand for foreign imports**, resulting in a worsening of the **trade balance** and reduced sales for domestic producers. A rise in interest rates → Currency appreciation → Exports become more expensive, imports become cheaper → Fall in export demand, rise in import competition → Reduced domestic production and sales → Lower aggregate demand.

Answer 19

Overall, a rise in interest rates typically leads to a **reduction in aggregate demand**. This occurs through multiple channels, including reduced consumer and business spending, lower investment, inventory reduction, and decreased export competitiveness. All of these factors contribute to **lower business revenue and profitability**, which can ultimately slow down economic growth.

Answer 20

Businesses will react differently depending on whether interest rates go **up** or **down**. **If Interest Rates Rise:** When interest rates go **up**, borrowing money becomes **more expensive**, and customers may **spend less**, especially on expensive items bought with loans (like cars or furniture). This usually makes things harder for businesses. Here's how they might respond: - **Borrow less** by reducing loans or overdrafts to save money on interest payments. - **Delay or cancel investment projects** that aren’t expected to be very profitable, because higher borrowing costs make them not worth it. - **Change growth plans** if the economy slows down. Some businesses might decide to grow more slowly, cut costs, or even **lay off staff** to save money. - **Save more** if they have extra cash, by putting money into **bank accounts**, which now offer better interest returns.

Answer 21

**If Interest Rates Fall:** When interest rates go **down**, borrowing becomes **cheaper**, and people are more likely to **spend**, especially on big items. This is usually good for businesses. Here's how they might respond: - **Invest more**, because it’s cheaper to borrow. Businesses might buy new equipment, update technology, develop new products, or even expand. - **Hire more staff and increase production** to keep up with rising demand. This might include moving to a bigger place or buying more machines. - **Raise prices** if demand is growing quickly, especially if customers will still buy the product even at a higher price. This helps increase **profits**.

Answer 22

Governments influence business decisions and economic activity through the use of **fiscal policy**, which includes changes in **taxation** and **government expenditure**. Taxation provides governments with the revenue necessary to fund public services and infrastructure, but it also directly affects the financial performance and strategic choices of businesses. There are two broad categories of taxes: **direct taxes**, which are charged on income and profits, and **indirect taxes**, which are applied to spending on goods and services. Most countries adopt similar tax structures to that of the UK, which includes a range of both types.

Answer 23

**1. Direct Taxes:** - **Income Tax:** A tax paid by individuals on personal income earned through employment or self-employment. - **National Insurance Contributions:** Paid by both employees and employers, this contributes to state benefits such as pensions and healthcare. - **Corporation Tax:** A tax levied on the profits earned by companies. - **Capital Gains Tax:** Charged when individuals or companies profit from selling an asset, such as property or shares. - **Inheritance Tax:** Paid on assets passed on after a person’s death. **2. Indirect Taxes:** - **Value Added Tax (VAT):** A consumption tax added to the sale price of most goods and services. - **Excise Duties:** Additional taxes applied to specific goods like fuel, tobacco, and alcohol. - **Customs Duties:** Taxes imposed on goods imported from other countries. - **Council Tax:** A local tax paid by residents to support public services such as waste collection and local infrastructure. - **Business Rates:** A tax paid by companies for the use of commercial property, used to fund local government services.

Answer 24

Taxation affects the profitability and spending capacity of both individuals and businesses. When direct taxes such as corporation tax increase, businesses retain less profit, which may limit reinvestment in growth, staff, or equipment. Similarly, a rise in income tax reduces consumers' disposable income, leading to lower demand for goods and services. On the other hand, indirect taxes, such as VAT and excise duties, increase the final price of goods. This can make products less attractive to consumers, especially for price-sensitive items, potentially reducing sales volume. As a result, higher taxation can force businesses to adjust by reducing costs, delaying investment, or revising pricing strategies. Conversely, a reduction in taxes may boost demand and profitability, encouraging expansion and innovation. Therefore, changes in taxation form a critical part of a business’s external environment, and companies must carefully monitor tax policies to manage their costs, maintain competitiveness, and plan effectively for the future.

Answer 25

Governments use fiscal policy—changes in taxation and government spending—to influence the overall performance of the economy. Taxation affects both individuals and businesses, and changes in tax policy can significantly influence business decision-making, financial performance, and strategic planning. The effects can be broken down into the following areas:

Answer 26

When the government reduces **direct taxes** such as income tax or increases personal allowances, consumers retain more of their income. This rise in disposable income tends to increase consumer spending on goods and services, which can lead to **higher sales and revenues for businesses**. Conversely, increases in income tax, National Insurance contributions, or council tax reduce consumers’ disposable income. This decrease in purchasing power can result in **reduced demand for non-essential goods and services**, negatively impacting business turnover, especially in sectors like retail, leisure, and hospitality.

Answer 27

Increases in **indirect taxes** such as Value Added Tax (VAT), excise duties, or customs duties raise the cost of supplying goods and services. In response, businesses often pass on these increased costs to consumers in the form of **higher prices**. This can reduce competitiveness, particularly for price-sensitive goods, and lead to a **decline in sales volume** if consumers reduce their spending. For example, an increase in VAT from 15% to 20% would directly raise the retail price of affected goods, potentially deterring consumers from making purchases.

Answer 28

Higher taxes increase **operating costs**, which can reduce a firm’s profit margins if price increases are not possible or effective. Taxes such as: - Corporation tax (on business profits), - Employers’ National Insurance contributions (on wages), - Business rates (on premises), and - Landfill tax (on waste disposal), ...all contribute to rising overhead costs. A business facing higher costs may try to **maintain profitability by raising prices**, but if market demand is elastic, this may lead to a **fall in revenue and reduced profits**. On the other hand, tax reductions can have the opposite effect, improving profit margins and enabling businesses to **reinvest earnings** in growth and innovation.

Answer 29

Higher business taxes reduce the amount of **retained profit**, limiting internal funds available for reinvestment. This can negatively impact: - The business’s ability to fund capital projects (e.g. machinery or new facilities), - Its ability to repay debt, - And its capacity to build inventory or hire more staff. As a result, higher taxes may **deter investment**, particularly in long-term strategic projects. In contrast, tax reliefs or lower corporate tax rates can **encourage investment**, supporting expansion, innovation, and productivity improvements.

Answer 30

Changes in taxes such as **capital gains tax** and **stamp duty** can influence individual and institutional behavior in financial markets. For instance, an increase in capital gains tax may discourage investors from purchasing shares or cause them to delay selling assets. This can impact businesses that rely on **equity financing**, potentially reducing access to investment capital.

Answer 31

Changes in **customs duties** affect the competitiveness of both domestic and international goods. For example: - A rise in tariffs on imported goods may **benefit domestic producers**, making locally made products relatively cheaper. - However, if a business **depends on imported raw materials or components**, its **costs will increase**, possibly reducing profitability or forcing the firm to adjust its pricing strategy. Higher import duties can therefore have **mixed effects**, depending on the business’s role in the supply chain.

Answer 32

Increases in employer-related taxes, such as National Insurance contributions, raise the **cost of employment**. This may lead firms to: - Reduce recruitment, - Reconsider pay increases, or - Invest in automation instead of hiring. Additionally, tax changes on company benefits (e.g. car tax or mileage allowances) may influence how businesses **design employee compensation packages**. This can impact employee satisfaction, recruitment, and retention.

Answer 33

Targeted taxes may influence specific sectors more directly: - A higher **landfill tax** may encourage manufacturers to **reduce waste** or **invest in recycling**. - An increase in **air passenger duty** could reduce demand in the **travel and tourism industry**, affecting airlines, tour operators, and hospitality businesses. Thus, taxation can act as both a financial burden and a tool for influencing environmentally or socially responsible behavior.

Answer 34

When taxes become too high, businesses may seek ways to **minimize their tax burden** through legal methods (tax avoidance) or illegal actions (tax evasion). For example: - A firm might limit hiring to reduce National Insurance payments. - A manufacturer might switch to local suppliers to avoid customs duties. - In extreme cases, a company might **illegally dump waste** to avoid landfill taxes, risking legal penalties and reputational damage. Governments must therefore balance tax policies to generate revenue without creating incentives for non-compliance.

Answer 35

Businesses usually prefer **lower taxes** because it means they can keep more of their profits and have more money to invest and grow. When taxes go up—especially if many different types of taxes increase—businesses often react in ways to protect themselves or avoid the extra costs.

Answer 36

- **Lower Consumer Demand**: If personal income taxes go up, people have **less money to spend**. This usually leads to a drop in demand for goods and services. Businesses might respond by **reducing production** or delaying investments because they expect **fewer sales**. - **Lower Investment**: If **corporation tax** (a tax on company profits) increases, businesses keep **less of what they earn**. This makes investment projects less attractive, and companies might choose not to expand or invest in new equipment. - **Relocating to Countries with Lower Taxes**: Some businesses may move their operations to countries where taxes are **much lower**. For example, the **corporation tax rate** is much higher in the United Arab Emirates (up to 55%) than in countries like Paraguay or Qatar (10%). A company might decide it’s more profitable to operate where taxes are lighter. - **Reducing Output Due to Higher Spending Taxes**: If taxes on spending, like **VAT** or other indirect taxes, are increased, it becomes more expensive for consumers to buy things. Businesses may respond by **cutting back production** if fewer people are buying their products. - **Weaker Business Confidence**: Higher taxes can create uncertainty and lower confidence in the economy. If businesses expect lower demand and profits, they may **avoid hiring new staff**, **delay upgrades**, or **hold back on expansion plans**.

Answer 37

- **Higher Demand**: Lower income taxes mean consumers have **more disposable income** to spend, which can increase demand for goods and services. - **More Investment**: If corporation tax is cut, businesses have **more profit left over** to reinvest. They might use this money to **upgrade machinery**, **launch new products**, or **expand their operations**. - **Business Growth**: With higher demand and more retained profits, businesses are more likely to **hire more employees**, **expand production**, and **grow faster**. - **Attracting Foreign Investment**: Countries with low tax rates are more likely to attract **foreign businesses**, since lower taxes mean higher potential profits. This is known as **foreign direct investment (FDI)**.

Answer 38

The government is in charge of spending money on important public services. These include things like **schools, hospitals, defence (military), roads, public transport, and welfare benefits** for people in need. For example, in **Australia**, the government planned to spend about **AUD 464.4 billion** in the year **2017/18**. This money was divided across different areas, which are shown in **Figure 4**.

Answer 39

Government expenditure plays a significant role in influencing the level of economic activity and, as a result, has direct and indirect effects on business performance. When a government increases its spending—particularly if this exceeds its revenue from taxation—there tends to be a **rise in aggregate demand** within the economy. This is because government spending on public services such as infrastructure, healthcare, education, and welfare increases the income of individuals and businesses, who in turn are likely to spend more. For example, if the government funds a major construction project, construction companies, suppliers, and workers involved will benefit financially, which can lead to higher consumer spending and increased demand for goods and services.

Answer 40

From a business perspective, **higher government expenditure can stimulate demand**, boost sales, and encourage investment in production capacity. This is especially true for businesses operating in sectors that supply goods and services to the government or benefit from increased consumer spending.

Answer 41

However, **excessive or poorly managed government spending** can have **negative long-term consequences**. If increased government expenditure leads to **budget deficits and a rising national debt**, this may force the government to borrow more. As debt levels rise, so do **interest payments** on that debt. This reduces the funds available for productive spending (such as on education and healthcare), leading to a high **opportunity cost**. Furthermore, large deficits can lead to **higher interest rates**, as the government competes with the private sector for borrowed funds. Higher interest rates may discourage private investment and reduce consumer spending, particularly on credit-financed purchases.

Answer 42

In response to unsustainable debt, governments may implement **austerity measures**, which involve cutting public spending. For example, in countries like **Greece**, where government debt became unmanageable, significant reductions in public expenditure were made. These cuts often involve **reducing the size of the public sector workforce** or **cutting back on welfare payments**, which in turn **lowers household incomes** and **reduces consumer demand**. As a result, businesses may experience a decline in sales, particularly those in retail, leisure, and non-essential services.

Answer 43

In summary, while **increased government spending can have a positive impact on business activity in the short term**, it must be managed carefully to avoid negative side effects such as inflation, rising interest rates, and unsustainable debt levels. Conversely, **cuts in government spending tend to reduce economic activity**, lower consumer demand, and can adversely affect business revenues and confidence. The overall effect of government expenditure on business therefore depends on the scale, focus, and sustainability of the fiscal policy being pursued.

Answer 44

When the government increases its spending, businesses often react positively. This is because higher government expenditure leads to greater overall demand in the economy. For example, if the government hires more public sector workers—such as teachers, police officers, or healthcare professionals—these individuals receive wages that they spend on goods and services. As a result, many private businesses experience an increase in customer demand. In response to this higher demand, businesses may choose to expand production, invest in more machinery or equipment, hire additional staff, and even open new locations. The growth in sales and revenue provides the confidence and resources needed for such expansion.

Answer 45

On the other hand, if the government decides to cut its spending, this often leads to lower demand in the economy. For instance, reducing the number of public sector jobs or cutting welfare benefits means less money is available for consumers to spend. This can cause a decrease in sales for many businesses, especially those dependent on consumer spending like retail or entertainment. To adjust to falling demand, businesses may reduce their production levels, delay or cancel investment plans, and in some cases, lay off workers. This creates a more cautious and defensive business environment.

Answer 46

The impact of government expenditure on businesses also depends on how the money is spent. Some industries benefit more than others depending on government priorities. For example, if the government focuses on renewable energy, businesses involved in solar power, wind farms, and green technology may receive contracts, grants, or tax breaks. These businesses may respond by investing in research and development, expanding operations, and creating new jobs. Similarly, large-scale infrastructure projects like highways or public transport upgrades tend to benefit construction companies, engineering firms, and materials suppliers, who may see increased demand for their services and products.

Answer 47

While government spending can stimulate business activity, too much of it may have unintended consequences. If the public sector uses up too many of the country’s resources—like skilled workers, land, or raw materials—it can create shortages in the private sector. This may lead to increased costs for private businesses, who then find it harder to compete. In response, private companies may raise their prices instead of expanding production. This can limit economic growth and create inflationary pressure. Therefore, some businesses may see high government spending as a challenge rather than a benefit.

Answer 48

-- ### **5. Summary** In summary, changes in government expenditure significantly influence business activity. Increased spending usually boosts demand and encourages growth, especially in targeted sectors. Reduced spending tends to lower demand and discourage investment. However, the overall impact depends on which areas the government chooses to prioritise and how resources are distributed across the economy. --- Would you like this turned into a revision-friendly format like bullet points or flashcards?

External Influences Unit 2.3.5 Flashcards

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