At Top Tutoring, we aim to help students not only learn academic concepts but to apply them to real life. Today we’ll be focusing how to use Economics in light of current events. One of the large economic events that has occured recently was Brexit or the exit of Britain from the European Union.

Background

The European Union (EU) was created after World War II to encourage economic cohesions between the European nations because “countries which trade together are more likely to avoid going to war with each other” (Hunt, Wheeler). The EU has its own currency, the euro, and a parliament that sets laws for the members of the EU. On June 23, 2016, Great Britain had a referendum to decide whether or not the United Kingdom should leave the EU, and “Leave won by 51.9% to 48.1%” (Hunt, Wheeler).

Rising inflation offset falling housing prices

Economists predicted that after Brexit, the act of Britain exiting the EU, housing prices in the UK would fall, entering a recession that could cause unemployment rates to rise. Immediately after Brexit, the value of the pound fell causing an inflation of 2.3%. Fortunately, according to the Phillips curve that illustrate the inverse relationship between inflation rate and unemployment rate, the inflation caused by the drop in the value of the pound has helped offset the rise in unemployment rate caused by the drop in housing prices, so “annual house price increases have fallen from 9.4% in June but were still at an inflation-busting 7.4% in December, according to the official ONS figures” (Hunt, Wheeler). In order to prevent any sudden changes in the economy, “it will take a minimum of two years for the United Kingdom to officially depart from the EU – Britain will relinquish access to the EU’s open market, resulting in trade and investment losses” (Williams). Because the change is gradual, it will allow the aggregate supply to adjust to the loss of aggregate demand caused by the loss of investments.

How does this affect the US?

For now, the British economy seems to be steady and Brexit has had only minor effects on the nation since precautions are being taken, but how does Brexit affect the economies of other countries like the United States? This is an important question to investigate since globalization means countries are becoming more and more reliant on each other’s economy. To understand how Brexit affects the U.S. economy, we must understand the cause and effect of inflation and deflation, shifts in aggregate demand and aggregate supply, and effects of fiscal policies.

Rising dollar - Time to buy those imports!

First, Brexit caused the value of the dollar to rise. Following Brexit, “the U.S. dollar quickly rallied against the British pound, up 6.3%” (Gillespie). The rise in value of the dollar means that there is deflation. Although deflation is good because the dollar is worth more, it is bad for exports, one of the key components of aggregate demand. Because the dollar is now worth more, U.S. products are now more expensive. This means the demand for American goods decreases causing suppliers to produce less. When suppliers produce less, they are making less profit meaning they will hire fewer employees. This is consistent with Phillips curve since inflation rates are lower, unemployment rates are higher. Although “a strong dollar could make imported items cheaper for U.S. consumers…at this point, fears of a stronger dollar appears to be outweighing positives of it” (Gillespie).

Second, Brexit created fear of an interrupted global market. One of the things that can cause the aggregate demand curve to shift is expectation. If consumers think that the economy is declining they will spend less. Also, “Brexit is already causing severe volatility in global stock markets,” (Gillespie) meaning the stock market is unpredictable leading to a decline in investments. Both changes in consumption and change in investment cause the shift of aggregate demand.

To understand the effects of the shift in aggregate demand, take a look at the graph below. Because loss in consumption and investment lowers national output from Y1 to Y2, the aggregate demand curve shifts left from AD1 to AD2, bringing the price level down from P1 to P2. The equilibrium moved from point A to point B left of the long-run AS, meaning the economy is in a contraction. Eventually, the U.S. suppliers will adjust and bring output back to Y1, and the short-run AS will shift right from AS1 to AS2, bringing price levels down to P3 and equilibrium to point C. As you can see on the graph, in the long run, the effects of Brexit is that it drops the price level from P1 to P3. Again this deflation can cause higher unemployment rates in the U.S.

Lastly, Brexit caused a change in fiscal policy in the U.S. As a result of recovering from the 2008 recession, “the Federal Reserve projected that it would raise rates four times” but after Brexit, “several Fed committee members were only calling for one rate hike in the wake of weak growth and slowing job gains” (Gillespie). Increased interest rates are good because it encourages people to save and invest more money. But since Brexit has already caused a deflation, there is already a drop in money supply, and increasing rates will cause the money supply to drop even more.

Lower interest rates

I think the Federal Reserve is making the right decision to keep interest rates low because lower interest rates will encourage people to spend more. When consumption rises, the aggregate demand curve will shift right and price levels will rise. We want the price level to rise because it will cause the inflation rate to rise, offsetting the negative effects of deflation caused by Brexit. When inflation rates are higher, the unemployment rate will drop, again alleviating job losses from export companies.

Although some may be concerned that the fiscal policies will cause inflation, I think keeping unemployment low is more important than keeping inflation low. This is because unemployment is more painful than inflation. When someone loses their job, not only do they suffer, their friends and family also suffer because they feel obligated to help the unemployed member financially, meaning they are also less wealthy. Their friends and family also suffer because it creates fear that they will lose their jobs too. The opportunity cost of keeping unemployment low is smaller than the opportunity cost of keeping inflation low.

Works Cited

Gillespie, Patrick. “How Brexit Impacts the U.S. Economy.” CNNMoney. Cable News Network, 24 June 2016. Web. 22 Apr. 2017.

Wheeler, Alex Hunt & Brian. “Brexit: All You Need to Know about the UK Leaving the EU.” BBC News. BBC, 30 Mar. 2017. Web. 22 Apr. 2017.

Williams, Armstrong. “America to Feel Economic, Political and Security Effects from Brexit.” The Washington Times. The Washington Times, 03 July 2016. Web. 22 Apr.