ChainWhat it assumes · how to break it
Start
The world economy falls into recession, as in 2008-09, and UK output and incomes fall as exports and investment collapse.
1
As a result, households and firms abroad cut spending, so demand for UK exports falls.
exports · income elasticity of demand (YED)
exports · income elasticity of demand (YED)
Assumes: UK exports are income elastic.
But: Exports of necessities and essential services fall less than exports of luxury goods, cars or financial services.
2
This means net exports fall, so aggregate demand shifts to the left.
net exports · aggregate demand
net exports · aggregate demand
Assumes: Imports do not fall by as much as exports.
But: If UK incomes fall too, spending on imports also falls, partly offsetting the fall in exports in net trade.
3
Consequently, exporting firms cut output and incomes, and through the multiplier the fall in real GDP is larger than the original fall in exports.
multiplier
multiplier
Assumes: The multiplier is large.
But: In an open economy like the UK, with high taxes and a high marginal propensity to import, leakages are large and the multiplier is small.
4
This means tax revenues fall automatically, because income tax, VAT and corporation tax all depend on incomes, spending and profits.
automatic stabilisers · tax revenue
automatic stabilisers · tax revenue
Assumes: Tax receipts move closely with GDP.
But: Some receipts, such as council tax, depend little on the economy, so revenue falls less than GDP.
5
At the same time, welfare spending rises as more people claim unemployment and income-related benefits.
automatic stabilisers · transfer payments
automatic stabilisers · transfer payments
Assumes: Unemployment rises with the fall in output.
But: If firms hoard labour, as many did after 2008, the rise in unemployment and benefit claims is smaller.
6
Consequently, the budget deficit widens, and the government may widen it further with a discretionary stimulus, as the UK did by cutting VAT from 17.5% to 15% in December 2008.
cyclical deficit · discretionary fiscal policy
cyclical deficit · discretionary fiscal policy
Best link to attack
Assumes: The wider deficit is cyclical and will close when growth returns.
Assumes: The wider deficit is cyclical and will close when growth returns.
But: If the recession permanently lowers potential output, part of the deficit becomes structural and will not close as the economy recovers.
End
The budget deficit widens through automatic stabilisers and any discretionary stimulus.
Evaluation chain
- E1However, whether the wider deficit is a lasting problem depends on how much of it is cyclical.
- E2If the recession only opens a temporary negative output gap, then tax receipts recover and benefit claims fall as growth returns.
- E3As a result, the cyclical part of the deficit closes on its own without tax rises or spending cuts.
- E4So the deficit is a serious concern only if the recession damages potential output, as many economists argued happened after 2008, leaving a structural deficit that needs fiscal consolidation.
Another way to attack it: The automatic stabilisers themselves cushion the fall in AD, so the recession is shallower than it would otherwise be. Rescuing banks, as the UK did in 2008, can add to the national debt beyond the effect on the deficit.
Can you say this chain from memory?
Members can hide the links, test themselves and track which chains they have mastered.
Practise this chainMembers can hide the links, test themselves and track which chains they have mastered.
Questions this answers
- Assess the impact of a global recession on a government's budget deficit.
- Explain the role of automatic stabilisers during a recession.
- Discuss whether a deficit that widens during a recession is a cause for concern.
Diagram
No standard diagram. Use public sector net borrowing data around 2008-10 as evidence.
Reverse and related
Global boom → tax receipts rise and benefit spending falls, so the deficit narrows automatically.