Brexit refers to the political event addressing the leaving proposal of United Kingdom from European Union. As of referendum of 23rd June of 2016, 51.9% participating UK electorate had voted in favor of leaving UK. Therefore, UK has to leave EU by March 2019 (Dhingra et al. 2016). The event though largely political but this has significant impact on the economy of United Kingdom.
The first direct impact of Brexit is on the exchange rate market. The sterling rate jumped to a considerable high level. The surging currency directly affected the largest companies of UK that recorded a decline a growth rate to 1.6% (theguardian.com 2018). The major macroeconomic indicators of the economy include GDP growth rate, inflation, unemployment, interest rate and other related indicators.
The inflation in the economy has risen sharply after the declaration of Brexit referendum. The measured consumer price index has declined until June 2016. However, the rising exchange by increasing the price of imported goods has increased the overall price index. The consumer price inflation rose from 2.6% in July to 2.9 percent in August (theweek.co.uk 2018). The rising price of import including prices off food, cloth and other necessary items picked up the inflation rate.
Figure 1: Brexit impact on consumer price
(Source: theguardian.com 2018)
The weak pound was expected to stimulate UK’s export and hence would address adverse effect lower consumer spending in the economy. However, in reality UK has faced significant difficulty in expanding trade outside EU border (Van Reenen 2016). The high import price make the economists’ to expect the trade deficit to be widened to £3.2bn.
Figure 2: Trade balance of goods and balance
(Source: theguardian.com 2018)
The trade deficit in reality however remained unchanged. The service sectors are facing hurdles because of declining service activity. The manufacturing sector however has benefitted somewhat from increasing overseas transaction (Gudgin et al. 2016) .
One positive impact of Brexit is on the unemployment rate of the economy. The rate of unemployment has reached to a significantly low level as result of lower wage growth as compared to consumer price inflation.
Figure 3: Brexit impact on unemployment
(Source: money.cnn.com 2018)
All these indicators together determine the macroeconomic state of UK. Except unemployment most of the major indicators have adversely affected. The economy is currency at a highly unstable state having deep uncertainty regarding future
The Brexit has brought a sudden shock for the economy of United Kingdom. Because of Brexit, the pound value has declined. However, conflict remain among the economist regarding the nature of the shocks (Pollard 2018). The shocks can be either demand side or supply side or both. Supply shocks refers to the external forces that affect the aggregate supply of the economy. Such shocks creates inflationary pressure. This is because the same amount of money now accompanied with relatively lower output (Gandolfo 2016). However, the supply constraint resulted from Brexit is not applicable for goods supplied to overseas market but not for the UK’s domestic market. Prior to Brexit, Britain being a member of European Union was a part of custom union. Members of the custom union derives benefit from a liberalized trade. When UK leaves EU, then UK will lose the advantages of free trade. This will make difficult for UK to sell goods overseas. When other member nations of EU places tariff on UK’s export, then selling price will push up. The Brexit thus possess a threat to UK’s goods sold overseas (theweek.co.uk 2018). This will definitely affect the currency of UK. Such shocks imply a lower demand for Great Britain Pound leading to a fall in currency valuation.
The possible effects of shocks as a result of Brexit and suitable policy responses can be analyzed using a framework of basic open economy model. The model consists of AD, ERU and BT curve, each having its own significance.
Figure 4: Basic Open economy model
(Source: as created by Author)
The macroeconomic stability is defined at the intersection point of three curves AD, BT and ERU. The macroeconomic equilibrium is at point E. Y* is the optimum output corresponding to point E.
After announcement of Brexit foreign investors might lose their confidence to invest in UK. This is because of future uncertainties that the economy is going to face as a result of higher accessing cost in the single market. The decline in FDI can lead to a fall in aggregate demand. The uncertainties associated with Brexit encourages consumer to raise level of saving (Berg et al. 2016). This by hurting spending adversely affect aggregate demand. Other factors that further aggravates the situation include fluctuation in the financial market, expectation about high tariff and such others.
Figure 5: Effect of a negative demand shock
(Source: as created by Author)
A negative demand shock causes a shift in aggregate demand curve to the left from AD to AD1. UK operating under a flexible exchange rate regime will face an immediate fall in nominal interest rate. In the short run, there is a depreciation of currency. The output in the short-run stay unchanged at F. Depreciation would lead to an import induced inflation (Agénor and Montiel 2015). With increasing wage bargaining inflation in UK will gradually increases reducing the competitiveness (θ). The new equilibrium will settle at B with a lower output at Y1.
An external trade shocks is defined as the unanticipated change in trade volume caused by some exogenous factors. Following Brexit, UK will face problem of exporting its goods to the overseas market. Separation of UK from custom union also raises the cost of imported raw material. All these causes a shock in the external sector and affect the balance of trade (Kierzenkowski et al. 2016). In the open economy model, the external trade shock lead to a shift in both AD and BT curve.
Figure 6: Effect of external trade shocks
(Source: as created by Author)
The external trade shocks will shift both the AD and BT curve in the same direction. AD shifts to the left from AD to AD1 and BT also shifts to the left from BT to BT’. The initial equilibrium is at E obtained at the intersection of AD and BT. The output is at Y*. The new equilibrium is at E’ leaving the output at same level Y*. The depreciation of exchange rate offset the fall in net export due to exogenous factors leaving the balance of trade unchanged.
In order to offset negative economic shocks, the recommended policy response is to undertake an expansionary fiscal and monetary policy. The expansionary fiscal policy might result in a high government debt (Agénor and Montiel 2015). The UK government thus relies on expansionary monetary policy in form lowering the interest rate. The low interest rate and increased money supply will help to raise level of economic activity and stabilize the economy in the long-run.
Banking
Before the announcement of Brexit, the financial sector was one of the strongest sector of the economy. The banking sector will be hurt severely due to Brexit. The sector is expected to lose around 10,500 jobs. The majority of city firms have declared to shift to the continent. Several established financial group including Morgan Stanley, Daiwa, Citigroup, Nomura and Sumintomo have already taken the decision of shifting their operation and is gradually moving their personnel from UK to EU (independent.co.uk 2018). This gloomy outlook of banking sector will hurt the financial strength of the economy.
Car industry
The car industry is expected to incur an addition cost £4.5bn due to imposed tariff by other EU members (cnn.com 2018). The break-down of trade in the post Brexit period will make permanent damage of the motor industry. This will bring a disastrous situation for UK car industry. One of the eminent automobile company, Toyota may shift its operation in UK to some other suitable place.
As like the automobile industry, construction and manufacturing industry will suffer a lot from Brexit. The situation will be even worse if Brexit prevents movement of labor across nations. The construction workers of EU are already leaving their jobs. An estimated number of 200000 jobs in construction industry is expected to be lost once Britain loses access to European market (theweek.co.uk 2018). This in turn will destroy infrastructure projects worth billions of pounds.
Food and drinks
The UK economy is experiencing a shrink-inflation that is inflation due to shrinking size of firms. People in the economy has faced a high food price because of decline in pound value against dollar (independent.co.uk 2018). The fast food chains will suffer a lot because of a hike in import price.
Pharmaceuticals
The departure of Britain from EU will make UK a less attractive place for investment impeding the future growth and development. With a decline in potential investment, the research in new drugs will be adversely affected (cnn.com 2018).
In sum, there are mostly a pessimistic view regarding future outlook of UK economy following Brexit referendum. The demand and supply side shocks will influence real GDP and price level. The major goods and service industry will suffer severely because of UK’s exist from EU. One optimism can be seen from a plausible long run productivity growth affecting aggregate supply and export expansion.
Reference list
Agénor, P.R. and Montiel, P.J., 2015. Development macroeconomics. Princeton University Press.
Berg, T., Saunders, A., Schäfer, L. and Steffen, S., 2016. ‘Brexit’and the Contraction of Syndicated Lending.
Dhingra, S. and Sampson, T., 2016. UK-EU relations after Brexit: What is best for the UK economy. Brexit Beckons: Thinking ahead by leading economists.
Gandolfo, G., 2016. International Finance and International Macroeconomics: An Overview. In International Finance and Open-Economy Macroeconomics (pp. 3-9). Springer, Berlin, Heidelberg.
Gudgin, G., Coutts, K., Gibson, N. and Buchanan, J., 2016. The macro-economic impact of Brexit: using the CBR macro-economic model of the UK economy (UKMOD). Centre for Business Research, University of Cambridge.
Inman, P. and Elliott, L. (2018). Gloomy Brexit forecasts for UK are coming true, says IMF. [online] the Guardian. Available at: https://www.theguardian.com/business/2017/dec/20/imf-christine-lagarde-brexit-forecasts-growth-uk-economy [Accessed 16 Mar. 2018].
Kierzenkowski, R., Pain, N., Rusticelli, E. and Zwart, S., 2016. The economic consequences of Brexit.
Kottasová, I. (2018). U.K. unemployment is at a 42-year low. That’s not as good as it looks. [online] CNNMoney. Available at: https://money.cnn.com/2017/08/16/news/economy/brexit-jobs-record-low-unemployment/index.html [Accessed 16 Mar. 2018].
Musaddique, S. (2018). This is how Brexit has impacted the business world in 2017. [online] The Independent. Available at: https://www.independent.co.uk/news/business/news/brexit-economy-sterling-currency-investment-cost-impact-business-financial-banks-insurance-retail-a7695486.html [Accessed 16 Mar. 2018].
Partington, R. and Clarke, S. (2018). How has the Brexit vote affected the UK economy? September verdict. [online] the Guardian. Available at: https://www.theguardian.com/business/2017/sep/26/how-has-brexit-vote-affected-uk-economy-september-verdict [Accessed 16 Mar. 2018].
Pollard, J.S., 2018. Brexit and the wider UK economy. Geoforum.
The Week UK. (2018). What will happen to UK imports and exports after Brexit?. [online] Available at: https://www.theweek.co.uk/advertisement-feature/90140/what-will-happen-to-uk-imports-and-exports-after-brexit [Accessed 16 Mar. 2018].
Van Reenen, J., 2016. Brexit’s Long-Run Effects on the UK Economy. Brookings Papers on Economic Activity, 2016(2), pp.367-383.
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