The Impact of Domestic Policies on UK Investments & Exports During the Financial Crisis (1970 - 2011)

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Abstract

This report examines the impact of the following policy reforms on the aggregate economy in the United Kingdom, during the financial crisis: A reduction in corporation tax (2008), a reduction in the bank rate (2009) and an increase in value added tax (2011). Firstly, an overview of historic economic events affecting the UK economy during 1970 to 2011 is given. It is found that oil ‘shocks’ during the 1970s were a major impact on the UK economy, with inflation at its highest and GDP growth at its lowest. During early stages of the 1990s, an end to the British membership of the exchange rate mechanism caused high interest rates, falling house prices and an overvalued exchange rate, therefore, leading the UK into a recession.

Following this event, the 2008 financial crisis triggered by the global ‘credit crunch’ plunged the UK back into a deep recession, with poor economic growth, high inflation and high unemployment. The resulting inflation caused by the crisis is then discussed in depth, examining the impact that the financial crisis and policy reforms had on prices in the UK. It is found that sharp rises in electricity and gas prices were the primary reasons for high inflation during the crisis years (2008 to 2011). It was also found that a reduction in the corporation tax and the bank rate both encouraged investments and consumption, which in turn created a positive impact on UK exports. However, increases in VAT directly led to a reduction in investments and consumption, as well as UK exports.

The impact of inflation on investments in the UK showed that a rise in prices evidently discouraged businesses and consumers to invest in capital goods or further investment projects. The impact of inflation on UK exports revealed that higher domestic prices not only discouraged foreign buyers from purchasing domestic goods, but domestic consumers were also discouraged from purchasing domestic goods. Increasing imports were therefore explained by this and so declines in UK exports were also explained by this conclusion. Further to this, the impact of inflation on consumption, imports and government expenditure is outlined.

Lastly, the UK’s economic growth is also assessed using real GDP growth as a form of measurement, where it is found that consumption is the largest contributor to the growth of GDP. Therefore, any ‘shock’ or policy affecting consumption has a large impact on the UK’s economic growth. A concluding section summarises findings of the report.

Abbreviations

Abbreviations used in this report have been listed below.

  • AD – Aggregate Demand
  • C – Consumption
  • CPI – Consumer Price Index
  • EEC – European Economic Community
  • FDI – Foreign Direct Investments
  • G – Government Expenditure
  • GDP – Gross Domestic Product
  • I – Investments
  • IMF – International Monetary Fund
  • M - Imports
  • OAPEC – Organisation of Arab Petroleum Exporting Countries
  • UK – United Kingdom
  • US – United States
  • VAT – Value Added Tax
  • WPI – Wholesale Price Index
  • X - Exports

Contents

1.0: Introduction……………………………………………………........................…..4

2.0: Overview of Economic Events Affecting the UK…………...............……....……5

Economic Events Affecting UK Economy (1970-2011)……………………...……5-6
The Global Financial Crisis (2008)…………………………........................……...6
UK Policy Reforms (2008-2011)…………………………..................………...….7

3.0: Impact on Inflation (2008-2011)…………………….................................…..…..8

Inflation Analysis (2008-2011)………………………………..........................……8-9
Impact of Corporation Tax Reduction on Inflation (2008)……......................……..9-10
Impact of Bank Rate Reduction on Inflation (2009)……………....................…….10
Impact of VAT Increase on Inflation (2010)……………........................………….10-11

4.0: Impact on Investments in the UK (2008-2011)…………....................…………..12

Impact of Inflation or Deflation on Investments (2008-2011)…….............……….12-13
Policy Impact Comparisons on Investments.............................................................13-14

5.0: Impact on UK Exports (2008-2011)…………………….….….….……...……….15

Impact of Inflation or Deflation on Exports (2008-2011)……….……...............….15-16
Policy Impact Comparisons on Investments………………...................…………..17

6.0: Impact on Other AD Components (2008-2011)…………...........................…….18

Impact of Inflation or Deflation on C, G & M (2008-2011)….......................……..18
Policy Impacts on C, G & M……………………………….........................………18

7.0: Impact on UK Growth (2008-2011)………………….........................…………..19-21

8.0: Conclusion……………………………………………….................………………22

9.0: References……………………………………………...................………………..23
10.0: Appendix 10.0
…………………………………..................……..………..……..24-29

10.1: Appendix 10.1…………………………………..................................…………..30-32

1.0 Introduction

  1. This report will examine the impact of specific economic policy reforms on the aggregate economy of the UK, using the theory of AD. The impact of inflation on the components of AD vis a vis the economic growth in UK will also be examined. Particular focus of the AD component analysis will be on UK exports and investments, and how these components have been affected by inflation.
  2. Analysis will be based on examining ‘peaks’ or ‘kinks’ observed in charts constructed using UK statistics, retrieved from the ‘World Bank’ database (Appendix 10.0). The sample period used in this report was converted from ‘nominal’ into ‘real’ terms to remove the effect of inflation, and consists of forty-two annual observations from the year 1970 to 2011. However, primary focus of the analysis will be based on the financial crisis years (2008 to 2011), as undoubtedly this historic ‘shock’ had a major influence on UK exports and investments, as well as the economic growth of the UK.
  3. The report begins with an overview of historic economic events affecting the UK during 1970 to 2011. The 1970s oil ‘shocks,’ the 1990s end to British membership of the exchange rate mechanism and the 2008 financial crisis had large adverse effects on the UK economy. Emphasis of this section will be on the financial crisis and reforms implemented through 2008 to 2011. In particular, the following monetary and fiscal policy reforms will be examined: a reduction in the UK’s corporation tax during 2008; a reduction in the bank rate during 2009; an increase in VAT during 2010.
  4. A section on the impact of events or policy reforms on inflation will clarify the effect on prices in the UK, during 2008 to 2011. Sharp rises in electricity and gas prices were the primary reasons for inflation during the crisis years. It was also found that a reduction in the corporation tax and the bank rate both encouraged investments and consumption, which in turn created a positive impact on UK exports. However, increases in VAT directly led to a reduction in investments and consumption, as well as UK exports. A discussion will then be formed around the effects that the resulting inflation or deflation had on the key components of AD (consumption plus investment plus government expenditure plus exports minus imports).
  5. Particularly, the impact on investment and UK exports will be analysed. Investments showed that price increases discouraged businesses and consumers to spend or invest in capital goods. The impact on UK exports revealed that higher domestic prices discouraged foreign buyers from purchasing domestic goods, but domestic consumers were also discouraged from purchasing domestic goods. Declines in UK exports were therefore explained by this conclusion. Lastly, the UK’s economic growth is assessed using real GDP growth as a form of measurement. It is found that consumption, exports and investments are the largest contributors to the UK’s economic growth. A concluding section summarises findings of the report.

2.0 Overview of Economic Events Affecting the UK

  1. This section will firstly outline major economic events that have affected the UK economy, through 1970 to 2011. Particular focus of the analysis will then be on events related to the following monetary and fiscal policy reforms:
  • A reduction in corporation tax (main rate), from 30.0% to 28.0% in 2008.
  • A reduction in the bank rate from 1% to 0.5%, in 2009.
  • A VAT increase from 15% in 2008-09, to 17.5% in 2010.

Economic Events Affecting UK Economy – 1970 to 2011

  1. The UK’s economy has encountered its fair share of ‘shocks’ and economic policy reforms through the period of 1970 to 2011.


Chart 2.2a: Annual Inflation & GDP Growth (1970-2011)

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The Global Financial Crisis – 2008

UK Policy Reforms – 2008 to 2011

  1. It is therefore evident that policy reforms or ‘shocks’ that occurred in the economy, both had either a direct or indirect impact on prices vis-á-vis inflation, as well as economic growth. The following sections will discuss the extent to which they are impacted.

3.0 Impact on Inflation (2008-2011)

  1. This section will examine the impact of the events and policy reforms during the financial crisis (stated ...

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