Economic Influences on Business: Interest Rates and Exchange Rates
Economic influences outside a business's control affect its costs, revenue and decisions. The interest rate is the cost of borrowing money (and the reward for saving it), set in the UK largely through the Bank of England's base rate; a rise in interest rates increases the cost of loan repayments and overdrafts for a business, and reduces consumer spending on credit-funded purchases as households' own borrowing costs and mortgage payments rise. The exchange rate is the price of one currency in terms of another; a stronger (appreciating) pound makes UK exports more expensive for foreign buyers and imported materials cheaper for UK businesses, while a weaker (depreciating) pound makes exports cheaper abroad and imports more expensive at home. Businesses that trade internationally, or that borrow heavily, are the most exposed to changes in these two economic variables.
Before you start
Make sure you're comfortable with these topics first:
Method
- Separate the two variables clearly: the interest rate affects the cost of debt and, through consumer borrowing costs, the level of consumer spending; the exchange rate affects the relative price of a business's exports and imports.
- Learn the direction of each effect precisely: a rise in interest rates raises a business's own borrowing costs AND tends to reduce consumer spending (since mortgages and credit cost more), so both effects usually point the same way, towards lower demand and higher costs.
- Learn the exchange rate effect using a simple rule: pound stronger, exports dearer abroad and imports cheaper at home; pound weaker, exports cheaper abroad and imports dearer at home.
- When a case gives an exchange rate, convert a foreign-currency price or cost into pounds (or vice versa) by dividing or multiplying by the exchange rate as appropriate, to quantify the impact rather than describing it only in words.
- Identify which businesses in a case are more exposed: highly geared or heavily indebted businesses are more exposed to interest rate rises; exporters, importers and multinationals are more exposed to exchange rate movements.
- For an evaluate question, weigh the direct financial impact calculated from the figures against the business's ability to respond, for example whether costs are fixed by a long-term contract, whether the business can pass a cost rise on through price, or whether it can hedge against currency movements.
Worked example
A UK exporter agrees to sell machinery to a US buyer for 120,000 US dollars, to be paid on delivery in three months. When the deal is agreed, the exchange rate is 1.25 US dollars to the pound (meaning 1 pound buys 1.25 dollars). By the time payment arrives, the pound has strengthened to 1.50 US dollars to the pound. Calculate how much the exporter receives in pounds at each exchange rate, and explain the impact of the pound's appreciation on the exporter.
- Calculate the pounds received at the original rate: 120,000 US dollars / 1.25 = 96,000 pounds.
- Calculate the pounds received at the new, stronger rate: 120,000 US dollars / 1.50 = 80,000 pounds.
- Find the difference: 96,000 - 80,000 = 16,000 pounds less than expected.
- Interpret the result: because the price was fixed in US dollars, the exporter receives the same 120,000 dollars, but each dollar now converts into fewer pounds, so the appreciation of the pound has cost the exporter 16,000 pounds in revenue on this single order.
- Conclude: a business that trades internationally and prices its contracts in a foreign currency carries exchange rate risk between the deal being agreed and being paid, which it could manage in future by pricing in pounds or using a forward currency contract to lock in today's rate.
Practice questions
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Q1Define exchange rate.Show answer
Answer: The price of one currency expressed in terms of another currency.
Q2State the effect of a rise in interest rates on a business's cost of borrowing.Show answer
Answer: It increases the cost of borrowing, since interest payments on existing variable-rate loans and any new borrowing both rise.
Q3A UK importer buys goods priced at 50,000 euros. Calculate the cost in pounds if the exchange rate is 1.10 euros to the pound.Show answer
Answer: 50,000 / 1.10 = 45,454.55 pounds (approximately 45,455 pounds).
Q4State whether a stronger pound makes UK exports more or less expensive for foreign buyers.Show answer
Answer: More expensive.
Q5Explain one reason a rise in interest rates can reduce consumer spending.Show answer
Answer: Higher interest rates raise the cost of mortgage repayments and other borrowing for households, leaving them with less disposable income to spend, and can also encourage saving over spending since the reward for saving has risen.
Q6Give one type of business that is especially exposed to a rise in interest rates.Show answer
Answer: A highly geared business with a large amount of variable-rate debt (or, accept: a business planning to take out a new loan).
Q7The same 50,000-euro import in the question above now costs the UK importer 47,619 pounds at a new exchange rate. State whether the pound has strengthened or weakened against the euro, and briefly justify your answer.Show answer
Answer: The pound has weakened, because more pounds (47,619 rather than 45,455) are now needed to buy the same 50,000 euros of goods.
Exam-style questions
Written in the style of a A Level Business exam paper, with a full mark scheme.
A UK manufacturer imports 60% of its raw materials from the eurozone and exports 30% of its finished output to the eurozone. Analyse the likely impact on this manufacturer of a significant weakening of the pound against the euro.
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Brennan Engineering exports precision parts, with 70,000 pounds a month in sales priced in US dollars at the current exchange rate of 1.30 dollars to the pound. The company has a variable-rate bank loan of 300,000 pounds, on which it currently pays 5% interest a year. Forecasters expect the Bank of England base rate to rise by 2 percentage points over the next year, and separately expect the pound to weaken to 1.15 dollars to the pound over the same period. Evaluate the likely overall impact of these two forecast changes on Brennan Engineering.
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