ChainWhat it assumes · how to break it
Start
UK consumer confidence falls sharply and households cut back 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, spending on imports falls, and the cuts fall heavily on imported durables such as cars, electronics and clothing, which households put off buying when they are uncertain.
marginal propensity to import (MPM) · durable goods
marginal propensity to import (MPM) · durable goods
Best link to attack
Assumes: A large share of the spending that households cut is on imported goods.
Assumes: A large share of the spending that households cut is on imported goods.
But: If households cut spending on domestic services such as restaurants, hairdressers and leisure more than on imported goods, imports fall much less than consumption.
4
Therefore, the value of imports falls while exports are unaffected, so the trade deficit narrows.
trade balance · current account
trade balance · current account
Assumes: Exports do not fall at the same time.
But: If confidence falls across the world together, demand for UK exports falls too and the trade balance may not improve.
End
The trade deficit narrows as imports fall, though the improvement reflects weaker spending, not stronger competitiveness.
Evaluation chain
- E1However, the size of the improvement depends on how far the spending cuts fall on imported goods.
- E2If households mainly cut spending on domestic services such as eating out and leisure, then most of the lost spending falls on UK firms.
- E3As a result, imports fall by much less than consumption, and the effect on the trade balance is small.
- E4So a fall in consumer confidence improves the trade balance only modestly, and does so for the wrong reason, since it reflects weaker demand rather than better competitiveness.
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Questions this answers
- Assess the likely impact of a fall in consumer confidence on the UK's current account.
- Explain why a fall in consumption can improve the trade balance.
- Discuss whether a narrowing trade deficit is always a sign of economic strength.
Diagram
No standard diagram. Use data on import volumes during a downturn such as 2008-09; an AD/AS diagram with AD shifting left can support the fall in income.
Reverse and related
Rise in consumer confidence → consumption and imports rise, so the trade deficit widens.