If you needed proof confidence is important, look no further than the UK

The decision of the UK to leave the European Union (EU) was widely predicted to be an economic disaster. Therefore we shouldn't be surprised that businesses and consumers have reacted to the move based on the uncertainty this situation has created.

A survey recently published survey shows there has been a sharp slowdown in orders, which will work through the economy to mean lower output. The slowdown is the worst since the Global Financial Crisis.

Both Consumption spending and Investment spending, both components of Aggregate Demand (AD) are partly determined by household and firms confidence (sentiment). Put simply if households are worried about future income they will spend less and save more now. Firms will not invest as much if they are uncertain about future prospects. Brexit has handed out one huge dollop of uncertainty and households and firms are reacting exactly as economic theory predicts.

The effect is to reduce both Consumer and Investment spending and AD will fall.

 

The diagram shows the result of a fall in business and consumer confidence. Inflationary pressure is reduced and this may well lead to the Bank of England having to cut interest rates and engage in more quantitative easing as the UK inflation rate is already well below target. Also with lower output UK economic growth will falter and the possibility of recession and higher unemployment will mean the government might have to allow the budget deficit to increase. 

The Bank of England has already indicated that they will take an accommodating stance  and the new British Chancellor (Treasury minister) has said the aim of returning the government budget to balance by 2020 will be abandoned. 

The BBC report on this story here

VCE students can use this to apply their knowledge of budgetary policy and note the link to monetary policy for the 'policy mix'. For IB students this is an excellent example of fiscal and monetary policy operation using the AD/AS model to analyze the consequences and responses. Not that there will be both discretionary and automatic responses from fiscal policy.