External InfluencesBy Richard Grover

The Business Cycle

If you were to study a graph of economic growth over time it is clear that it fluctuates but in a fairly routine pattern.

This pattern of recession and boom is known as ‘The business cycle’.

The next section will outline the stages of the cycle and the effect on the firm.

Recession

• Characterised by decreasing output and gloomy outlook.

• Firms may experience falling demand and so cut prices and dismiss staff; losses are made; investment falls; some go out of business.

Recovery

• The economy begins to expand again, expectations begin to rise although they are limited.

• The firm will find demand increases again, they may review employment and investment positions but may still be cautious.

Boom

• Rapid growth in output, confidence is high but fear of inflation.

• Firms tend to increase investment, hire more staff, however skill shortages may occur, increase in prices and profit margins.

Downturn

• Cycle returns to beginning, growth starts to slow again.

• Demand falls and reductions in output and investment can be expected.

Effect on firms

In the cycle personal consumption usually fluctuates less than business investment so different firms are affected in different ways when a slump occurs.

Firms producing capital equipment (e.g. machinery) will be badly affected due to reduced investment undertaken by other firms.

Effect on firms (Episode two)

Firms selling durables will be badly hit as people put off buying these items until an upturn when their confidence in employment and income is higher.

Firms selling basic necessities will experience less of a fall, it may even increase as people switch expenditure from luxuries onto these items.

Benefits of Recession

Firms are forced to examine its weaknesses in product range, organisation etc and to become more ‘lean’.

This can lead to improved efficiency and if competitors have gone bust the firm may get a chance to increase its market share.

Interest Rates

Interest rates are a key tool of economic policy. They determine the cost of borrowing and therefore also the level of spending.

This means that they have huge impacts upon individuals (e.g. mortgage repayments) as well as firms (cost of loans, highly geared firms affected more).

Interest Rates (continued)

If interest rates go up firms are hit twice as cost of borrowing increase but in addition spending will usually be reduced so demand for its products may also fall.

Low interest rates may be used to stimulate growth in an economy (e.g. interest rates after 9/11 kept low to curb downturn). High interest rates may be used to curb growth and inflation as too faster growth can be dangerous.

Interest Rates (UK examples)

Interest rates are currently 4% and are expected to rise in the near future. But this is typically very low. Long-term average is 5%.

As recently as 1998 interest rates were as high as 7.5% and in the depression of the late 80’s were sky high as 15% (duepartly to incompetent Tory government)

Exchange Rates

Exchange rates are constantly fluctuating this depends on demand and supply of currencies.

If demand is high i.e. there is a lot of investment in that country then the currency will increase in value. In turn if the market is flooded with a particular currency it will decrease in value.

Exchange Rates (series 2)

A rising exchange rate means:

• For an importer, lower costs for imported items.

• For an exporter, reduced price competitiveness and profit margins.

Similarly falling exchange rates benefit exporters but disadvantage importers.

Exchange Rates

Multinationals are in a stronger position to deal with these fluctuations, compared to firms based in one country, as they can move resources and accounting procedures in order to take advantage of these fluctuations.

Inflation: Causes

• Cost-push inflation occurs when production costs increase, perhaps due to pay rises or through exchange rate changes on imports, that are not supported by productivity increases.

• Demand-pull occurs when demand exceeds supply. This can be controlled by limiting credit or increased taxation to reduce spending power.

Inflation: Measuring it.

The most common measure of inflation is the retail price index (RPI). The prices of a typical sample of purchases or a typical ‘shopping basket’ are weighted by importance and recorded. The index is calculated against a base year has a figure of 100.

Inflation: Importance

Firms and entrepreneurs have inflationary expectations, their business plans are affected by what they expect to happen to inflation. For example in R of I is expected to increase then they may buy large quantities of goods now thus increasing demand-pull inflation, their workers may demand a rise due to the expected increase in cost of living thus producing cost push inflation. This is known as a self-fulfilling prophecy as their actions actually make what they expected to happen to be true.

Inflation: Importance

Inflation affects firms behaviour and chances of survival. Long-term planning becomes more difficult, profit margins may be squeezed as the firm cannot always pass on rises in costs to the customer. Increased interest rates during high inflation periods makes it doubly difficult for firms.

Unemployment: Types

• Structural - is where industries are in structural decline through lack of competitiveness. Mining is a good example of this, huge job losses occurred in the late 80’s. Steel and shipbuilding are other examples.

• Frictional – caused by time lag between one job and the next.

• Seasonal – found in sectors such as agriculture and tourism.

• Cyclical – due to downturn in the business cycle.

Unemployment

Seasonal, frictional and cyclical unemployment will always occur and these are not usually too greater threat to an economy.

Structural unemployment causes major problems for government and society as it is often large numbers it can be difficult to re-train people and find them new jobs, whole areas can go into decline etc. A declining industry needs to be managed to reduce its impacts. (A good example of how not to do this is Thatchers approach to mining in the late 80’s)

Macroeconomics: It’s all related!

All macroeconomic issues are interrelated inflation affects interest rates which affect exchange rates and so on.

Nothing can be viewed in isolation when studying an economy all macroeconomic data must be looked at together.

They think its all over!

IT IS NOW!

Thank you for Listening