ChainWhat it assumes · how to break it
Start
The world economy falls into recession and incomes fall in the UK's main export markets, such as the EU and the USA.
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 the value of exports falls, which on its own worsens the trade balance.
value of exports
value of exports
Assumes: Export prices and volumes both fall.
But: If the currency depreciates during the crisis, as the pound did in 2008, exports become more price competitive and volumes fall less.
3
At the same time, UK incomes fall too, because of the lower exports and the multiplier, so households and firms spend less on imports.
marginal propensity to import (MPM)
marginal propensity to import (MPM)
Assumes: UK income falls along with the rest of the world.
But: If the UK is hit less hard than its trading partners, its imports fall less than its exports.
4
Therefore, the overall effect on the trade balance depends on whether exports fall by more than imports.
trade balance
trade balance
Best link to attack
Assumes: Exports and imports respond similarly to income.
Assumes: Exports and imports respond similarly to income.
But: The UK has a high marginal propensity to import, so a fall in UK income cuts imports sharply, which can improve the trade balance.
5
In addition, world commodity prices usually fall in a global recession, so the cost of imported oil and raw materials falls.
import prices · terms of trade
import prices · terms of trade
Assumes: The country is a net importer of commodities.
But: A commodity exporter loses export revenue as prices fall, so its trade balance worsens instead.
End
The trade balance may worsen or improve, depending on whether exports fall faster than imports.
Evaluation chain
- E1However, the effect depends on how strongly UK imports respond to the fall in UK income.
- E2Because the UK has a high marginal propensity to import, a fall in UK income leads to a large fall in spending on imported goods.
- E3As a result, imports can fall by as much as or more than exports, especially if UK demand falls further than demand abroad.
- E4So a global recession can leave the trade balance little changed or even improved, although that improvement reflects weaker incomes rather than stronger competitiveness.
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Questions this answers
- Assess the likely impact of a global recession on the UK's current account balance.
- Explain why a recession abroad may not worsen a country's trade balance.
- Discuss the effects of a global recession on countries that export primary commodities.
Diagram
No standard diagram. Use current account data across 2008-09 as evidence; an AD/AS diagram with AD shifting left supports the income effect on imports.
Reverse and related
Global boom → exports rise, but rising domestic incomes also raise imports, so the effect on the trade balance depends on which grows faster.