Business Confidence: Its Effect on Aggregate Demand and the Economy

What’s it: Business confidence describes how optimistic or pessimistic businesses are about their current and future operating and financial conditions. Several factors influence it, including economic conditions, consumer confidence, demand, and operating conditions.

Business confidence is an important indicator because it affects the economy. For example, it influences a business’s decision to invest. If businesses are optimistic, we expect them to invest more in capital goods. An increase in investment increases aggregate demand, pushing the curve to the right. As a result, the economy grows higher and produces more output.

In addition to investing in capital goods, businesses increase recruitment to increase output. Thus, the unemployment rate also falls because there are more jobs available. Finally, higher economic growth improves household income and employment prospects.

Such a situation makes households more optimistic. As an effect, they are willing to spend more money on consumption expenditure. This condition ultimately encourages them to increase demand for goods and services. As a result, aggregate demand grew stronger, allowing the economy to continue to expand.

What are the factors affecting business confidence?

Several factors affect business confidence, including:

• Consumer confidence
• Interest rate
• Exchange rate
• Tax
• Increase in input price
• Economic policy

Consumer confidence

When consumers are pessimistic about their income and employment prospects, they cut back on spending, lowering the demand for goods and services. Conversely, if they are optimistic, they increase spending. Finally, consumer confidence trends affect businesses’ confidence in their profitability.

In addition, consumer optimism influences business decisions about whether to increase production by utilizing existing capacity or investing. If consumers are more confident than in previous months, businesses are more optimistic about future demand and profit. Finally, they started investing by ordering capital goods.

Interest rate

Aggressive interest rate increases cost when businesses borrow to finance investments. For example, they must pay higher coupons when issuing bonds.

In addition, high-interest rates also discourage consumers from buying goods and services such as cars, houses, and furniture. Again, it is because they often rely on loans or buying on credit for such items. Hence, it weakens demand for such items. 

Exchange rate

The sharp exchange rate appreciation makes domestic goods uncompetitive in foreign markets as they become more expensive, causing export sales to fall. But, it also makes imports cheaper.

Meanwhile, sharp depreciation increases cost when companies import raw materials or capital goods as they become more expensive. But, for exporters, their goods are more competitive in foreign markets because they are cheaper, potentially increasing demand.

Tax

An increase in taxes reduces the money available for investment. Businesses must set aside more profits to pay taxes, thus, less retained earnings.

The tax increase also lowers the households’ disposable income, prompting them to reduce consumption. As an impact, the demand for goods and services decreases.

Increase in input prices

For example, an increase in oil prices increases production costs. As a result, inflation skyrocketed and caused household purchasing power to fall. This situation could lead to stagflation, as is the case now and in the 1970s.

Stagflation is a policymaker’s dilemma because it cannot be overcome through monetary or fiscal policies. Both are ineffective because the problem comes from the supply side. Meanwhile, both policies affect the demand side.

Economic policy

Uncertainty about policy direction makes it difficult for businesses to write business plans. In fact, they consider the economic policy stance to predict where the economy will move in the next year.

In addition, pessimism can also arise if policymakers take steps beyond market expectations (this does not mean the market dictates to policymakers). For example, the central bank raises interest rates too aggressively.

How does business confidence affect aggregate demand and the economy?

What is aggregate demand? It is the total expenditure in the economy by the four macroeconomic sectors: households, business, government, and foreign. We add household consumption, business investment, government spending, and net exports.

• Aggregate demand = Consumption + Investment + Government spending + Net exports

In short-run macroeconomic equilibrium, an increase in aggregate demand shifts the curve to the right. As a result, real GDP increases. Conversely, a decrease in aggregate demand shifts its curve to the left, resulting in a decrease in real GDP.

An increase in real GDP indicates the economy is growing and producing more output. Conversely, a decline means the economy is contracting, producing less output.

Changes in real GDP have far-reaching impacts. For example, it affects the unemployment rate and the inflation rate. For example, an increase in real GDP decreases the unemployment rate as more jobs become available. And it also results in increased upward pressure on the price level, driven by increased demand. Conversely, the opposite effect applies when real GDP falls.

So how does aggregate demand relate to business confidence?

Business confidence influences their decision to utilize existing capacity and invest. For example, when businesses are optimistic, they invest. On the other hand, if they are pessimistic, they reduce their investment. These changes in investment ultimately affect aggregate demand, as shown in the above equation.

Business is pessimistic

Businesses are pessimistic about their business and financial performance because they see household demand worsening. This situation encourages them to postpone investment. Instead, they take efficiency measures.

In the early stages, businesses may simply cut hours and freeze hiring. They also canceled orders for capital goods such as heavy equipment and still bought light equipment to support efficiency.

But, if demand falls further, they take more stringent efficiency measures. As a result, they started laying off workers. In addition, they reduce investment spending, both for light equipment and heavy equipment. As a result, aggregate demand declines as investment falls. This situation could get worse and lead the economy into a recession.

Business is optimistic

When businesses are optimistic, businesses are more confident. They expect the demand for their products to increase. So they took a plan to increase production.

Initially, they may not have recruited new workers and invested in capital goods. Instead, they rely on existing production facilities and workers. Moreover, they maximize production to near full capacity, for example, by increasing overtime hours.

For households, this situation improves their job and income prospects. For example, layoffs decreased because businesses needed their services to increase production. Instead, they earn additional income by increasing working hours. As a result, households increase their demand for goods and services because they are more optimistic about their future.

Stronger demand makes businesses more optimistic. They see an opportunity to earn more profit by increasing production. For this reason, they start recruiting new workers and investing in capital goods. Consequently, the unemployment rate declines, and household income grows more strongly, increasing aggregate demand further.

Long story short, increased investment encourages further economic growth by lowering the unemployment rate and improving household income. That allows the economy to sustain expansion.

In addition, investment also increases the capital stock in the economy. Thus, the economy has a higher production capacity to produce goods and services. As a result, potential output (or potential GDP) increases.

How to track business confidence?

Some countries introduce a business confidence index. You can get the data on sites like OECD, tradingeconomics.com, or economy.com.

The index describes businesses’ confidence in their current and future business and financial performance. The data is collected through surveys and processed using the net balance method.

How to read it? Generally, numbers above 100 indicate optimism. Conversely, a reading below 100 indicates pessimism.

What variables are tracked to represent business confidence? It can vary between countries depending on the method and approach taken. For example, in India, it tracks information about:

• Overall business situation
• Production
• Booked order
• Raw material inventory
• Finished goods inventory
• Profit margin
• Employment
• Export
• Capacity utilization

In Japan, the index is formed based on information about:

• Business conditions
• Sale
• Current profit
• Domestic demand
• Overseas demand
• Selling price 
• Input purchase price
• Inventory level (raw materials and finished goods)
• Financial position
• Utilization of production and sales facilities
• Number of non-permanent employees and part-time workers

What to read next

• Aggregate Demand Curve: Meaning, Sloping Reasons, Determinants
• Aggregate Demand: Formula, Components and Determinants
• Business Confidence: Its Effect on Aggregate Demand and the Economy
• Capacity Utilization: Its Relationship With Profitability, Aggregate Demand and the Economy
• Consumer Confidence: Its Effect on Aggregate Demand and the Economy
• Demand Shock: Definition and a Brief Explanation
• How Exchange Rates Affect Aggregate Demand and the Economy
• How Fiscal Policy Affects Aggregate Demand and the Economy
• How Household Wealth Affects Aggregate Demand and the Economy
• How Monetary Policy Works Affects Aggregate Demand and the Economy