Brexit and UK National Income via the Circular Flow of Income

Question

The British voted in a referendum in 2016 to withdraw the United Kingdom (UK) from the European Union (EU) and this is commonly known as Brexit. This has raised the fear of an adverse impact on exports and foreign direct investment. It has also resulted in an immediate drastic depreciation in the pound that caused inflation to rise above the 2% target, to 3.1% in 2017, adding to the UK cost of living squeeze. This happens at a time of stagnant living standards which has persisted since the global financial crisis.

Using the circular flow of income, explain how the Brexit referendum might impact UK’s national income. [10]

Answer

The circular flow of income tracks the flow of money, goods and services between the four sectors of an economy — households, firms, the government and the foreign sector. National income changes when the injections and leakages of this four-sector flow move out of balance. This answer first identifies the changes to injections and leakages that the Brexit referendum sets off, then traces their multiplied effect on UK national income.

Four-sector circular flow for the UK. The Brexit shock lowers the investment injection (I, including FDI) and raises the saving leakage (S); with injections falling below leakages, the flow contracts.

A fall in injections and a rise in leakages. In the four-sector flow, injections — investment (I), government spending (G) and exports (X) — add to the flow of income and cause it to expand, while leakages — saving (S), taxation (T) and imports (M) — drain from it and cause it to contract. The preamble points to a fall in confidence on both sides of this balance. The fear of an adverse impact on exports and foreign direct investment signals falling investor confidence, which directly reduces investment — business investment, portfolio investment and FDI — and so lowers the injection I. At the same time, falling consumer confidence amid rising inflation and the cost-of-living squeeze makes households less willing to spend and more inclined to save a larger share of their income, raising the leakage S. Injections fall while leakages rise.

The multiplied fall in national income. With injections now below leakages, national income falls — and by more than the initial imbalance, through the multiplier effect. The fall in the investment injection and the rise in withdrawals leave firms with an unplanned accumulation of inventory, prompting them to cut output and employ fewer factors of production, including labour. Household disposable income therefore falls, and induced consumption falls with it — by an amount governed by the marginal propensity to consume. The lower consumption is itself reduced income for other firms, who in turn cut output and employment, lowering household income again. Each round is smaller than the last, and the contraction continues until the fall in disposable income becomes negligible. UK national income thus falls by a multiple of the initial fall in injections and rise in leakages.

In sum, by lowering the investment injection and raising the saving leakage, the Brexit referendum unbalances the UK’s circular flow towards contraction, and the multiplier effect translates that initial imbalance into a larger fall in national income.