6.

1 ECONOMIC ISSUES

The Business/ Trade Cycle

An economy will not always go through an economic growth; there is usually a cycle, as shown
above.

Growth – when GDP is rising, unemployment is falling and there are higher living standards in
the country. Businesses will look to expand and produce more and will earn high profits.

Boom – when GDP is at its highest and there is too much spending, causing inflation to rapidly
rise. Business costs will rise and firms will become worried about how they are going to stay
profitable in the near future.

Recession – when GDP starts to fall due of high prices, as demand and spending falls. Firms will
cut back production to stay profitable and unemployment may rise as a result.

Slump – when GDP is so low that prices start to fall (deflation) and unemployment will reach
very high levels. Many businesses will close down as they cannot survive the very low demand
level. The economy will suffer.

(When the government takes measures to increase demand and spending in the economy to
take it from a slump to growth, it is called as the ‘recovery’ period). The cycle repeats.

Economic Objectives

Here, we’ll look at the different economic objectives a government might have and how their
absence/negligence will affect the economy as well as businesses.

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 Maintain economic growth: economic growth occurs when a country’s Gross Domestic
Product (GDP) increase i.e. more goods and services are produced than in the previous year.
This will increase the country’s incomes and achieve greater living standards.

Effects of reducing GDP (recession):

 As output falls, fewer workers will be needed by firms, so unemployment will rise
 As goods and services that can be consumed by the people falls, the standard of living in
the economy will also fall

 Achieve price stability: inflation is the increase in average prices of goods and services over
time. (Note that, inflation, in the real world, always exists. It is natural for prices to increase
as the years go by. In the case there is a fall in the price level, it is called a deflation)
Maintaining a low inflation will help the economy to develop and grow better.

Effects of high inflation:

 As cost of living will have risen and peoples’ real incomes (the value of income) will have
fallen (when prices increase and incomes haven’t, the income will buy lesser goods and
services- the purchasing power will fall).
 Prices of domestic goods will rise as opposed to foreign goods in the market. The
country’s exports will become less competitive in the international market. Domestic
workers may lose their jobs if their products and firms don’t do well.
 When prices rise, demand will fall and all costs will rise (as wages, material costs,
overheads will all rise)- causing profits to fall. Thus, they will be unwilling to expand and
produce more in the future.
 The living standards (quality of life) in the country may fall when costs of living rise.

 Reduce unemployment: unemployment exists when people who are willing and able to
work cannot find a job. A low unemployment means high output, incomes, living standards
etc.

Effects of high unemployment:

 Unemployed people do not produce anything and so, the total output/GDP in the
country will fall. This will in turn, lead to a fall in economic growth.
 Unemployed people receive no incomes, thus income inequality can rise in the economy
and living standards will fall. It also means that businesses will face low demand due to
low incomes.
 The government pays out unemployment benefits to the unemployed and this will rise
during high unemployment and government will not enough money left over to spend
on other services like education and health.

 Maintain balance of payments stability: this records the difference between a

country’s exports (goods and services sold from the country to another) and imports (goods
and services bought in by the country from another country). The exports and imports
needs to equal each other, thus balanced.

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 Effect of a disequilibrium in the balance of payments:
 If the imports of a country exceed its exports, it will cause depreciation in the exchange
rate– the value of the country’s currency will fall against other foreign currencies.
 If the exports exceed the imports it indicates that the country is selling more goods than
it is consuming- the country itself doesn’t benefit from any high output consumption.

 Reduce income equality/achieve effective income redistribution: the difference/gap

between the incomes of rich and poor people should narrow down for income equality to
improve. Improved income equality will ensure better living standards and help the
economy to grow faster and become more developed.

Effects of poor income equality:

 Unequal distribution of goods and services- the poor cannot buy as many goods as the
rich- poor living standards will arise.

Government Economic Policies

Government can influence the economic conditions in a country by taking a variety of policies.

Fiscal policy is a government policy which adjusts government spending and taxation to
influence the economy. It is the budgetary policy, because it manages the government
expenditure and revenue. Government aims for a balance budget and tries to achieve it using
fiscal policy.

Increasing government spending and reducing taxes will encourage more production and
increase employment, driving up GDP growth. This is because government spending creates
employment and increases economic activity in the economy and lower taxes means people
have more money to consume and firms have to pay lesser tax on their profits. On the other
hand, reducing government spending and increasing taxes will discourage production and
consumption, and unemployment and GDP will fall.

Taxation
• Governments earn revenue through interests on government bonds and loans, incomes
from fines, penalties, grants in aid, income from public property, dividends and profits on
government establishments, printing of currency etc.  
• But its major source of revenue comes from taxation. 
• Taxes are a compulsory payment made to the government by all people in an economy.
Classification of Taxes

Taxes can be classified into direct or indirect and progressive, regressive or proportional.

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Direct Taxes are taxes on incomes. The burden of tax payment falls directly on the person or
individual responsible for paying it. 

• Income tax: paid from an individual’s income. Disposable income is the income left after
deducting income tax from it. When income tax rise, there is little disposable income to
spend on goods and services, so firms will face lower demand and sales, and will cut
production, increasing unemployment. Lower income taxes will encourage more spending
and thus higher production.

• Corporate Tax: tax paid on a company’s profits. When the corporate tax rate is increased,
businesses will have lower profits left over to put back into the business and will thus find it
hard to expand and produce more. It will also cause shareholders/owners to receive lower
dividends /returns for their investments. This will discourage people from investing in
businesses and economic growth could slow down. Reducing corporate tax will encourage
more production and investment. 

• Capital gains tax: taxes on any profits or gains that arise from the sale of assets held for
more than a year.
Indirect Taxes are taxes on goods and services sold. It is added to the prices of goods and
services and it is paid while purchasing the good or service. It is called indirect because it
indirectly takes money as tax from consumer expenditure. Some examples are:

• GST/VAT: these are included in the price of goods and services. Increasing these indirect
taxes will increase the prices of goods and services and reduce demand and in turn
profits. Reducing these taxes will increase demand.

• Customs duty: includes import and export tariffs on goods and services flowing between
countries. Increasing tariffs will reduce demand for the products.

• Excise Duty: tax on demerit goods like alcohol and tobacco, to reduce its demand.

Monetary policy is a government policy that adjusts the interest rate and foreign exchange
rates to influence the demand and supply of money in the economy, and thus demand and
supply. It is usually conducted by the country’s central bank and usually used to maintain price
stability, low unemployment and economic growth.

Increasing interest rates will discourage investments and consumption, causing employment
and GDP to fall (as the cost of borrowing-interest on loans – has increased, and people prefer
to earn more interest by saving rather than spend). Similarly, reducing interest rates will boost
investment, consumption, employment, and thus GDP.

Supply-side Policies

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Both the fiscal and monetary policies directly affect demand, but the policies that influence
supply are very different. It can include:

 Privatisation: selling government organizations to private individuals- this will increase

efficiency and productivity that increase supply as well encourage competitors to enter and
further increase supply.
 Improve training and education: governments can spend more on schools, colleges and
training centres so that people in the economy can become better skilled and
knowledgeable, helping increasing productivity.
 Increased competition: by acting against monopolies (firms that restrict competitors to
enter that industry/having full dominance in the market) and reducing government rules
and regulations (often termed ‘deregulation’), the competitive environment can be
improved and thus become more productive.

*EXAM TIP: Remember that economic conditions and policies are all interconnected; one
change will lead to an effect which will lead to another effect and so on, like a chain reaction in
many different ways. In your exams, you should take care to explain those effects that are
relevant and appropriate to the business or economy in the question*

How might businesses react to policy changes? It will depend varying on how much impact the
policy change will have on the particular business/industry/economy. Here are a few examples: