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Commentary: Brexit could lead to recession, says Bank of England

An economic commentary on the article "Brexit could lead to recession, says Bank of England"

Date the commentary was written: 24/ 05 /2016


Read the original article on the guardian: Brexit could lead to recession, says Bank of England by Katie Allen - 12/05/2016


The article under consideration is about multiple predicted implications that would occur if Britain decides to the leave the EU (Brexit) according to the Bank of England. The main macroeconomic aspects of this article which would be featured in this commentary are the claims of recession, inflation, unemployment and economic growth.

The idea of Britain leaving the EU (European Union) has brought about the question of its economic justification. Economically, there is a lot of ambiguity, however this article claims that a Brexit would not be economically justified for Britain. The greatest argument made in this article is that of recession. Recession is the significant decline of economic activity in an economy lasting longer than two successive quarters. The recession in turn would be caused by a combination of inflation and unemployment. Inflation simply refers to the persistent increase in the average price level of goods and services in an economy over a period of time (12 months). Unemployment refers to people of working age, able, willingly and actively looking for a job but do not have one. According to the Bank of England in this article, all of this would occur if Britain leaves the EU. Hence all of the macroeconomic objectives of England would not be met (including a current account surplus, as it would be more expensive for Britain to trade with EU counties and the US). Also, since there is an increase in unemployment and inflation, stagflation would also be occurring.

Unemployment is said to increase. This is mainly due to an increase in the cost of production of firms. Without the EU, many sectors in the British economy would not have subsidies and would have to pay more taxes. The price of most raw materials would increase, transportation cost would also increase and trade between the EU and Britain would be highly disadvantageous to Britain as the EU would impose high tariffs. The labor market diagram below shows the effects.


Figure 1



As illustrated on the diagram. Due to the higher cost of productions, firms in Britain would be forced to ‘let go’ their labor force. Hence there is a decrease in the aggregate demand for labor. This causes natural unemployment. The aggregate demand of labor shifts to the left, due to the decrease in demand for labor.

 British goods would become expensive and would lose international competitiveness. Hence, sales would be lower, the pound would lose its value and Britain would gradually have a large deficit on their balance of payments. GDP would decrease, hence economic activity also decreases and furthermore a decrease in economic growth.

Inflation is also claimed to increase above the target rate of 2%. This inflation would most probably be a cost push inflation. This type of inflation refers to the increase in cost of production in many firms, hence the average price level of goods and services generally increases. The effect is illustrated on the diagram below;


Figure 2



As shown on the diagram, an increase in cost of production causes the short run aggregate supply curve to shift to the left, further on increasing the inflation and decreasing the real GDP. This creates excesses demand and simply increases the value of inflation.


So it may appear that the Brexit is a recipe for a recession. So is this fate inevitable? No, there is a simple solution for Britain to have a strong economy without these problems if they are to leave the EU. The British Government can start large scale infrastructure developments in Britain, in order to prevent the unemployment caused by the Brexit. The British government may also have to impose high tariffs on goods and services offered by the EU only, hence not only does this generate money for Britain but it also allows domestic firms to thrive which would increase employment, GDP, economic growth and would strengthen the pound. The psychological effect of Brexit may also aid in higher productivity of workers and higher consumption of locally made goods and services instead of imported commodities. The balance of payments would also improve to a more favorable figure (surplus or surplus leaning). The Bank of England can also increase key interest rates, to “increase” the value of the pound.

Inflation can also be less severe if the Bank of England increases the interest rates and subsidizes important goods and services in the country. An increase in the interest rates would increase the general public’s marginal propensity to save, hence aggregate demand would decrease and relative to the very slow cost push inflation, the inflation would be barely “felt” by the economy.

 The British government must also loosen its controls in the banking industry as this would then allow Banks in EU to easily invest or even relocate to Britain because of lower constrains from a governing body.   

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