ChainWhat it assumes · how to break it
Start
Consumer confidence falls sharply, for example because of fears about job losses during the 2008 financial crisis.
1
As a result, households save more as a precaution against losing their jobs, so the saving ratio rises.
saving ratio · precautionary saving
saving ratio · precautionary saving
Assumes: Households can afford to save more.
But: Low-income households with no spare income cannot raise saving, so the effect is concentrated among better-off households.
2
This means consumption falls, particularly on big items bought on credit such as cars and furniture, so aggregate demand shifts to the left.
consumption · aggregate demand
consumption · aggregate demand
Assumes: Consumption is a large share of AD.
But: Consumption is over half of UK GDP, but if government spending or exports rise at the same time, AD may not fall.
3
Consequently, firms expect lower future sales and cut investment by a larger proportion than the fall in consumption, because they no longer need extra capacity: the accelerator.
accelerator
accelerator
Best link to attack
Assumes: Firms are near full capacity and expect the fall in demand to last.
Assumes: Firms are near full capacity and expect the fall in demand to last.
But: If firms already have spare capacity, they were not planning to invest anyway, and if they see the dip as temporary, they keep long-term investment plans.
4
Therefore, the fall in consumption and investment is multiplied as incomes fall, so real GDP growth slows and the economy may move into the downturn phase of the trade cycle.
multiplier · trade cycle
multiplier · trade cycle
Assumes: The central bank does not offset the fall.
But: Cutting interest rates lowers the reward for saving and the cost of borrowing, which can restore spending.
End
Economic growth slows as falling consumption and investment are magnified by the accelerator and the multiplier.
Evaluation chain
- E1However, the size of the fall in investment depends on firms being near full capacity and expecting weak demand to last.
- E2If firms already have spare capacity or see the fall in confidence as temporary, then they do not cut planned investment much.
- E3As a result, the accelerator effect is weak and the fall in AD is limited mainly to the fall in consumption.
- E4So growth slows by less than the accelerator suggests, unless the loss of confidence is deep and lasting, as in 2008-09, when investment fell sharply.
Another way to attack it: A rise in saving is not all bad: higher saving can fund investment in the long run, though in a downturn it is more likely to reduce AD (the paradox of thrift). Falling confidence is often a reaction to other shocks, so it amplifies a downturn rather than starting one.
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Questions this answers
- Assess the impact of a fall in consumer confidence on economic growth.
- Explain how the accelerator can make a fall in consumption lead to a larger fall in investment.
- Discuss the extent to which changes in confidence cause the trade cycle.
Diagram
AD/AS diagram: AD shifts left as consumption and investment fall; real output falls and a negative output gap opens.
Reverse and related
Rise in consumer confidence → saving ratio falls, consumption and investment rise through the accelerator, and growth increases.