Economic Domino Chains

A rise in interest rates

1. The Bank of England raises Bank Rate, so commercial banks raise the interest rates they charge on loans and mortgages and pay on savings.
2. This leads to lower consumption because borrowing is more expensive, households on variable-rate mortgages have less disposable income after repayments, and saving becomes more rewarding.
3. This leads to lower investment because the cost of borrowing to fund capital projects rises, so fewer projects are expected to be profitable.
4. Higher UK interest rates can attract inflows of hot money, which leads to an appreciation of the pound because demand for sterling rises. UK exports become dearer and imports cheaper, so net exports (X − M) fall.
5. Consumption, investment and net exports are components of aggregate demand, so AD shifts to the left, and the multiplier effect makes the final fall in real GDP larger than the initial fall in spending.
6. This leads to a lower rate of inflation because there is less demand-pull pressure as the economy moves further below full capacity, although the full effect takes around 18–24 months to come through.

A depreciation of the pound

1. The pound depreciates against other currencies, so each pound buys less foreign currency.
2. This leads to cheaper UK exports in foreign-currency terms and dearer imports in pounds, because the price of goods is converted at the new exchange rate.
3. Overseas buyers purchase more UK exports and UK consumers switch away from imports, so net exports (X − M) rise, provided demand for exports and imports is sufficiently price elastic (the Marshall–Lerner condition). In the short run the trade balance may worsen first (the J-curve) because contracts are fixed and demand takes time to adjust.
4. Net exports are a component of aggregate demand, so AD shifts to the right, and the multiplier effect leads to a larger increase in real GDP.
5. This leads to cost-push inflation because imported raw materials, components and energy cost more in pounds, raising firms’ costs of production.
6. It also adds demand-pull inflation because higher AD puts pressure on capacity, especially if the economy is already close to full employment.

An indirect tax on a demerit good

1. The government places an indirect tax, such as a specific tax per unit, on a demerit good like cigarettes, which raises producers’ costs of supply.
2. This leads to the supply curve shifting to the left (vertically upwards by the amount of the tax) because firms now need a higher price to supply each quantity.
3. The equilibrium price rises, but by less than the full tax because some of the tax is absorbed by producers. Demand for demerit goods tends to be price inelastic, so consumers bear most of the incidence.
4. The quantity bought and consumed falls, a movement along the demand curve. Because demand is price inelastic (the good is habit-forming and has few close substitutes), the fall in quantity is relatively small.
5. Lower consumption reduces the negative consumption externalities, such as passive smoking and extra costs to the NHS, which moves output closer to the socially optimal level and reduces the welfare loss.

Evaluate: because demand is inelastic, the tax raises significant revenue that can fund health services, but the externality is only partly corrected unless the tax is set equal to the marginal external cost.