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Economic climate

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Business Studies

Have you ever wondered why some countries are good for businesses to invest in, and others not so much? For example, why did Apple open its stores in the UK but not in Ethiopia? One of the reasons is probably that the GDP of Ethiopia is not as high as that of the UK. Moreover, in the UK, the unemployment rate is lower in the UK and people are more likely to afford Apple’s products. All of these aspects are related to the economic climate and how it affects businesses.

Economic climate definition

In order to understand the term economic climate, it is essential to first look at the definition of the economy.

As you might already know, every country has an economy. The United Kingdom, France, Germany, and all the other countries of the world are therefore economies. Each of these economies consists of numerous consumers as well as many businesses and governments.

For example, in the UK, the government is made up of millions of British customers, millions of both British and foreign businesses, the UK Government, and many local governments. All of these entities buy, sell, produce, import and export goods and services. The sum of all these activities creates the economy. The state of the economy is referred to as the economic climate.

The economic climate describes the state of the economy.

The economic climate considers the key factors within the country. These are:

  • The quantity of goods and services produced

  • The affordability of goods and services

  • The availability of jobs.

Economic climate change in business

The economic climate tends to change. It may either improve or weaken in accordance with several key factors (see Figure 1 below).

Economic climate change, StudySmarterFigure 1. Economic climate change, StudySmarter

As you can see, the economic climate is highly influenced by changes in key factors such as levels of production, consumer income, spending, and employment. When one of these factors increases, the economic climate improves. Conversely, when one of them decreases, the economic climate weakens.

Because of COVID-19, workers in many countries were fired, leaving them unemployed. The levels of employment decreased and changed the economic climate for the worse.

Impact and example of economic climate change on businesses

The economic climate is a factor that a business should consider when entering a new market or when expanding in an already entered market. The success and profitability of the business are highly related to the economic situation of the country it operates in.

There are three main aspects of the economic climate that can affect a business:

  • Interest rates

  • Level of employment

  • Consumer spending.

Interest rates

Interest rates are the cost of borrowing money (expressed as a percentage).

When taking out a loan, a business or a customer not only has to repay the amount borrowed, but also an additional fee known as the interest rate. A high interest rate means that the borrower has to pay more, whereas a low interest rate means that the borrower has to pay less. For a lender it's the reverse: when an interest rate is high they earn more, but when the interest rate is low, they earn less.

Imagine you borrowed £1,000 from a bank and the interest rate is 5%. When repaying the loan, you will have to pay £1,050 (105%). This way, you lose £50 and the bank earns £50.

Influence of interest rates on customers and businesses

  • Consumers - When it comes to consumers, interest rates can have an impact on the amount of money they spend. If interest rates are low, they will feel encouraged to take out a loan and spend more money, as low interest rates mean less money to repay. However, when interest rates are high, customers will be discouraged from taking out a loan and therefore spend less money. After all, with high interest rates, they will have more to repay.

  • Businesses - Interest rates can also affect business costs. If interest rates are low, firms have to repay less on their existing loans and their costs will thus be reduced. Moreover, they will be encouraged to invest by taking out further loans. However, if interest rates are high, they will have to repay more on their existing loans and their costs will increase. They will also most likely refrain from investing by taking out further loans.

Influence of low and high interest rates

  • Low interest rates typically result in an improvement in the economic climate. When interest rates are low, customers are willing to spend more and businesses are willing to produce more. In general, low interest rates are associated with increased sales. This benefits both customers and businesses.

  • High interest rates typically worsen the economic climate. When interest rates are high, customers tend to spend less and businesses produce less. In general, low interest rates are associated with decreased sales. This is unfavourable for both customers and businesses.

Level of employment

The level of employment is defined as the number of people engaged in productive activities in an economy.

The level of employment reflects the number of people that are employed. These can either be employees of a business or self-employed persons.

Influence of high level of employment

When the level of employment is high, this means that the great majority of people in the economy have a job. For businesses, this means that they are employing more people, who in turn produce more goods and services. As a result, sales increase, which can result in higher earnings. When it comes to customers, a high level of employment typically means that they earn more money and can afford to buy more products and services.

Influence of low level of employment

A low level of employment means that a small number of people have jobs. Low levels of employment typically mean that businesses are employing a relatively small number of people, who in turn produce fewer goods and services. This downturn is associated with decreased sales and lower earnings. For customers, low levels of employment are related to low earnings and the inability to buy many products.

Consumer spending

Consumer spending is the monetary value of goods and services bought by consumers over a time period, usually a month or a year.

Customers spend money on a variety of goods and services. These items may include necessities such as food and housing or products that are not essential, such as designer clothes and expensive electronics.

Demand and income

Consumer spending is highly related to both consumer demand and income.

If consumers earn a high income, demand will typically increase. This applies particularly to non-essential luxury products. High demand and income are typically associated with high consumer spending. When customers spend more, business sales and earnings increase.

However, when the income of consumers is low, demand for products and services will typically decrease. Customers will most likely refrain from buying non-essential luxury products, as they will be more willing to save. Low demand and income contribute to low customer spending. If customers spend less, business sales and earnings then decrease.

As you can see, the economic climate is a factor that has a significant influence on businesses and their sales and earnings. For this reason, companies should keep close track of the economic situation of the countries where they operate.

Economic climate - Key takeaways

  • The economic climate describes the state of the economy.
  • The economic climate considers key factors within a country including the number of goods and services produced, affordability of goods and services, and the availability of jobs.
  • Rising levels of production, consumer income and spending, and employment improve the economic climate. Falling levels of production, consumer income and spending, and employment weaken the economic climate.
  • There are three main aspects of the economic climate that can affect a business: interest rates, level of employment, and consumer spending.
  • Interest rates are the cost of borrowing money expressed as a percentage.
  • The level of employment is defined as the number of people engaged in productive activities in an economy.
  • Consumer spending is the value of goods and services bought by consumers over a period of time, usually a month or a year.

Economic climate

The economic climate describes the state of the economy. It considers the key economic factors within a country. These are: the quantity of goods and services produced, the affordability of goods and services and the availability of jobs. 

There are many ways in which the economic climate can affect business operations. For example, fluctuating interest rates can increase or decrease the costs of production. An increase in interest rates might decrease production whereas a decrease in interest rates would increase production.

The economic climate can deteriorate the performance of a business. If the level of production, consumer income and spending, and employment fall, business sales and earnings are very likely to decrease. 

There are many ways in which the economic climate can influence a business. For example, if the level of employment in a country where a business operates falls, consumer spending can fall as well, which is often associated with lower sales and earnings for a business.

Economic climate change can bring both benefits and costs to a business. That is why a business should constantly monitor the economic situation in countries it operates in to be able to either take advantage of them or act to prevent losses.

Final Economic climate Quiz

Question

What is unemployment? 

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Answer

Unemployment is the state of being unemployed. 

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What are the two types of unemployment?

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Voluntary unemployment and involuntary unemployment

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What is voluntary unemployment?

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People choose not to work because they are wealthy or have other obligations, e.g. a housewife/houseman who chooses to stay at home and take care of the children. 

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What is involuntary unemployment?

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People are actively looking for a job but unable to find one, e.g. a newly graduated student who are seeking employment. Some people are unable to choose because they are ill.  

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What is the unemployment rate? 

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Answer

The proportion of the total population who are unable to find work

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When does unemployment rise?

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When the economy is stable or experiencing growth. 

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What are the reasons people are unemployed?

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A reduction in demand for goods and services

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What causes a reduction in output? 

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A fall in demand for goods and services

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How does unemployment affect consumers?

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Answer

Being unemployed means that people don’t have a source of income to support themselves. Their living standards will drop while the stress of finding a new job can take a heavy toll on their physical and mental well-being. 

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What happens to businesses when the unemployment rate is high?

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Lower output

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What happens to the government when the unemployment rate is high?

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Answer

A reduction in tax revenues - income tax, corporate tax, VAT

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What happens to the unemployment rate when the economy experiences a recession?

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Unemployment rise 

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What kind of business may thrive in case of high unemployment?

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Businesses that offer cheap alternatives such as supermarket goods

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What are the benefits of economic growth to businesses and individuals?

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High sales as the demand increases

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What is the challenge for businesses in times of recession?

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A fall in demand for goods and services which results in lower revenues. Businesses may also need to lay off workers as they are no longer able to hire them. 

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What is taxation?

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Taxation is a payment by individuals and businesses to the government for funding education, infrastructure, national healthcare, defence, etc. 

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What are the five main types of tax in the UK? 

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  • Income tax

  • National insurance

  • Value-added tax (VAT)

  • Corporate tax

  • Business rates. 

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What is the classification of tax?

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Direct taxes or indirect taxes.

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What is the direct tax?

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Direct tax is taxation on income. It is deducted from an employee’s salary or a business’s earnings and paid directly to the government.

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What is indirect tax?

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Indirect tax is taxation on spending. Businesses collect indirect taxes on the government's behalf by adding them to the price of their products and services.

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Which tax is progressive?

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Direct tax. It is based on the level of income - the higher the income, the more taxes one has to pay. 

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What are regressive taxes? Give an example. 

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Answer

Regressive taxes are not based on the level of income. No matter how much one earns, the amount of taxes paid is the same. 


An example of a regressive tax is VAT (Value-Added Tax). 

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What is income tax? 

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Income tax is a tax on a person’s income. 

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What is income tax personal allowance? 

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The amount of income up to which one does not have to pay tax. 


In the UK, the personal allowance is £12,570. You are exempt from tax for the first £12,570 you make. 

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Is income tax progressive?

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Yes - it is based on the level of income.

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Where do National Insurance contributions go to?

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National Health Service (NHS), unemployment benefits, illness and disability allowances, and state pension. 

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Who is obliged to pay National Insurance in the UK?

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Any person aged above 16 who earns a salary of  £155 per week or is self-employed with a profit of £5,955 per year is obliged to pay National Insurance.

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What taxes are automatically deducted from one's salary (these are shown on the payslips)?

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Answer

income tax and national insurance.

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What is VAT?

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Value-Added Tax - This is a tax on goods or services purchased. 

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What is the tax rate for most goods and services in the UK?

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20 percent

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Which products or services have zero VAT?

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Most food and drink 

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What is corporate tax?

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Corporate tax is a tax paid by a business to the government. 

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What are business rates? 

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Business rates are taxed based on the property where a business takes place. 

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What happens when the government increases income tax?

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An increase in income tax will reduce consumer disposable income (income after income tax), resulting in lower demand for goods and services. This can lower business revenues. 

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How can the government encourage more spending in the economy?

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By reducing taxes. 

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What is consumer spending?

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Consumer spending is the spending by individuals and households on goods and services. 

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Which side of the supply-demand function does consumer spending belong to?

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Demand side

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What are the four main types of consumer spending?

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Answer

Necessities, non-durable goods, durable goods, and luxury goods.

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What does the rise in consumer spending on luxury and durable goods indicate? 

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Answer

More high-income individuals. 

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What are the five determinants of consumer spending?

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Disposable income

Income per capita

Income inequality

Household debt

Consumer expectation

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How does consumer expectation affect spending?

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Answer

Consumer expectation is measured by the Consumer Confidence Index (CCI), which indicates how confident people are about the future. If people anticipate inflation in the coming years, they will spend more today to take advantage of the lower prices. 

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What is income per capita, and how does it predict consumer spending?

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Income per capita is the measure of the income a person earns in a particular area, e.g. a state, a city, or a country. It is calculated by dividing total income for the area by the number of people in that area - higher income per capita may indicate a higher standard of living and more spending on goods. 

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What is the relationship between consumption and production of goods?

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Consumption is the goal and motivation for the production of consumer goods in an economy. 

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What is spending stored for future use called?

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Savings

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Why should businesses and investors pay close attention to consumer spending data and patterns?

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To forecast business growth and make better plans regarding products, pricing strategies, and investment. 

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What happens to businesses when consumer spending increases?

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A rise in consumer spending can increase the demand for goods and services which results in more production and jobs provided by a business. 

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What does a decrease in consumer spending do to businesses?

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Lower demand for the company's products.

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What kind of business may benefit from a drop in consumer spending? 

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Businesses that produce basic or second-hand goods. As people have lower incomes, they will spend less on luxury goods and more on daily necessities. 

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In which case are people more likely to purchase luxury or updated versions of the products they already own? 

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An increase in income 

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Are all businesses affected negatively by a fall in consumer spending?  

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No,  businesses that offer cheaper alternatives or second-hand products can benefit from more sales as people's income and spending power drop. 

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