EXTERNAL ECONOMIC ENVIRONMENT

OR
EXTERNAL ECONOMIC INFLUENCES
ON BUSINESS BEHAVIOUR
BY
PREM PARAJULI, Ph. D.
EXTERNAL ECONOMIC INFLUENCES

ON BUSINESS BEHAVIOUR
The term economic environment refers to all the
external economic factors that influence buying habits of
consumers and businesses and therefore affect the
performance of a company. These factors are often
beyond a company's control, and may be either large-scale
(macro) or small-scale (micro). It includes, business cycle,
fiscal policy, monetary policy, exchange rate policy,
employment, and so on.
Economic objectives of
government
Economic objectives are what the government wants to
achieve and include:
• Stable prices (low inflation)
• Steady and sustained economic growth
• Low unemployment or full employment
• A balanced balance of payments
• Exchange rate stability
• Reduce inequality of income distribution.
Why economic growth is
considered desirable
Economic growth occurs when real output
increases over time. Sustainable economic
growth means a rate of growth which can be
maintained without creating other significant
economic problems, especially for future
generations. Support to increase GDP,
Leaving standards, higher level output,
increase in export, decrease import, reduce
poverty, increase in government income .
Business Cycle
The business cycle/ economic cycle/ trade cycle refers to
the fluctuations of economic activity and indicators about
its long term growth trend. The cycle involves shifts over
time between periods of relatively rapid growth of output
(recovery and prosperity), and periods of relative
stagnation or decline (contraction or recession). These
fluctuations are often measured using the real gross
domestic product
Business cycle
 Stage of Business cycle
Recession
refers to a period of six months or more of declining real
GDP. it is also known as the downturn which results from
too little spending. GDP is falling
Demand in the economy will fall leading to closure of
firms and high unemployment
Business cannot expand since they will be making losses
Slump
a very serious and prolonged downturn can lead to a slump
where real GDP falls substantially and the house and asset
prices falls. High level of unemployment.
Business will rapidly close down creating serious
consequences for the economy.
Growth

A period where the real GDP start to increase

again from a slump. it is also known as the
recovery stage of economy.
GDP is rising Unemployment is falling
Business are experiencing rising profits
‘Feel good’ factor among the people as their
incomes are rising.
Boom
Refers to a period of very fast economic
growth with rising incomes and profits
Results from too much spending. Economy
experiences rapid inflation
Factors of production become expensive
Slump
Slump
a very serious and prolonged downturn can
lead to a slump where real GDP falls
substantially and the house and asset prices
falls
High level of unemployment.
Business will rapidly close down creating
serious consequences for the economy.
 Problems of high economic growth rate
to an economy.
It leads to the depletion of natural resources
 Can lead to resource shortages
 Decrease in current consumption
 Economy experiences rapid inflation
 Factors of production become expensive
Polices used by the government
to promote economic growth
i. Lowering interest rate to promote
investments
ii. Increasing government expenditure to boost
aggregate demand in the economy
iii. Reducing taxation
iv. Providing subsidies to firms
100- 0%= 100- 30= 70
100-15% =85- 30= 55
Business strategy on economic
growth
For luxury product
 increase range of product, increase price
level, increase out put, promote exclusively
and style.
For normal goods
Add extra value to product, improved in
packaging, promoting product.
For inferior goods
Increase in quality, add extra value, effort to
shift product up market.
Business strategy on economic
recession
for luxury products
– may not decrease price level for damaging long term
image, increase credit terms, offer promotion, wide
product range with lower price model.
For normal goods
– lower prices, higher promotion, or do nothing,
For inferior product
- Promote good value and low price
- Free consumer tests
- Increase range of distribution
 Inflation
Inflation is defined as the persistent increase in the
level of consumer prices or a persistent decline in
the purchasing power of money caused by an
increase the supply of domestic currency and
credit beyond the proportion of available goods
and services. Over the long term, inflation erodes
the purchasing power of your income and wealth.
This means that, as you save and invest, your
accumulated wealth buys less and less. High rate
of inflation leads to lower purchasing power for
consumers resulting in lower demand for goods
and services. Moreover, a higher inflation rate will
make business uncompetitive in the international
market leading to lower sales for the business.
 How to measure Inflation
.Every month the Government surveys prices and generates
the current consumer price index (CPI)
. This allows the government to compare current figures with
past figures
.Consumer basket is established ( a sample of goods which
are usually bought by people and this goods have a direct
impact on the people’s standards of living)
.Weight are assigned to the goods to reflect the importance
of each goods in the consumer basket
. A base year is also established. This a year where there is
low/no inflation. The CPI in the base year is usually 100 . If
the current CPI is 120 then the inflation rate will be 20% in
comparison with the inflation rate which prevailed in the
base year.
Causes of Inflation
Demand-Pull Inflation: This inflation occurs
when the government / consumers / business
try to purchase more output than the
economy is capable of producing. Thus
inflation results when the macro economy has
too much demand for available production.
Major drivers of demand pull inflation
 Unnecessary printing of more note and
coins by the central bank
 Excessive government expenditure
 Supply shortages
 Policies to solve demand –pull inflation
 Reduce government expenditure and increase
taxation (fiscal policy)
 The central bank must raise interest rates and
reduce the supply of notes and coins in the
economy (monetary policy)
 The government to work on supply bottlenecks
Reducing demand –pull inflation and the impact
on businesses
 High interest rates will discourage investments
 Aggregate demand will fall and the firms may
decide to relocate to other countries
 Businesses may begin to offer less expensive goods
 Cost-Push Inflation
Cost-push inflation is inflation due to
decreases in supply, primarily due to
increases in production cost
Major drivers of cost-push inflation
Increase in wages
 Increase in the world price of imported raw
materials
 Lower exchange rate pushing up prices of
imported raw materials
 Increase in the cost of production
 Policies to solve cost-push inflation
High exchange rate policy (revaluation of domestic
currency)
 Discourage high wages by limiting trade union powers
 Come up with cheaper local resources
Reduce indirect taxation
 Provide subsidies to firms
Reducing cost -push inflation and the impact on
businesses
High interest rates will discourage foreign direct
investments
High exchange rate will make exports less competitive on
the world markets
 Workers become less productive when the wages are
Business strategies in period of
inflation
Try to reduce labour costs
 Avoid excessive borrowing
 Sale goods on cash basis
Reduce the credit period to customers
 Avoid unnecessary expansion programs
 Deflation
Refers to a fall in the average or general price level
of goods and services. The purchasing power of
money will be increasing. Thus one dollar will be
buying more goods today than it did yesterday.
Deflation occurs when the inflation rate falls below
0%.This should not be confused with disinflation, a
slowdown in the inflation rate. Inflation reduces
the real value of money over time.
Business strategies in period of deflation
-Sale goods on credit basis
- Borrow more money for expansion
- Increase the repayment period to credit customers
 Unemployment
Unemployment Refers to a situation where people who
are able and willing to work cannot find a job. It only
caters for people in the working population who are
willing and able to work.
 Formula: Unemployment rate = unemployed / labour
force x 100 / eg. 20/80 X100= 25%
Labour force/ economically active group means working
people between 16 years to 64 years .
 Causes or types of unemployment
Structural unemployment
- Occurs when the economy changes and industries die out e.g
important industries like the mining and secondary industries. In
another way when structure is change ( labour intensive to capital
intensive)
- It also due to changes in the consumer tastes and expenditure
patterns
- Structural unemployment can affect businesses in the local area
Solutions
-Training is needed to give the unemployed workers new skills
- The government to invest in declining industries
 Cyclical unemployment
unemployment resulting from low demand for goods and services in
the economy during a period of slow economic growth or a
recession.
Caused by the business cycle. Unemployment which result from low
demand for goods and services in the economy during a period of
recession. Cyclical unemployment can lead to a decrease in sales
meaning businesses need to look for new markets
Solutions
Increase government expenditure and reduce taxation (fiscal policy).
Increase the supply of notes and coins and reduce interest rates
(monetary policy).Maintain a competitive exchange rate so that the
demand for exports does not fall (exchange rate policy)
 Frictional unemployment
Unemployment resulting from workers losing or leaving jobs
and taking a substantial period of time to find alternative
employment. It is Caused when people are temporarily out of
work as they are changing jobs. What it means is that the jobs
are available somewhere in the country but it takes time for
unemployed to for the unemployed to apply for the jobs, to
attend interviews and to relocated to those areas. Frictional
unemployment is not a problematic type of unemployment.
Solution-
Improve the flow of information by setting up job centres or
employment agencies. Reduce the unemployment benefits
 Effects of high unemployment
 Decrease in the output of goods and services in the economy.
 Lower GDP or national income.
 Lower living standards for the unemployed.
 Increase in social problems e.g crime and other social ills.
 The government has to give the jobless people
unemployment benefits.
 The skills of the unemployed people become increasingly out
dated.
 Skill of human resource become outdated.
Macro Economic Policies
To achieve its objectives the government will use macro
economic policies. Macro economic policies are defined
as the set of government rules and regulations to control
or stimulate the aggregate indicators of an economy.
These policies are designed to work on the whole
economy
1. fiscal policy
2. Monetary policy
3. Exchange rate policy
 Fiscal policy
It is concerned with decisions about government
expenditure, tax rates and government borrowing.
These operate largely through the government’s annual
budget decisions. Fiscal policy is the use of government
spending and taxation to influence the economy. Fiscal
policy is what the government employs to influence and
balance the economy, using taxes and spending to
accomplish this. Fiscal policy tries to nudge the economy
in different ways through either expansionary or
contractionary policy, Basically, fiscal policy intercedes
in the business cycle by counteracting issues in an attempt
to establish a healthier economy, and uses two tools -
taxes and spending - to accomplish this.
 Fiscal policy cont…….
however, generally focus on the effect of changes in the
government budget on the overall economy. The term
"fiscal policy" is usually used to describe the effect on
the aggregate economy of the overall levels of
spending and taxation, and more particularly, the gap
between them. Government Budget/ National Budget
= Tax revenue – Government spending . Government
budget deficit- arise when the value of government
spending exceeds revenue from taxation and
Government budget surplus occurs when taxation
revenue exceeds the value of government spending
 Types of Fiscal Policy
Tight or Contractionary Fiscal Policy
Fiscal policy is said to be tight or contractionary when
revenue is higher than spending (i.e., the government
budget is in surplus) . The government will
deliberately reduce its expenditure and raise taxation.
The overall result will be a reduction in the level of
aggregate demand so as to control inflationary
pressure and BOP deficits. This policy is usually used
by the government when the economy is booming and
is in the danger of overheating.
 Loose or Expansionary Fiscal
Policy
loose or expansionary occurs when spending is
higher than revenue (i.e., the budget is in
deficit). The government will deliberately
increase its expenditure and reduce taxation
levels. Aggregate demand will increase hence
national output and employment will increase.
This policy is usually used by the government
when the economy is in a recession
 Impact of Fiscal Policy on
businesses
Direct taxes will affect consumers’ disposable income.
Disposable income refers to income after tax
 Direct taxes also affect company profits
Indirect taxes will increase retail prices of goods and the
impact on either consumers or businesses will depend on
the elasticity demand for each product
Reduced government spending will affect businesses that
provide goods and services directly to the government i.e
firms that used to benefit from government tenders
100+13=113, 130+ 130 X 13%=
 Monetary Policy
Monetary policy concerned with decisions about the rate of
interest and the supply of money in the economy. It is the
process by which the monetary authority of a country
controls the level of interest rates and the supply of money
with the purpose of promoting stable employment, prices,
and economic .
Type of Monetary Policy
1. Expansionary Monetary Policy
2. Contractionary Monetary Policy
Expansionary Monetary Policy
Expansionary Monetary Policy It occurs the government
through its central bank increases the supply of notes and
coins and lower the level of interest rate to increase the
level of aggregate demand in the economy. An increase in
money supply will decrease interest rates and investment
is promoted. A rise in investments will increase aggregate
demand in the economy hence national output and
employment will increase. Expansionary monetary policy
is used when the economy is in a recession.
Contractionary Monetary
Policy
It occurs the government through its central bank decreases
the supply of notes and coins and raises the level of
interest rate to decrease the level of aggregate demand in
the economy. A decrease in money supply will increase
interest rates and investment is discouraged. A fall in
investments will decrease aggregate demand in the
economy hence inflationary pressure is reduced. Tight
monetary policy is used in a boom where the inflation rate
is very high.
Impact of Monetary Policy on
Businesses
 Interest rates affect the cost of borrowing to
the businesses which then affect its
profitability.
 Interest rates affects consumer borrowing
and this may lead to fall in demand for goods
and services.
 Changes in interest rates may affect the
exchange rate which then affect the ability of
firms to buy raw materials from outside.
Exchange Rate Policy
The government can also try to influence the economy by
adjusting the external value of domestic currency. The
government can choose to fix the exchange rate or to
allow it to float (or to be determined by demand and
supply factors) or to join a monetary union where member
countries uses a common currency.
Types of exchange rate policy
1. Free Floating Exchange Rate
2.Fixed Exchange Rate
3.Managed Float or Dirt Float Exchange Rate System
 Free Floating Exchange Rate
The exchange rate is determined by the operation of the price
mechanism. The interaction of the demand for and supply of
foreign currency will determine the equilibrium exchange rate.
Advantages- Automatic correction of BOP disequilibrium.
Reduces need for the foreign currency reserves.
May reduce speculation as the exchange rate move freely up or
down.
 Disadvantages - Fluctuating prices of imported raw materials
and components, making costing of products difficult.
 Fluctuations in export prices and overseas competitiveness,
which lead to unstable levels of demand.
 Uncertain over profits to be earned from trading abroad or
from investing abroad.
 Fixed Exchange Rate
An exchange rate that is determined by the government. The
government will set an exchange rate then make an effort to
support it to prevent the exchange rate from moving up or
down.
Advantages
 Stable exchange rate provide a basis for business expansion.
 Stability encourages increased trade
Disadvantages
 Large reserves of foreign currency are required to support the
exchange rate.
 There is no auto-correction of BOP deficit
 Managed Float Exchange
Rate System
Managed Float or Exchange Rate System Refers to a
situation where the exchange rate is allowed to fluctuate
between the set exchange rate bands. Thus it is partly
fixed and partly determined by market forces. Higher and
lower rate of currency is set up by central bank. Risk on
foreign trade is moderate in this type of exchange rate.
 Common Currency
An economy may join a monetary union which uses common
currency is called currency zone..
Advantages
 Planning is made easy since one currency is used
 No extra cost of converting domestic currency into foreign
currency
 Comparison of prices from different countries becomes easy
Disadvantages
 Conversion costs from one currency to the common currency
could be high in terms of dual pricing and the change over of
notes and coins.
 Local central bank will lose its independence to control
money supply