Brexit's Economic Impact and Policy Response

This assignment provides an in-depth analysis of the economic impact of Brexit on the UK economy. The report examines the effects of Brexit on trade balance, employment, and inflation, highlighting the potential for stagflation. It also discusses the government's policy response, including monetary easing through interest rate reductions. The document is based on relevant literature and reports from various sources, providing a comprehensive understanding of the economic implications of Brexit.

Running Head: OPEN ECONOMY MACROECONOMICS
Open Economy Macroeconomics
Name of the Student
Name of the University
Author note

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Table of Contents
Part a...........................................................................................................................................2
Part b..........................................................................................................................................3
Brexit and possible future economic consequences...............................................................3
Brexit and economic shocks...................................................................................................4
Policy response.......................................................................................................................7
References..................................................................................................................................8

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Part a
The event of Britain’s exit from EU has an immediate and long-term impact on
growth, prosperity and trade in the United Kingdom. The economy wide impact of Brexit can
be seen from the performance of different macroeconomic indicators including GDP growth,
movement of price level, labor market condition, strength of domestic currency and other
related indicators.
The GDP growth rate in UK constitutes a mixed performance. GDP growth recovered
marginally in the third quarter of 2017 to 0.4 percent from 0.3 percent in the previous quarter.
UK after Brexit referendum is lagging behind most of the G7 countries. UK’s growth in the
post Brexit period is 0.5% lower on an average than prior to the referendum (McGrattan and
Waddle 2017). The construction sector is UK has undergone successive recession after
Brexit.
The pound exchange rate against Dollar and Euro has risen significantly indicating a
weak domestic currency. Day after the Brexit referendum, the exchange rate has continued to
surged upward. The weak currency by raising import cost of the companies has led to a
decline in business growth.
The price level has accounted a steady rise following a weak pound that imposes a
higher cost of import. Because of an inflated level of price, the living standard has
deteriorated. The increasing price of essentials such as food, fuel and clothes has pushed up
the price level to 2.9% from 2.6% in the last quarter (theguardian.com 2018).
The weak currency gives a ray of hope that that expected increase in trade volume
will help to offset the downturn in consumption demand. However, the recent trade statistics
has revealed that expansion of trade, outside the EU border has knocked down (Economics
2016). The overall trade deficit in UK has remained unchanged.

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The labor market condition has improved as revealed by a declining unemployment to
4.3% in recent years. The left workers though suffered from a decline in real wage by 0.4%
the average earnings have risen by 2.1% (theguardian.com 2018). This is the only optimistic
sign of Brexit until now.
Part b
Brexit and possible future economic consequences
Immigration
Since 2012, the net migration from EU has grown to more than double. The
immigrant labor force from European Union plays an important role in UK’s economy. The
strength of the labor force has allowed UK maintained a sustained economic growth without
increasing wage and helped the economy to keep interest and price to a considerable low
level (Obstfeld 2016). The Brexit has imposed uncertainties about the future of immigrant
labor force. The gain to UK from restricting immigration depends on future of UK’ relation
with EU. In case Britain want retain its access to the single market, it has to allow free
movement of labor between UK and EU. Brexit has a potential threat on available labor
supply. This might hampers productivity of the economy.
Manufacturing and Trade
The UK’s trade statistics show that more than half of the UK’s exportable is
channeled to the expanded market of European Union. Being the member of custom Union,
UK previously enjoy several trade benefits for trading with other EU members. After Brexit,
UK is less likely to enjoy benefits from a favorable trade agreement. However, prior to Brexit
UK exporters would have to bear some additional expenses to comply with the rules of EU.
As far as impact of Brexit is concerned, there is doubt whether UK will be actually hurt from
the breakdown of trade relation with EU (Portes and Forte 2017). In view of deterioration of

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manufacturing sector and declining importance of Europe in the global economy, the benefit
of being an EU meme now is lower as compared to that few years ago. The effect of Brext
will vary across different sectors of the economy. Brexit comes with an opportunity for
Britain to establish an independent unilateral trade policy with countries outside EU. The
production sector of UK economy has faced a bigger challenge than service sector. The
production units, dependent on UK-EU trade relation is likely to suffer more. Some
economists hold optimistic view about the possible impact of Brexit (Begg and Mushövel
2016). They believe that after leaving EU, the external sector of UK may be better off if the
freedom from independent trade could be used optimally.
Financial service
The finical service is the most vulnerable sector to Britain’s exit from European
Union. After Brexit, UK would loss its influence over single market. The City though hurt in
the short run but it would not spell much disaster. This is because of the competitive
advantage that City enjoys (Economics 2016). Exit from EU would encourage UK to involve
it trade relation with the emerging markets, which would pay dividends in the long-run for
financial services.
Foreign investment
Policymakers are extremely concern about the possible dry up of foreign investment
in the post-Brexit period. The foreign investment in UK will hurt from losing access to the
single market. UK could experience a long period of weak inflow of foreign funds because of
renegotiation of UK’s new relationship. However, single market access is not the only
benefits that foreign investors enjoy. The investors enjoy several advantage in the form of
having a foothold over the country (Jonathan and Forte 2017). The foreign investment could
recover its lost ground if investors can utilize other favorable terms in the post Brexit period.

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Brexit and economic shocks
The sudden exit of Britain from EU is likely to bring some possible shocks for the UK
economy. In the Brexit transition, possible supply shocks can be resulted from an interrupted
labor supply through migration of jobless residents in EU to Britain. In the post Brexit period,
the financial sector of UK may get a hit dropping GDP by 5%. The effect of possible supply
side shocks can be analyzed using the open economy model build with a framework of AD-
ERU- BT.
The external shocks in supply is defined as an unexpected change in global terms of
trade between raw material and manufacturers. A depreciation of pound against major trading
partners will raise the import cost of manufacturing firms. This kind of external trade shocks
along with it supply side impacts lead to a change in price setting real wage curve (Mankiw
2014). Consequently, there will be a shift in AD, ERU and BT curve. All the three curves
shift in the same direction. The combined effect of the supply shocks causes a change in
output.

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Figure 1: Effect of negative external trade shocks
(Source: as created by Author)
In the open economy model, the position of wage setting and price setting curve depend on
the world’s terms of trade and exchange rate (Carlin and Soskice 2014). A weak currency
means a higher price of imported raw materials for manufacturing firms. The terms of trade
raises from T1 to T2. Domestic firms in order to maintain their profit margin reduces real wage
paid to the workers. Consequently, the price-setting curve at the new terms of trade shifts
downward. In the labor market, equilibrium point shifts from point A to point B. This in turn
causes a leftward shift of the ERU curve from ERU to ERU1.
The overall impact of such external shocks can be evaluated in a complete open
economy model that captures the effect on aggregate demand (AD), trade balance or BT

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curve, impact on wage setting and price setting curve and hence a shift of the ERU curve
(Baumol and Blinder 2016).
Figure 2: Effect of different shocks in the economy
(Source: as created by Author)
The AD and BT curve shifts following a shock in aggregate demand and trade
balances. The positive effect on trade balance from exchange rate depreciation offset by the
increased tariff cost of imported raw materials. This causes a leftward shift in both AD and
BT curve. The focus is given on the shift of ERU curve. From Brexit, there is a clear upward
pressure on price. A is the initial equilibrium point which lies above the new ERU curve
ERU1. Corresponding to E2, the prevailing real wage is lower than the wage-setting real wag.
The rationale behind the downward movement of wage is that cost to the domestic firms have
increased now (Gandolfo 2016). This lead to a higher domestic price cutting the real wage.
Under external trade shocks the adjustment through depreciation of exchange rate settle

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equilibrium at A’ leaving output at the same level Y1. The monetary expansion results in
currency depreciation at point A’. There may occur a situation of stagflation as defined as co-
existence of high inflation and high unemployment (Carlin and Soskice 2014). As the
economy moves from A’ to B’, the unemployment rises because of a declining output at Y0.
The increased unemployment co-exists with rising price level.
Policy response
In order to counter economic shocks, the government uses the tools of fiscal and
monetary policy. However, for uncertainties resulted from Brixit referendum the UK
economy need monetary easing. One common policy that Bank of England uses is to reduce
the interest rate to a reasonably low level (ft.com 2014). This by improving productivity
growth might help to correct the gloomy outlook for the economy in future.

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References
Baumol, W.J. and Blinder, A.S., 2016. Principles of Macroeconomics. Cengage Learning.
Begg, I. and Mushövel, F., 2016. The economic impact of brexit: jobs, growth and the public
finances.
Carlin, W. and Soskice, D.W., 2014. Macroeconomics: Institutions, instability, and the
financial system. Oxford University Press, USA.
Economics, C., 2016. The economic impact of ‘Brexit’. Report prepared for Woodford
Investment Management, Oxford.
Ft.com. (2018). Brexit uncertainty calls for stable monetary policy. [online] Available at:
https://www.ft.com/content/a2454be2-3fb3-11e6-8716-a4a71e8140b0 [Accessed 25 Mar.
2018].
Gandolfo, G., 2016. International Finance and International Macroeconomics: An Overview.
In International Finance and Open-Economy Macroeconomics (pp. 3-9). Springer, Berlin,
Heidelberg.
Jonathan, P. and Forte, G., 2017. The Economic Impact of Brexit-Induced Reductions in
Migration to the UK. Vox EU, January, 5.
Mankiw, N.G., 2014. Principles of macroeconomics. Cengage Learning.
McGrattan, E.R. and Waddle, A., 2017. The impact of Brexit on foreign investment and
production (No. w23217). National Bureau of Economic Research.
Obstfeld, M., 2016. The initial economic impact of Brexit: an update to early December
2016. Brookings Papers on Economic Activity, 2016(2), pp.359-366.

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Partington, R. and Clarke, S. (2018). How has the Brexit vote affected the UK economy?
September verdict. [online] the Guardian. Available at:
https://www.theguardian.com/business/2017/sep/26/how-has-brexit-vote-affected-uk-
economy-september-verdict [Accessed 25 Mar. 2018].
Portes, J. and Forte, G., 2017. The economic impact of Brexit-induced reductions in
migration. Oxford Review of Economic Policy, 33(suppl_1), pp.S31-S44.