The Impact Of Rising Prices

Published Date: 02 Nov 2017

Abstract

The topic that has been chosen for conducting this dissertation is ‘Interest rates direct impact on the businesses’.

Interest rate being defined as cost of borrowing money is integral part of any economic system around the globe. It is sometimes treated as a variable to control or influence other variables in the macro economy to achieve the desired results. The activity of the interest rate can be found at any level with a supplier relying on overdraft amount from the bank to supply to its customer on credit, with customer paying through its overdraft account, with business investing money in the savings account of the business, with near end of retirement people investing their amount in pension funds every transaction encompass at some level the effect of interest rate.

The topic has been divided into a series of parts so as to make a coherent approach in developing the dissertation. The following parts along with a brief explanation, makes up with this dissertation.

Introduction: The dissertation begins with providing an introduction about the topic and a brief insight as to the explanation of this topic and its possible implications. For instance, the role of the central bank has been explained which controls the money supply, which in turn is the key influencer of the interest rate. Likewise, the definition of the interest rate has been provided. Further, a relation has been developed between the interest rate changes and its possible implications on the business expenses. The Introduction is finally concluded with a brief explanation of the economic theories in relation to the dissertation.

Literature Review: The next segment focuses upon the use of the work on the economic theories in relation to the topic. This include the commenting and explaining the work of AW Phillips who created the theory of Phillips Curve and making use of other economic concepts like Wage-price spiral. These theories has been discussed in detail and in the end of this segment is related to the topic so as to create relevance of the use of theories in this dissertation.

Further, the impact of this topic is also considered in categorization of the different types of businesses such as manufacturing and retail types of businesses so as to develop a better understanding of the possible implications of this topic to every kind of businesses.

Methodology and analysis: This part of the dissertation focuses upon the use of primary data gathered to comment upon this topic along with the positive and negative implications of making use of primary data. Types of analysis would include looking into macroeconomic insights (such as discussing the impact of interest rates on GDP and GNP), before giving a deeper insight into industry specific analytics. Finally, using this analysis it would be judged whether if and to how extent the changes of interest rate effect the business expenses.

Conclusion: The final part of the dissertation is concluded with providing a conclusion, whose basis would be based upon the material used in preparing the literature and methodology and analysis section of this dissertation. There would be arguments presented in a summarized form at the end to give a snap shot of the entire workings in the dissertation as this would help the readers too to facilitate while reading this dissertation.

Introduction

The Central Bank is considered to be the main pivot cog that regulates the money supply in the country. Forex traders defines Central Bank as a financial institution charged with the responsibility to manage the regularity of the size of a nation’s money supply, the management of providing credit and at the same time keeping a check on the foreign exchange value of its currency. (Forextraders.com, 2012)

The roles of the central bank however vary from country to country but all that had in common includes the addressing of the issues such as:

The extent of the central bank’s ability to design policy and to implement these policies. They would also cover addressing issues which includes determining the exchange rate policy and the setting of the objectives that includes both monetary and exchange rate policies.

The extent of the central bank’s ability to hold the responsibility for the financial stability of the whole country. This would include addressing the questions as to the instruments available at its disposal to discharge its responsibilities.

How the central bank did would ensure a balance between the various infrastructure systems that are the pillars to support the payments and the settlement systems.

What are the other financial and non-financial functions that would fit with the overall monetary and fiscal policy and the financial stability task? (David Archer, 2012)

To demonstrate a real life example, I am illustrating the scope and function of the Central Bank of England.

The Bank of England purpose is to ensure the provision of monetary stability and to contribute towards the financial stability of the country. (Bank of England, 2012)

Among these objectives two main core purposes have been established that addresses each of the purpose mentioned above.

Monetary Stability:

Monetary stability, as the name denotes, represents the stability of the price level within the country along with maintaining focus on keeping the confidence in the currency. The price levels/ targets are set by the Government’s inflation target which then the Bank work towards the meet those target explaining the efforts made towards reaching that goal and communicating it transparently in the money markets.

Financial Stability:

This aspect looks at the protection of the overall financial system which includes the Bank’s financial and other operation including acting as a lender of the last resort.

In attaining both of these objectives the central bank work closely with other central banks, international organizations, HM Treasury and the Financial Service Authority which has to be pursued under the terms of the Memorandum of Understanding, to pursue financial stability. (Bank of England, 2012)

Interest rates are considered to be an important economic tool to achieve the desired government objectives. The Central Bank may influence the supply and demand of the.

Investopdeia describes interest rates as ‘ the amount charged, expressed as a percentage of principal, by a lender to a borrower for the use of the assets (i.e. cash).’ (Investopedia, 2012a)

The rationale behind charging the interest rate is to compensate the lender for the loss of the asset’s use or the opportunity cost of not using the money he has.

Businesses are interlinked with the changes in the economic environment of the country in which they operate. Changes at the economic level could either impact them directly or indirectly depending upon how much the activities of the business are tied up with that particular economic indicator and how it responds to a change in its level.

Likewise, changes in the level of interest rate have direct and indirect impact upon the business. The interest rates however, have the largest impact on long term businesses where investment income forms the major portion of the earnings for a business. (Swiss Re, 2012)

When correlating the relationship between the interest rate changes and its impact on the business expenses, it is important to distinguish of which of the business expenses are affected directly and which would be affected indirectly.

International Accounting Standard 23 defines finance costs as ‘interest and other costs that an entity incurs in connection with the borrowing of funds’. (Ready Ratios, 2013)

The finance costs therefore includes the interest expense on the loans taken out by a company and includes other items which consists of finance charges on the finance lease, exchange differences etc.

On the other hand there may be instances where finance costs could be associated with capital expenditures being undertaken by the businesses. Generally, the companies tend to pursue growth by spending on capital expenditures to improve their fixed assets turnover for the current business or to avail an opportunity to exploit new profitable market segments. Whatever the reason maybe for growing it is evident that the companies tend to pursue a combination of debt and equity to incur the least cost of capital, which would ultimately leads to higher profits from the project being undertaken.

The interest rate therefore plays an important role in determining the outcome of the investment project and how it can influence the finance costs of such projects.

Non finance costs could be described as expenses incurred on the activities which exclude the financing of the business.

They would therefore encompass every sort of expenditure which the company would be undertaking other than that of the finance costs.

Interest rate change, has an indirect impact on the non finance costs as determined by the following para:

In relation to the wholesale prices in Hamburg and England and rate of interest in the central banks and on the open market in Berlin and London, Wicksell wrote that, ‘it must be admitted that if it is possible to discover any connection between them all, it is that a high rate of interest is associated with high commodity prices and a low rate of interest with low commodity prices, rather than the other way round. Faithful to the principle we established earlier, however, we are not going to let ourselves be put out by this circumstance but, for the time being, we shall test the theory itself on grounds of logic’. (Wicksell, 1898, p.78)

This quotation from Wicksell clearly indicates a positive correlation between rate of interest and the inflation rate, which is now referred to as Gibson’s paradox.

The Gibson’s paradox can be illustrated with an example to exactly know how this relation between interest rate and the inflation rate is developed.

Consider a company producing food products. The company finds a need to expand or to finance its working capital requirements to meet its liabilities as they fall due, in search for the sources of finance, the company approaches a bank and enters into a loan with a variable interest rate.

The loan is payable over a period of, for instance, five years. The company uses the loan facility to finance out its working capital requirement or to undertake the investment projects. In some time, interest rate rises and so does the cost of borrowing for the company. With keeping ceteris paribus constant, the company passes of this increase in cost of borrowing towards its increased sales price (as we assume that company wants to maintain constant gross profit margin). The result is that, the increase in interest rates are passed out in the form of increased prices for the commodities hence, resulting in inflation.

The impact of rising prices as mentioned above does not restrict to only this situation, consider the macroeconomic theory of ‘wage-price spiral’.

(A short explanation for some macroeconomic models, that would be used in this dissertation, are mentioned below, just to demonstrate how inflation impacts different aspects of business, although a more detailed explanation would be provided in the literature section)

According to investopedia, ‘wage-price spiral’ explain the cause and effect relationship between rising wages and rising prices, or inflation. (Investopedia, 2012b)

Also called cost push inflation, the general idea behind wage spiral is when inflation has increased the general price level of commodities the union, generally powerful worker’s union, claim to compensate the increased price levels in the form of increase wages as to maintain the current level of real income.

If the wages are increased the, increased costs to the company is passed down in the cost of production and assuming that the company keeps constant gross profit levels, the prices of commodities are increased again. Worker’s would again demand a rise in pay to compensate the increase price levels and so this ‘spiral’ continues to grow.

Another macroeconomic theory, called Phillips curve could be used to demonstrate the relation between unemployment and the inflation rate.

Study of A.W. H. Phillips’s in relation to unemployment and inflation has found that there is an inverse relationship between the inflation and the unemployment rate. When the unemployment rate is high, the inflation rate is low and when unemployment rate is low, the inflation rate is high.

Chapter 4

Analysis

The previous sections have paved the way for a comparative analysis that examines both macro level indicators and industry-specific circumstances for each country. This section will attempt to answer the five hypotheses laid out in the previous chapter and comment on the findings and possible implications of the results. Each hypothesis will be discussed below.

4.1 Hypotheses Testing

4.1.1 Hypothesis 1: A positive correlation exists between level of interest rate and the level of inflation rate.

In the previous sections we have considered the possibility that the different theories such as Phillips Curve and the wage price spiral were used to consider the type of relationship between the level of interest rates and its influence on the inflation rate, the study undertaken as follows has been used to consider that whether it continues to support this fact or not. The hypothesis therefore arises from the fact that the ongoing debate of whether there exists a positive relation between the interest rate and the inflation rate.

To answer this we have considered the consumer price index and the interest rate level of three developed and three developing countries in order to judge whether the interest rate do impact the general price level of the businesses present in these countries.

Country

CPI in % (Annual average Inflation rate)

Average Interest Rate %

Correlation Coefficient

2008

2009

2010

2011

2008

2009

2010

2011

2008 - 2011

Canada

2.37

0.31

1.78

2.91

3.00

0.57

0.60

1.00

0.83

UK

3.61

2.17

3.29

4.48

4.60

0.80

0.50

0.50

0.67

USA

3.85

-0.34

1.64

3.16

2.10

0.25

0.25

0.25

0.82

China

5.97

-0.72

3.17

5.53

7.00

5.30

5.40

6.35

0.85

Brazil

5.67

4.90

5.04

6.63

12.47

10.25

9.85

11.75

1.00

Turkey

10.43

6.28

8.85

6.45

15.90

9.65

6.80

6.00

0.96

Table 1: Correlation Coefficient between CPI and Interest Rates

The consumer price index indicates the increase in the general price level of commodities, which in turn makes it a measure to gauge inflation. If the consumer price index is positive it depicts that there is increase in inflation which in turn would increase the price of different inputs used by business to operate, these different inputs could range from the raw material prices to the wage of labor and may also impact to increase the rent paid by the companies. Thus, while considering the citrus paribus to remain constant, an increase in Consumer Price Index (CPI) would lead to increase in business expenses.

While examining the data provided in the table it can be observed that the interest rate for every country has fallen after 2008 and this has also led to a fall in the consumer price index as well, it therefore establishes that there is a positive correlation in the year from 2008 to 2009. However, as we consider the year 2009 and 2010 this relation seems to get different for each country, where some countries such as Canada and China showed a positive relationship between the two variables at the same time there were some countries like UK, Brazil and Turkey that experienced negative correlation between the two variables while USA showed a completely different picture for where its interest rate stood at 0.25 % constant from 2009 but its CPI have increased from -0.34% in 2009 to 1.64% in 2010. In 2010 till 2011 period, this odd instance of increase in CPI while interest rate being constant has been experienced by USA as well as by the UK. This might establish the reason that interest rate do have a medium to long term impact and is not a macroeconomic measure that could be used to attain short term objectives, unless if there is a significant change in the level of interest rates. Other countries like Canada, China, Brazil and Turkey all witnessed a positive correlation during the period from 2010 till 2011.

The overall correlation for all these countries over the period from 2008 till 2011 have all shown a positive correlation while Brazil reported an absolute positive correlation during this period, followed by Turkey which also almost reached the level of absolute positive correlation. The correlation coefficient for Canada, USA and China were all in the range of 0.85 while the figures for the UK were the lowest standing at 0.67, showing the least correlation of all the countries selected.

It therefore brings us to the fact that there exists a positive correlation, if not absolute positive correlation, between the level of interest rate and the level of inflation rate which in turn influences the level of business expenses being incurred by different organization in the economy irrespective of whether they are in the primary sector of industry or the secondary or the tertiary sector of the economy.

4.1.2 Hypothesis 2: Interest rate movements have differing impact on developing economies rather than developed ones.

As stated earlier the impact of interest rate changes may affect the developed and the developing differently due to different economic features both types of countries contain. While developed countries being considered better off in every way (such as reduced unemployment rate, inflation rate and better GDP growth than the developing countries) might be the reason that the business in both these countries may differently feel the impact of interest rate changes on their operations and expenses.

Country

Labor costs (Index points)

Average Interest Rate %

Correlation Coefficient

2008

2009

2010

2011

2008

2009

2010

2011

2008 - 2011

Canada

120.00

122.45

123.40

126.00

3.00

0.57

0.60

1.00

0.78

UK

95.80

100.00

101.60

102.00

4.60

0.80

0.50

0.50

0.66

USA

108.30

106.50

105.30

107.60

2.10

0.25

0.25

0.25

0.67

China

120.00

122.00

130.00

115.00

7.00

5.30

5.40

6.35

0.99

Brazil

123.00

124.00

142.00

164.00

12.47

10.25

9.85

11.75

0.99

Turkey

143.00

141.00

164.00

187.00

15.90

9.65

6.80

6.00

0.89

Table 2: Correlation Coefficient between Labor Costs (Index points) and Interest Rates

The table above considers the labor costs in terms of index points and the average annual interest rate for each country.

Before we move on to consider the impact of changes in interest rate upon the labor costs index of the developed and developing economies, from the previous hypothesis we have already reached the conclusion that there is a positive correlation between the level of interest rate and the consumer price index of all the six developed and developing countries.

However, if we refer back to the previous table in the previous hypothesis it could be seen clearly that the correlation is stronger in case of developing rather than the developed countries. Taking out the average for the correlation coefficient for the three developed countries it comes to 0.94 as opposed to 0.77 of the coefficient that pertains to that of developed countries.

We have to consider this and test further to ascertain that whether the interest rate can influence the labor costs to the in the same way and to the same extent when the changes in interest rates were correlated against the Consumer Price Index (CPI).

The period 2008 to 2009 saw a decline in interest rate and mixed trends were observed between all the six countries. The labor cost index for the Canada, UK, China and Brazil increased whereas that of Turkey and USA decreased. In 2009 to 2010 the labor costs index for all countries increased except for that of USA in relation to the mixed interest rate trend observed and in 2010 to 2011 saw the experience of the same trend as that of in the previous period where the labor costs index for all countries except for China increased in relation to generally declining and constant interest rate policy being introduced by the six countries.

The result however in the end showed a positive correlation between the interest rate level and the labor costs index which explains that there exists a positive correlation between not only the interest rate and the Consumer Price Index (CPI) but also between the interest rate level and the labor costs index too.

It is interesting to note that the correlation being observed between the interest rate and the labor costs index is almost absolute positive correlation reaching to 0.99 as opposed to less correlation being observed for the three developed countries the average of which reaches makes up 0.70.

This not only supports the previous hypothesis conclusion that the correlation observed between the interest rate and the CPI is the same as the correlation observed between the level of interest rate and the labor cost index but the correlation movement is more significant in the later case for the developing economies as compared to that of the developed ones. This further proves that the level of interest rate changes do quickly reflect in the labor costs at all levels of the industry sector of the developing countries where for developed countries it takes less than proportional increase in the labor costs.

4.1.3 Hypothesis 3: Interest rate is the most dominating macroeconomic factor that influences the level of business expenses.

This hypothesis is in direct relation to the topic of the dissertation and considers the possibility that the interest rate only is the source of change that may influence the business by influencing the expenses they incur. While the interest rate are described as cost of borrowing money, this hypothesis considers that the influence of interest rate is greater than other macroeconomic indicators like inflation rate on the business expenses or not.

(In this dissertation the labor costs has been considered as one of the most important expense for any business. The reason being that in any type of business there would be labor involved which would constitute to be the variable cost for any business. The wages are often linked in line with the profits earned by businesses where the employees are provided with bonus when a company achieves a higher level of profits or the company might implement the profit participation policy. While being considered as variable costs, the wages provide a more logical expense item to be considered since it is directly linked with the level of production and hence provides a more rational representative expense among the other variable costs incurred by businesses. Further, a better expense item would have been the expenditure made on the purchase of raw material and semi finished goods but due to the limitation of data not being available, the next best option has been considered i.e. labor costs)

Country

Correlation between Interest rate and the Labor cost index

Correlation between CPI and Labor costs Index

Correlation between Unemployment rate and Labor costs Index

Correlation between Unemployment rate and CPI

Correlation between Interest rate and unemployment rate

2008 - 2011

2008 - 2011

2008 - 2011

2008 - 2011

2008 - 2011

Canada

0.78

0.89

0.99

0.85

0.72

UK

0.66

0.97

0.99

0.96

0.58

USA

0.67

0.80

0.98

0.70

0.52

China

0.99

0.78

0.99

0.79

0.97

Brazil

0.99

1.00

0.97

0.98

0.99

Turkey

0.89

0.96

0.97

0.97

0.94

Table 3: Correlation Coefficient between different macroeconomic indicators

The table above considers three macroeconomic factors comprising of the interest rate, inflation rate and the unemployment rate and their correlation with the labor cost index.

While we have considered the correlation between the interest rate and the labor cost index we would be looking at the remaining two macroeconomic factors i.e. the Consumer Price Index and the unemployment rate.

While looking at the correlation between the consumer price index and the labor costs, the average correlation of all six countries is greater than that of the average correlation of interest rate and labor costs index. Although it is interesting to note that there was a similar relation being observed in terms of correlation when Interest rates were compared with labor cost index as opposed to when CPI was compared with Labor cost index. This is depicted from the fact that the correlation between the CPI and labor cost for China stood at 0.78 while for Brazil and Turkey stood at 1 and 0.96 denoting almost an absolute positive correlation. Similar odd instance was noted for USA where its correlation coefficient was the lowest among the all three standing at 0.8 where that of Canada and UK stood at 0.89 and 0.97.

The correlation between the labor costs and the unemployment rate shows almost an absolute positive correlation for all the six countries. However, this would be incorrect to state that the unemployment rate is the macroeconomic factors that dominate among others to influence the level of business expenses being incurred.

The reason being that unemployment rate in turn directly impact one business expense i.e. wages, we would have to consider the factor that would be most influential of the three considered here.

That leaves us with the choice of interest rate and the inflation rate. To reach a conclusion we need to consider the level of correlation between the interest rate and the inflation rate, between the inflation rate and the unemployment rate and between the interest rate and the unemployment rate. Since we have already considered that the unemployment rate is not the most influential factor of all, therefore which ever correlation i.e. of interest rate or inflation rate is higher in relation to unemployment that factor would be the most influential of all on the expenses incurred by the business.

The average correlation for all the six countries is more stronger in the case of considering unemployment rate with inflation rate as compared to unemployment rate being compared with interest rate, therefore by considering this data it could be said that it is inflation that has a more dominating influence on the level of business expenses rather than the interest rate.

Although, this area could further be researched upon to determine which of the macroeconomic factor has a dominating influence upon the business expense level of an organization.

4.1.4 Hypothesis 4: The 2008 financial crisis affected the business in the developed economies more than developing ones.

This hypothesis considers impact that the recent financial crisis had upon the level of interest rate and the therefore the level of business expenses being incurred by business.

(The level of business expenses is considered by looking at the level of returns being provided over the years by the businesses in the six countries being considered. With increasing profitability could only be due to two reasons, first the increase in the overall activity and hence production and sales by the business which would be reflected upon in the GDP of the economy and the second reason would be the operational efficiencies in controlling the costs incurred by the business. Therefore by keeping GDP constant for instance and assuming that the businesses continues to provide same level of returns, the increase in returns would be associated with reduction in business expenses being incurred)

The 2008 financial crisis led to many countries around the world seeing their stock markets (and economies) plummets to double-digit negative figures. The crisis caused foreclosures of many financial institutions, including Lehman Brothers, one of the biggest names in the financial services industry.

The main tool for this analysis is an evaluation of social as well as macro-level indicators. This is due to the fact that while macro indicators such as GDP show the economic side of the picture, the impact on an individual is best measured through social indicators. The analysis includes comparing the Human Development Index ‘standard of life’, (see table 7, below) a tool that encompasses several areas that define the social environment of a country.

Table 6: HDI Values

Human Development Index (HDI) value

2008

2009

2010

2011

China

0.665

0.674

0.682

0.687

Brazil

0.716

0.719

0.726

0.728

Turkey

0.704

0.709

0.715

0.720

Canada

0.909

0.907

0.909

0.910

United Kingdom

0.86

0.86

0.862

0.863

United States

0.907

0.906

0.908

0.91

Table 4: Human Development Index for selected countries

As is evident from the table, there is a substantial difference between the values for developed and developing markets, with Brazil being the closest to developed markets (its HDI value being just 0.144 points lower than the UK).

We can see from the analysis that the 3 yr growth rate remains constantly positive for all of the developing markets. This is in contrast to values for developed countries, which have either declined or seen constant results, especially between 2008 and 2009. While one could argue that the level of saturation reached by these economies would mean only large changes in values could increase the HDI, it can also mean that core components of the wider society - such as GNI and standard of living - were more affected in the developed nations from 2008-09.

Another important analysis tool is the Gini index. This is simply the measure of income inequality, and therefore, a higher number represents inadequate form of income distribution. The Gini index for 2011 is shown below.

Table : The 2011 Gini Index

Gini Index

2011

China

42.7

Brazil

55.9

Turkey

39

Canada

32.6

United Kingdom

36

United States

35

Table 5: Gini Index for selected countries for 2011

This figure shows a slightly more equivalent picture of social development than compared to HDI. Here China has a better result than the United States, and is very close to the other developed markets. Read in conjunction with other data on social development, the results show a suitable positive change in the social development result for emerging markets.

The results from this table, as well as the results obtained from Hypothesis 2, somewhat enable us to concur with the findings of Bano (2011) that index based returns generated higher volatility for developing markets and in fact, showed a significant decline in 2008-09, the social indicators displayed a consistent rise towards betterment.

In addition, the reduction in numbers itself cannot suitably be reason enough to conclude that a particular hypothesis is valid. For instance, an important component of HDI is the standard of living, measured by taking the natural log of per capita GDP at purchasing power parity (PPP). Assuming that the close down of businesses themselves lead to deflation, as GDP per capita drops, so would PPP and therefore the results may remain consistent or even improve, despite the actual living conditions having worsened or stayed the same. Also, other aspects of HDI (such as life expectancy and adult literacy) are based on medical and educational advances made over a long period of time. Eventually adopting these advancements may cause the HDI to rise quicker for developing nations and show growth that surpasses developed economies, but, for example, this does not mean the developed markets do not already possess these medical facilities.

The lack of data on past Gini results would hamper the findings for growth on social development components here. However, another key component of evaluating the impact on an economic scale is the GDP. Using GDP comparisons (as shown below), it is possible to see the change in trends in the six economies from 2008-2011.

Figure 4: GDP Growth (2008-2011)

Figure 5: Real GDP growth (%) for selected countries

The trend in the figure above shows how most of the developed economies fell during 2008-09. This is a natural movement; considering that most of the crisis took shape in 2008, the impact reflected on the numbers for 2009. It is interesting to note, however, that recovery was rather fast-paced with all of the three developing countries reaching positive growth indicators back in 2010, despite drops as low as -4.7% (Turkey).

Surprisingly, 2009 was a year of favorable growth for nearly all three of the emerging markets, with China consisting on 2008’s growth rate of 9% with 9.1% growth, a strong positive result. This could be explained due to reduction of interest rate which increased the money supply with in the country allowing more production to take place. Subsequent years show a more normalized rate for developing markets, and a boost for developed markets returning to business.

However, portfolio returns during the period 2008-09 were higher (mainly due to the decrease in the average interest rates and increase in the unemployment rate for all six countries allowing the production activities to pick up more quickly) for markets in developing regions as compared to others. By the set of results above, it is possible to say that there is some evidence explaining how the financial crisis affected developed markets more than emerging ones.