ChainWhat it assumes · how to break it
Start
The world economy falls into recession, as in 2008-09 after the global financial crisis, and incomes fall in the UK's main export markets.
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
Best link to attack
Assumes: The multiplier is large.
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
Therefore, real GDP growth slows or turns negative, and a negative output gap opens.
negative output gap · recession
negative output gap · recession
Assumes: There is no offsetting policy.
But: The central bank can cut interest rates and the government can raise spending, as both did in 2008-09, to support AD.
End
Economic growth slows or turns negative and a negative output gap opens.
Evaluation chain
- E1However, the fall in real GDP depends on the size of the multiplier.
- E2Because the UK has high leakages through taxes, saving and imports, each pound of lost export income leads to a smaller fall in total spending than in a closed economy.
- E3As a result, the multiplier effect is limited, and the fall in GDP is driven mainly by how large a share of GDP exports make up.
- E4So the impact on growth through trade alone is larger for very open, export-led economies than for the UK, although in 2008 the UK was also hit hard through its banking sector.
Another way to attack it: In 2008 the pound fell sharply, making UK exports cheaper and cushioning the fall in net exports. Falling world commodity prices also lower firms' costs, which supports output.
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Questions this answers
- Assess the likely impact of a global recession on economic growth in the UK.
- Explain how the multiplier affects the impact of a fall in exports on real GDP.
- Discuss the extent to which an open economy is vulnerable to recessions in its trading partners.
Diagram
AD/AS diagram: AD shifts left because net exports fall, real output falls below the full-employment level (negative output gap).
Reverse and related
Global boom → demand for exports rises, net exports and AD rise, and the multiplier raises growth further.