ChainWhat it assumes · how to break it
Start
The world economy falls into recession and demand falls around the world, as in 2008-09.
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, a negative output gap opens and firms have spare capacity, so they cut prices or hold them down to win sales.
negative output gap · demand-pull inflation
negative output gap · demand-pull inflation
Assumes: Firms cut prices when demand falls.
But: Prices are sticky: firms may cut output and jobs rather than prices, so inflation falls slowly.
4
In addition, world demand for oil, metals and food falls, so commodity prices fall and firms' costs fall.
commodity prices · costs of production
commodity prices · costs of production
Assumes: Commodity prices fall in a global recession.
But: Supply disruptions or cuts by oil producers can keep commodity prices high even when world demand is weak.
5
Therefore, the rate of inflation falls, and there is a risk of deflation if the recession is deep.
disinflation · deflation
disinflation · deflation
Best link to attack
Assumes: The exchange rate stays stable.
Assumes: The exchange rate stays stable.
But: If the currency depreciates, import prices rise in domestic currency; after the pound fell sharply in 2008, UK inflation rose above target for several years despite weak demand.
End
Inflation falls and may approach deflation, unless a depreciation raises import prices.
Evaluation chain
- E1However, the fall in inflation depends on the exchange rate staying stable.
- E2When investors see the country as badly exposed to the crisis, as with the UK banking sector in 2008, then the currency depreciates sharply.
- E3As a result, import prices rise in pounds, adding imported cost-push inflation that offsets the downward pressure from weak demand.
- E4So inflation may fall less than expected or even rise, as UK inflation did in the years after 2008.
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Questions this answers
- Assess the impact of a global recession on the rate of inflation in the UK.
- Explain why a negative output gap tends to reduce inflation.
- Discuss why inflation in the UK did not fall further after the 2008 financial crisis.
Diagram
AD/AS diagram: AD shifts left, the price level is lower than it would have been and real output falls below full employment.
Reverse and related
Global boom → demand and commodity prices rise, so demand-pull and cost-push inflation increase.