ChainWhat it assumes · how to break it
Start
Consumer confidence falls sharply and households cut their spending.
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, a negative output gap opens, so firms have spare capacity and unsold stock.
negative output gap · spare capacity
negative output gap · spare capacity
Assumes: The economy was not already above full capacity.
But: If the economy was overheating, the fall in demand simply closes a positive output gap and inflation falls only from a high level.
4
This means firms discount prices and hold back price rises to win customers, so demand-pull inflationary pressure eases.
demand-pull inflation
demand-pull inflation
Assumes: Firms compete on price when demand falls.
But: Prices are often sticky downwards, and firms with market power may protect margins by cutting output instead.
5
Therefore, as unemployment rises, wage growth slows, which reduces firms' costs and lowers inflation further.
wage growth · unit labour costs
wage growth · unit labour costs
Best link to attack
Assumes: Inflation is mainly driven by domestic demand and wages.
Assumes: Inflation is mainly driven by domestic demand and wages.
But: If inflation is driven by cost-push factors such as energy prices or a falling exchange rate, weaker confidence does little to bring it down.
End
Inflation falls as weaker demand opens a negative output gap and slows wage growth.
Evaluation chain
- E1However, the fall in inflation depends on inflation being driven by domestic demand and wages.
- E2When inflation comes from cost-push factors such as higher world energy prices, as in 2022, then falling confidence reduces demand without removing the cause of rising prices.
- E3As a result, the economy can suffer weak spending and high inflation at the same time.
- E4So falling confidence lowers demand-pull inflation, but has only a limited effect on cost-push inflation, and the fall in confidence may itself be a result of high inflation squeezing real incomes.
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Questions this answers
- Assess the impact of a fall in consumer confidence on the rate of inflation.
- Explain the link between the output gap and inflation.
- Discuss whether a fall in consumer spending will always reduce inflation.
Diagram
AD/AS diagram: AD shifts left, the price level falls (or rises more slowly) and real output falls below full employment.
Reverse and related
Rise in consumer confidence → spending rises, the output gap closes and demand-pull inflation increases.