Main drivers of business cycle fluctuations

Part 1 (Max 1000 words in total, this part counts for 2/3 of the grade)

How is Brexit likely to affect the UK business cycle?

Suggested approach (feel free to deviate)

1) Focus on the main drivers of cyclical fluctuations. How is Brexit likely to affect them and why?

2) How would these affect the relevant macroeconomic indicators? Are there feedback effects?

3) Discuss possible policy responses and how they could affect the cycle.

Part 2 (Max 500 words in total, this part counts for 1/3 of the grade)

(Please choose between Question 2a and Question 2b.)

2a Pick a sector in the UK economy and discuss the main opportunities and threats that macroeconomic changes to the business environment (due to Brexit) could create.

The main drivers of business cycle fluctuations are interest rate, investment and multiplier effect of investment and consumption, inflation etc. When the output of the economy increases, there is a boom phase in business cycle. The equation of national income is presented as Y = C + I+ G + (X-M), where Y represents national income or GDP, I represents investment, G represents government spending and the last components is net export. When, the federal bank increases the interest rate, the cost of borrowing increases. This has direct impact on private investment. Business organisations reduce their investment spending. In the view of neoclassical economists the supply shocks are main determinants of business cycle fluctuations. The sources of supply shocks are technology, increase in productivity of labour or capital. These factors affect the business performance during a period. When there is technological up gradation or improvement in factor productivity, output in different sectors of the economy increases (Thomas 2015).

Inflow of capital affects the business cycle. Brexit is likely to affect UK business and other countries, which are related through business agreement. Before Brexit UK enjoyed advantage of single market in the European Union. After Brexit there would be a trade relationship between the UK and EU. The new tariff rate in UK and single market of EU are likely to be different. This can impact the business prospects of UK economy. There is a possibility of increase in trade deficit in UK economy as UK may lose the existing privilege of free trade agreement with EU. If EU increases the tariff rate for the import from UK, the export of UK becomes costly, which decreases the trade balance of UK. The trade deficit decreases cash flow in the economy. It may also reduce the volume of trade between UK and rest of the economy in the EU. Decrease in export in the EU may reduce output of the export sectors in UK, which negatively affects country’s GDP (Baker et al. 2016).

Impact of Brexit on UK business cycle

Some market analysts expect that the value of pound is likely to fall due to Brexit. Therefore, depreciation of currency may hit the internal market in the form of rising inflation. Depreciation increases export and reduces import, as import gets costlier. Inflation increases the borrowing cost. Therefore, investment in real estate and business tends to fall. Private investment falls due to rise in interest rate. Decrease in investment reduces output and employment in the economy. Therefore, the economy is likely to enter into the recession stage (Moultonet et al. 2016).

Figure 1: Changes in investment rate

(Source: created by author)

Increase in interest rate has other aspects. Rise in interest rate influence people to save more. Therefore, economy experiences a decrease in consumption. Decrease in consumption reduces aggregate demand. It also negatively affects the economy by reducing output. As the consumption decreases given the same level of investment, aggregate decreases below aggregate demand and thus there is accumulation of inventory in the economy. Hence, in the next period, national output is likely to fall. Chances are there to enter into recessionary stage increases.

Figure 2: Impact on Real GDP

(Source: created by author)

Brexit may make the UK economy a less attractive location for investment. Firms of other country may intend to sell in EU markets, as it may give more facilities for business operation. Therefore, reduction in external investment may reduce capital inflow. This effect may also increase unemployment rate in the UK economy. IMF has warned that, Brexit is likely to have adverse impact on UK as the possibility of inflation in more. High inflation rate may decrease standard of living of UK people. There is lots of argument against Brexit. Presently Britain gets facility to sell goods in the European market easily. Moreover, the influx of migrant from different region of European countries increases supply of labour in the UK market. The immigrant workers contribute significantly in country’s growth (global-counsel.co.uk, 2016).

Baker et al. (2016) argues that Brexit has positive impact Brexit is likely to affect the employment policy of UK, as UK can freely regulate the labour market without the influence of EU. Therefore, the government can regulate the productivity of labour through labour market reform. At present UK has to follow the EU’s agency worker’s directive, which gives the temporary workers same working environment and right of equal pay as the permanent workers. The UK economy incurs annual cost of €490 million due to these regulations. Exit from European Union will give Britain the freedom of own policy formation in the labour and product market. However, unemployment in UK may rise after Brexit, which would reduce the pressure in the wage rate.

Possible policy responses

In case of recessionary stage, the monetary policy is more effective than fiscal policy. According to Keynesian economics, in very short run, the federal bank has to boost up aggregate demand by raising money supply. Investment can be encouraged by reducing interest rate. The central bank can buy short term government bonds to increase money supply in the economy. Increase in investment increases output in several sectors in the economy. As a result, output, employment can rise in medium term. The recessionary effect is offset somewhat as the recessionary gap is reduced. The recessionary gap arises due to gap in actual GDP level and potential GDP. In recessionary period, the actual output falls below potential output. Possibility of increase in tax rate is there with decrease in government spending. However, this also has political impact (Thomas 2015).

Currently UK is an important financial centre of Europe. In cross border bank lending, the UK have 17% share in international market. In hedge fund assets and wholesale financial services, UK have significant share. However, the Euro zone countries want the wholesale banking to be overseen by the ECB. After Brexit, this enforcement is more likely to happen. UK may suffer an opportunity cost as it cannot take part in liberalising initiatives of Capital market union after Brexit (Smales 2016). The actual outcome of Brexit on UK depends on treaty between UK and EU. Brexit may have mixed impact on UK financial sector. HSBC has decided recently to continue business in UK even after Brexit. However, chief executive of JP Morgan mentioned in Financial Times 2016, that this bank may reduce business in London after exit of Britain from EU. Reducing banking business in UK will have effect on employment. Unemployment in banking sector may rise after Brexit (Monaghan and Elliott 2016).)

Passporting is an important pillar of EU financial system. The Markets in Financial Instruments Directive (MiFID) allows the banks to carry business in member states without having license in each country. Any other bank belonging to country other than member of EU, cannot get the opportunity of passporting system. Presently mainly third country banks thus established business in London to use the EU market for financial services. After Brexit, this facility will depend on the negotiation between UK and EU. UK banks may then require new licenses to operate multiple EU jurisdictions under capital requirement directives (Moulton et al. 2016). Currently, the European banks, which trade derivatives, operate under the European Market Infrastructure Regulations (EMIR). The banks require following regulations regarding clearing, trade reporting and risk reporting in line with G20 group. These rules are not applicable for UK after Brexit. However, being a G20 member, UK may have to follow principles of EMIR even after exit from EU. 

Brexit may increase the interest rate in the market raising the borrowing costs. Average cost of mortgage can increase up to £1000 annually. Therefore, investment in real estate sector may fall. As UK may face recession after Brexit, many economists have suggested that Bank of England should cut the interest rate to boost the economy. Reduction in interest rate would encourage domestic private investment. After Brexit, the UK banks may lose their rights to provide services based on passport. This will not have much effect on retail banking product as few customers obtain retail services in short or medium term. In case of consumer credit, Brexit may have positive effect (bbc.com, 2016). UK is likely to implement the Consumer Credit Directives, which imply that the lender has to comply with one regime for consumer loans up to £60260 and a different regime for consumer loan in excess of the amount and for business loan.

References

Baker, J., Carreras, O., Ebell, M., Hurst, I., Kirby, S., Meaning, J., Piggott, R. and Warren, J., 2016. The short-term economic impact of leaving the EU.National Institute Economic Review, 236(1), pp.108-120.

bbc.com (2016). How will Brexit affect your finances? – BBC News. [online] Available at: https://www.bbc.com/news/business-36537906 [Accessed 4 Aug. 2016].

global-counsel.co.uk (2016). [online] Available at: https://www.global-counsel.co.uk/sites/default/files/special-reports/downloads/Global%20Counsel_Impact_of_Brexit.pdf [Accessed 4 Aug. 2016].

Monaghan, A. and Elliott, L. (2016). British economy begins to show signs of post-Brexit slowdown. [online] the Guardian. Available at: https://www.theguardian.com/business/2016/jul/28/health-check-of-key-sectors-post-brexit-vote-counter-growth-figure [Accessed 4 Aug. 2016].

Moulton, R., Coiley, J., Perry, J.,  Aird, R., and Ward, N., (2016). Brexit: potential impact on the UK’s banking industry           [online] Available at: https://www.ashurst.com/doc.aspx?id_Content=12909 [Accessed 4 Aug. 2016].

Smales, L.A., 2016. ‘Brexit’: A Case Study in the Relationship between Political and Financial Market Uncertainty. Available at SSRN 2805807.

Thomas, D.S., 2015. Social Aspects of the Business Cycle (RLE: Business Cycles) (Vol. 7). Routledge.