Economic Environment

The economic environment of the business is one of the external factors that can influence strategy and decision-making in the business context. Economic factors are important because they are directly related to goods, services, and consumers. They also have a huge impact on how the business is able to operate in its country of origin and partner with other businesses in different countries. Let's examine this topic in more detail.

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Table of contents

    The Economic Cycle

    The economic cycle (also known as the business cycle) is an important tool for understanding economic activity.

    The economic cycle or business cycle represents the value of economic output and activity in the macroeconomy.

    The business cycle is made up of four main phases.

    Economic environment The business cycle StudySmarterThe Business Cycle

    The boom phase can be characterized by high levels of spending. The highest point of an economic boom is known as the peak. Consumers, businesses and investors are confident in the economic environment and therefore spend more. In this phase unemployment also tends to be low due to rapid expansions in businesses which creates jobs. Costs and prices also tend to be high due to confidence in the business environment.

    A contraction or recession can be characterized by slower economic activity. Investors are not as confident in the economic environment and spend less. Consumers also decrease their spending which leads to lower profits for businesses. Unemployment also rises as businesses cut back on expansion and production.

    A depression or slump phase is an extended period of low and declining economic activity. The lowest point of depression is known as the trough. This period can be characterized by low consumer spending and investment. During this time the economy is contracting and a lot of businesses fail. Unemployment is increasing and prices tend to decrease.

    A recovery or expansion comes right after the through and it can be characterized by things getting better in the economy. Consumers and investors are more confident and increase their spending. As a result, unemployment also starts decreasing.

    Types of Economic Environment

    In this section, we will go over all the different factors of the economic environment:

    Economic Environment: Gross Domestic Product (GDP)

    Gross domestic product (GDP) is the total output of economic activity in a country within a certain period of time (usually one year).

    GDP includes all investments made into business ventures, consumer spending and government spending. GDP can be used as a tool to measure how a country's economy is doing. If GDP is increasing, it can mean that a country's economy is growing.

    Economic Environment: Exchange Rates

    An exchange rate is a rate at which one currency can be exchanged for another.

    Exchange rates are constantly changing and they determine how much of one currency has to be given up to receive a certain amount of another currency.

    Currently, with £1 you can currently buy €1.18.

    Economic Environment: Taxation

    There are two types of taxes to consider.

    Direct taxes are taxes on income, wealth and profit.

    Income taxes are taxes people have to pay on their income made from working (salary), owning assets or trading. Corporate taxes are taxes companies have to pay on their profits.

    Indirect taxes are taxes levied on spending.

    This includes VAT, which is a standard rate charged on most purchases. In the UK, VAT is currently 20%.

    Economic Environment: Inflation

    Inflation is the continual increase in average prices in the economy.

    During inflation, the purchasing power of money decreases. A rise in price levels - or inflation - means that a unit of a currency (ie £ 1) will buy you less than it did previously.

    Economic Environment: Fiscal Policy

    Fiscal policy is a type of government policy that impacts taxation and government spending.

    It can either be expansionary with the aim of increasing economic activity by increasing government spending and/or decreasing taxation. Fiscal policy can also be contractionary, which aims to decrease economic activity by increasing taxation and/or decreasing government spending.

    Economic Environment: Monetary Policy

    Monetary policy involves changing the supply of money in an economy.

    Monetary policy involves adjusting interest rates, manipulating exchange rates, and controlling the money supply. The purpose of monetary policy is to keep inflation rates stable and low to promote economic growth. In the UK, monetary policy and setting interest rates are the responsibility of The Bank of England.

    Effects of Economic Environment on Businesses

    In this section, we will outline how each economic factor impacts the business environment and business decision-making.

    Economic Environment: Gross Domestic Product and Decision-Making

    GDP can impact business decisions in multiple ways.

    GDP can be used as a tool to let investors know whether the economy is growing or decreasing. If economic prospects are positive (economy growing), it could signal to investors that it is a good time to invest in businesses, encouraging investment.

    Economic growth can also mean that consumers are spending more on average, which increases businesses' profits. This could be a good time for businesses to invest in expansion and growth, as their profits are high and investors are more likely to invest during favourable economic conditions.

    However, the opposite may also hold true. If GDP is decreasing, the economy might be contracting. Consumers are spending less, resulting in low business profitability. During an economic recession, investment is also likely to decrease.

    Economic Environment: Exchange Rates and International Markets

    Exchange rates are an important factor for international markets.

    If your business is operating in the UK, your main source of income will most likely be in GBP (£). If you are looking to expand to a foreign country, ie Germany, it is more favourable for you to do so when you can exchange £1 for a high rate of EUR.

    It would be more profitable for you to invest when the EUR is valued lower than GBP, as you get more for your investment - it is cheaper for you to invest abroad. However, if you were looking for foreign investment, it may be more likely that the German company would invest in your company when the GBP is valued lower than usual.

    Economic Environment: Taxation's Impact on Businesses

    Direct taxation can influence business decisions significantly. The level of influence, however, is dependent on the type of business you operate. As mentioned earlier, income taxes are part of direct taxation. Changes in the rate of income taxes impact consumer spending.

    If there was an increase in taxation rates for income, consumers will most likely spend less, as their disposable income decreases. This is especially prominent for businesses operating in the luxury industry (ex. luxury holidays or designer goods).

    Businesses manufacturing necessities and food products are less likely to be impacted by higher direct taxation.

    Indirect taxation can also influence business decisions. An increase in VAT will decrease consumer spending, as consumers now have to pay higher prices when purchasing goods and services. Again, certain industries will be affected more than others, depending on the price elasticity of demand for the product. For example, consumers will continue purchasing basic necessities even if their prices increase.

    Economic Environment: Effects of Inflation

    Inflation will also impact business decision making. In markets where inflation is increasing, consumers spend less, as their purchasing power decreases. This will lead to lower profits for certain businesses.

    Economic Environment: Impacts of Fiscal Policy

    When expansionary fiscal policy is implemented (lower taxes, higher government spending), consumers will likely demand more goods and services - spend more. This can increase the profitability of a business and encourage growth or expansion.

    When contractionary fiscal policy is implemented, consumers demand less and therefore spend less on products and services. A contractionary policy may also increase unemployment. When consumers spend less, certain businesses are once again, more heavily impacted than others.

    Economic Environment: Impacts of Monetary Policy

    Monetary policy can impact firms in different ways mainly due to changes in interest rates. Not all businesses are affected equally.

    Small businesses that portray a high rate of borrowing, and have access to less financial reserves, will be impacted by high interest rates significantly.

    Sometimes high interest rates can also lead smaller firms to bankruptcy. Larger businesses that do not rely on borrowing as much as small firms, and have access to a larger financial reserve, will be less impacted by high interest rates.

    However, this can still have a significant impact on large businesses, as they now need to increase their expenditure on interest and lower their expenditure in other areas of the business like production or marketing.

    Economic factor Effect
    GDPUsed to see whether the economy is growing or expanding.
    Exchange RatesImportant for international markets and investment.
    TaxationChanges in taxation could mean businesses are giving up more of their earnings.
    inflationIncreasing inflation can lead to less consumer spending and lower profits.
    Fiscal Policy Can be expansionary or contractionary.
    Monetary Policy Impacts interest rates.

    Economic Environment - Key takeaways

    • The economic environment of the business is one of the external factors that can influence strategy and decision-making.
    • Economic factors include GDP, exchange rates, taxation, interest rates, fiscal policy, monetary policy and inflation.
    • The business cycle is an important tool for understanding how the economy works.
    • An increase in GDP favors businesses, as consumers spend more and investors are more likely to invest in prosperous economies.
    • Exchange rates influence international markets and foreign direct investment.
    • There are two different types of taxation: direct and indirect.
    • Direct taxes include income and corporate taxes. Indirect taxes include taxes like VAT.
    • When income taxes and VAT increase, consumers spend less on non-essential products and services.
    • Inflation also decreases consumer spending, as their purchasing power decreases.
    • Fiscal policy can be either expansionary or contractionary. During expansionary fiscal policy, taxation is lower and government spending is higher. During contractionary policy, taxation is higher and government spending decreases.
    • Monetary policy involves interest rates and controlling the supply of money in the economy.
    Frequently Asked Questions about Economic Environment

    what is an economic environment? 

    The economic environment of the business is one of the external factors that can influence strategy and decision-making in the business context. 

    How does economic growth impact the environment? 

    Economic growth has the following impact on the environment.
    High levels of spending, confident investors and consumers, and more employment opportunities 

    What are the types of an economic environment?

    Gross domestic product (GDP), exchange rates, taxation, inflation, etc. are the types of an economic environment. 

    Why is the economic environment important?

    The economic environment is important because it shows the level of confidence people have in the environment. Businesses flourish, people get more job opportunities, and customers spend more because of a favorable economic environment. 

    Test your knowledge with multiple choice flashcards

    Which of the following is not a phase of the business cycle?

    Which of the following statements is correct? Corporate taxes are a form of indirect tax. VAT is a form of indirect tax.

    During inflation __________. 


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