Economic Environment in Practice: Inflation & Interest Rates (AQA A Level Business): Revision Note

Inflation

• Inflation is a sustained rise in the general price level of goods and services in an economy over time

  • It is measured in the UK using the Consumer Prices Index (CPI), published monthly by the Office for National Statistics

  • This index is based on average price rises of a typical 'basket of goods' purchased by UK households

Causes of inflation

Demand-pull inflation

• Demand-pull inflation occurs when total demand in the economy grows faster than the economy's ability to supply goods and services

  • It is often linked to low unemployment, low interest rates or strong consumer confidence

• Businesses can often raise prices without losing many customers, but this creates pressure to expand their productive capacity quickly

Cost-push inflation

• Cost-push inflation occurs when the costs of production rise, such as raw materials, energy or wages

  • Businesses pass these higher costs on as higher prices

• Profit margins are reduced if costs rise faster than businesses can increase prices

Recent trends

• Inflation fell during the 2020-2021 Covid-19 pandemic as household spending was significantly reduced

• It rose sharply during 2021 and 2022 as a result of supply chain pressures caused by the Russia-Ukraine conflict

• The introduction of a range of tariffs by the Trump administration in 2025 increased the rate of inflation, though their impact is easing

• The Bank of England has an inflation target of two per cent, set by the government

• UK inflation was 2.6 per cent in the twelve months to June 2026, down from 2.8 per cent the previous month

• Monthly inflation rose by just 0.1 per cent in June 2026, compared with a rise of 0.3 per cent in June 2025

  • The fall was mainly due to cheaper transport costs - especially motor fuel and diesel

• Inflation is gradually falling back towards the Bank of England's target, although services inflation remains relatively high

Benefits of low, stable inflation for business

• Costs and prices become easier to predict, helping businesses to more accurately budget and plan for the long-term

• Wage demands from employees are lower, reducing the pressure on labour costs

• Businesses find it easier to commit to long-term investment, as the future value of returns is more certain

Challenges of high inflation for business

• Costs of raw materials, energy and wages rise, reducing profit margins

• Consumers have less real disposable income, which can reduce demand, particularly for non-essential goods

• Forecasting costs and revenues becomes more difficult, making financial planning less reliable

• Employees push for higher wages to protect their real income, risking higher labour costs or industrial disputes

• Rising inflation is not always felt evenly across a business, as some suppliers or cost categories rise faster than others

Example

A restaurant chain may choose to hold its prices steady to protect customer numbers, even as the cost of food ingredients and staff wages continues to rise, leaving it with significantly lower profit margins on each sale

Impact on functional areas

Interest rates

• Interest rates are the cost of borrowing money, or the reward for saving it, usually expressed as a percentage of the amount borrowed or saved

• In the UK, the base rate is set by the Bank of England's Monetary Policy Committee (MPC) which meets roughly eight times a year

  • The rates charged by commercial banks on loans, mortgages and savings are heavily influenced by the base rate

Interest rates and inflation

• Higher interest rates make borrowing more expensive and saving more attractive

• This has a knock-on effect on spending

  • Mortgages and loans become more expensive

    • People with variable-rate mortgages or loans see their repayments rise, leaving less spare cash to spend on goods and services

  • Saving becomes more rewarding

    • With better returns on savings, people are tempted to save rather than spend

  • Borrowing to spend becomes less appealing

    • Credit cards, car finance and other borrowing cost more, so people take out less of it

• With less money circulating and being spent, demand for goods and services falls

  • When demand falls, businesses have less room to keep raising prices so inflation slows down

• This is why the Bank of England raises interest rates when inflation is too high, and cuts interest rates when the economy needs a boost

Recent trends

• The Bank of England base rate was held at 3.75 per cent in July 2026, having been cut from four per cent in December 2025

  • Services inflation was persistently high at 3.7 per cent, so a future base rate rise is likely

  • However, some economists forecast the base rate could fall further, towards 3.25 per cent by the end of 2026, if inflation continues to ease

• Mortgage interest rates fell from around 4.65 per cent in early 2025 to 4.22 per cent by mid-2026

  • This remains high by recent historical standards and continues to reduce household spending power

The impact of a change in interest rates

Revenue

• Rising rates reduce consumers' disposable income, as mortgage and loan repayments increase, lowering demand for many goods and services

• Falling interest rates tend to boost consumer spending and revenue

Costs

• Rising rates increase the cost of paying back loans, overdrafts and other variable-rate borrowing, reducing profit

• Businesses holding significant debt are affected most

Business decisions

• Higher rates discourage investment in new equipment, premises or expansion, as borrowing is more expensive and the risk of committing to repayments increases

• Businesses may delay capital investment projects until rates fall

Sector-specific challenges

Business responses to changes in interest rates

• Businesses may switch to fixed-rate borrowing

  • They aim to protect themselves from further rate rises and improve certainty over future costs

• Capital investment, such as new premises or equipment, may be postponed until borrowing costs fall

• Some businesses prioritise paying down existing debt over expansion

  • This reduces their exposure to interest rate changes

• Where possible, businesses may pass on higher borrowing costs to customers through price increases

  • However, this risks reducing demand further