The eco-political event of Britain’s exits from European Union is known as Brexit. In order to decide about UK’s future in EU a referendum was issued on 23rd June, 2016. 51.9% votes were obtained in favor of UK’s leaving proposal from UK (bbc.com 2018). This single event has an economy wide impact on Britain.
The growth performance of UK since the Brexit referendum can be seen in two segment. A relatively strong performance of the economy was recorded at the end of 2016. The performance however has slowed down in 2017 (Cameron 2017). The current macroeconomic state of UK can be analyzed viewing five key indicators
The growth rate of UK though improved in second quarter of 2017 to 0.3% but it is lower than UK’s average growth rate of 0.5% since 2010 (ft.com 2018). The figure above shows that a comparatively low growth rate has kept UK at a bottom line when compared with other G7 nations. It is though difficult to say that Brexit has damaged growth performance of UK as there is possibility of growth reversal once the squeeze on average income passes. However, a below expected growth rate for two consecutive quarter has dimmed out such positive outlook.
The proportion of income saved by household has reached to a recorded low level in the first quarter of 2017. This indicates that people are saving less and are relying on borrowed fund to satisfy their consumption need.
The living standard is indicated by the rate of earning growth that is adjusted for inflation. The average standard of living in UK has declined since Brexit referendum as a weak currency of UK and resulting high price level is associated with stagnant wage level.
The labor market in UK is showing a positive influence from EU referendum. The unemployment and underemployment has gone down with an associated increase in labor force participation and employment rate. The unemployment rate in UK has declined from 4.9% to 4.4 percent in the last year (Vasilopoulou 2016).
The value of pound has fallen drastically both against Euro and Dollar. The Pound-euro exchange rate though had been fallen prior to brexit, it reached to 10 percent below that the level in 2016 against both the currency value (ft.com 2018).
The sudden separation of Britain from EU has both short run and long run implication for the economy. The economic shocks appeared to be caused from different channels. Both internal and external factors causes a change in macroeconomic environment of the economy. The open economy model depicts the macroeconomic status with three curves AD, ERU and BT. AD curve shows combination of output level (Y) and real exchange rate (θ) corresponding to equilibrium in goods market (De Blas and Russ 2015). At this point, real interest rate equalizes with world interest rate. The ERU curve defines the combination of output and real exchange rate corresponding to the point where price setting real wage is equal to the wage setting real wage. Any point on this curve implies a constant level of prices. The BT curve reflects output and exchange rate combination at which trade balance occurs that is export equals import (MacDonald 2016). These three together determine equilibrium in the economy.
The figure above shows basic AD-ERU-BT model to determine optimum output level. A is the stable point of equilibrium where the three curve intersects and associated output level is Y1.
The possible shocks from Brexit causes a shift in any of three curve and changes combination of output and exchange rate. Brexit has caused a slowdown in GDP growth rate. This is likely to cause a recession for the economy. The economic turmoil resulted from Brexit cause loss of investors’ confidence. Britain’s separation from EU thus will affect the level of investment. UK will face a higher cost to have access to a Single market. The decline in investment level will lead to a decline in aggregate demand. Britain’s uncertain future will hurt consumers’ confidence as well. The consumer spending in UK accounts nearly 70% of UK’s aggregate demand. The behavior of consumers thus plays an important role in deciding future output of the economy (Cameron, F., 2017). The Brexit effect may transmitted to rest of world affecting other nations in the Eurozone. A slowdown of economic growth of other nations will magnify the recession effect of Brexit. The effect of negative demand shocks is analyzed in the figure given below
The adverse demand shock will cause an inward shift of AD curve from AD to AD’. The first direct impact on the exchange rate. The exchange rate depreciates shows a weak currency status. However, output in the short run cannot be adjusted. The economy will be at point E in the short run. In the short run, the effect off output from the demand shocks is completely offset by currency depreciation from a reduced interest rate (De Blas and Russ 2015). The depreciation reduces real wage followed by a relatively high price level in the domestic economy relative to world economy. This in the long reduces competitiveness resulting in a fall in output from Y1 to Y2.
The second channel through which Brexit affects UK economy is the channel of trade. Prior to Brexit, EU was the largest trade partner of UK. After leaving EU, the volume of trade between UK and EU will decline because higher tariff and non-tariff barriers imposed by other European nations. Additionally this will reduce the benefits that UK is likely to enjoy from any future market integration that take place within UK (Vasilopoulou 2016). The effect of a lower trade volume after Brexit will be reflected from the shift in both AD and BT curve.
The analysis of trade external trade shocks is quite straightforward. The BT and AD curve will shift in the same direction. The slope of AD is greater than that of BT. There will a greater proportional shift of BT curve as compared to AD. F indicates the point of medium term equilibrium. This is associated with high unemployment, low real wage, higher import cost and ultimately a deficit in trade balance. Under a flexible exchange rate system, following short run depreciation the economy will shift to the point E1 before the adjustment made by AD’. The effect of lower volume of trade will offset by the depreciation of exchange rate leaving the output level unchanged at Y0.
In the phase of negative internal or external shocks, fiscal and monetary policy stimulus is needed to restore economic growth of the nation. As per deputy governors of Bank of England the monetary authority of UK will have to undertake further stimulatory policy to counter economic shocks. The Bank of England generally relies on expansionary monetary policy in the form of quantitative easing policy or a cut in the interest rate (De Blas and Russ 2015). The Bank has announced a package of program to mitigate the risk arising from demand and external trade shocks. The Bank has already cut the interest rate to the lowest level of 0.25%. The quantitative easing policy of bank include transaction of cooperative and government bond between banks and financial institution. BOE is purchasing more bonds and is lending the proceeds to other sectors of the economy. The monetary stimulus of the bank will help the economy to recover from post Brexit shocks. Because of policy measure, the economic slowdown may not be as sharp as was initially expected.
The banking sectors of UK will be severely affected in the post Brexit period. With contraction of financial sectors, a considerable number of job will be lost in this sector. The dimmed outlook of financial sector will hurt future productivity growth (Cameron 2017). The tariff imposed by other European nation will significantly increase the cost to car industry. Many of the eminent automobile company will shift their production operation from UK to other free trade zones. After the Brexit, the free movement of labor will be restricted. This will hurt industries like construction, manufacturing and automobile industry.
The Brexit thus moves UK towards an uncertain future. The strength of internal economy and Bank of England’s stimulatory policies though bring some positive outlook but it will take some more time to adjust with resulting shocks.
References
BBC News. (2018). Brexit: All you need to know. [online] Available at: https://www.bbc.com/news/uk-politics-32810887 [Accessed 23 Mar. 2018].
Cameron, F., 2017. After Brexit: Prospects for UK-EU cooperation on foreign and security policy. EPC Policy Brief 30 October 2017.
De Blas, B. and Russ, K.N., 2015. Understanding markups in the open economy. American Economic Journal: Macroeconomics, 7(2), pp.157-80.
Ft.com. (2018). The UK economy since the Brexit vote — in 5 charts. [online] Available at: https://www.ft.com/content/cf51e840-7147-11e7-93ff-99f383b09ff9 [Accessed 23 Mar. 2018].
MacDonald, S., 2016. The impact of Brexit on the UK’s reputation, influence and soft power. Cultural Trends, 25(4), pp.280-286.
Vasilopoulou, S., 2016. UK Euroscepticism and the Brexit referendum. The Political Quarterly, 87(2), pp.219-227.
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