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Inflation, exchange rates and interest rates

Edexcel IAL Business · WBS12 Managing business activities

Businesses cannot control the economy, but changes in inflation, exchange rates and interest rates affect their costs, prices and sales. You need to trace the effects through to cash and profit.

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Inflation

Inflation is a sustained rise in the general price level, measured as a percentage change per year.

Costs rise: materials, energy and wages (workers want pay rises to protect their real income).
Firms may pass costs on as higher prices, but this depends on competition and price elasticity.
Customers' real incomes may fall, reducing demand for non-essentials.
Planning is harder because future costs and prices are uncertain.
High inflation compared with other countries makes exports less competitive.

Some firms gain: those with strong brands, or those whose prices rise faster than their costs.

Exchange rates

The exchange rate is the price of one currency in terms of another.

Appreciation (currency rises): exports become dearer abroad, so export sales may fall; imports become cheaper, so firms buying imported materials see lower costs.
Depreciation (currency falls): exports become cheaper abroad, helping exporters; imported materials become dearer, raising costs.

Use SPICED: Strong Pound (currency) Imports Cheap, Exports Dear.

Foreign-currency price = home price x exchange rate (foreign currency per unit of home currency).

	At $ 1.25 per £1	At $ 1.4 per £1
£40 UK product sold in the US	$50.00	$56.00

An appreciation of the pound makes UK exports dearer in dollars

Interest rates

The interest rate is the cost of borrowing and the reward for saving, set in many countries by the central bank.

When interest rates rise:

Loan and overdraft costs rise, cutting profit and cash flow, especially for highly borrowed firms.
Investment projects become less attractive.
Consumers face higher mortgage and credit payments, so demand falls, especially for goods bought on credit (cars, furniture, holidays).
Saving becomes more attractive, reducing spending.
The currency may appreciate, hurting exporters.

Cuts in interest rates have the opposite effects.

Worked example

A UK firm sells a product for £40 in the US. The exchange rate rises from $1.25 to $1.4 per pound. Find the change in the dollar price and explain the impact.

Old dollar price = 40 x 1.25 = $50.00
New dollar price = 40 x 1.4 = $56.00
Increase = $6.00, or 12%
US customers may buy less unless the product is unique; the firm could cut its pound price to hold the dollar price but would lose margin.

Answer: The dollar price rises by 12% to $56.00, so export sales may fall.

Key idea: Inflation raises costs and cuts real incomes. Appreciation: exports dearer, imports cheaper; depreciation: the reverse. Higher interest rates raise borrowing costs and reduce consumer spending.

Check yourself

A product costs 50 euros. The exchange rate is 1.10 US dollars per euro. What is the price in dollars?
Show answer
$55.00. 50 x 1.10 = $55.
A firm imports a component priced at $240. The exchange rate is $1.20 per euro. What does the component cost in euros?
Show answer
200 euros. 240 / 1.20 = 200 euros.
A component costs $300. The euro falls from $1.25 to $1.00. By how many euros does the cost of the component rise?
Show answer
60 euros. Before: 300 / 1.25 = 240 euros; after: 300 / 1.00 = 300 euros; rise of 60 euros.
A business has a $200,000 loan. The interest rate rises from 5% to 6.5%. By how much do annual interest payments rise?
Show answer
$3000. 200,000 x 0.015 = $3,000 a year.
Annual material costs are $80,000. Inflation for these materials is 7%. What will they cost next year?
Show answer
$85600. 80,000 x 1.07 = $85,600.
An appreciation of a country's currency is most likely to benefit
- a firm that exports most of its output
- a hotel relying on foreign tourists
- a domestic firm competing against imports
- a firm that imports most of its raw materials
Show answer
a firm that imports most of its raw materials. Imports become cheaper.
A rise in interest rates is most likely to reduce demand for
- bread
- new cars bought on credit
- toothpaste
- bus tickets
Show answer
new cars bought on credit. Big purchases financed by borrowing are most sensitive.
Explain one way inflation can affect a business.
Show answer
Inflation raises the firm's costs, such as wages and materials; if it cannot pass these on in higher prices, its profit margins fall.. Rising costs, falling real incomes and demand, or harder planning.

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Sources

Pearson Edexcel International Advanced Subsidiary/Advanced Level in Business specification (2018)

Last updated 8 November 2026. Spotted a mistake? Tell us.