How Brexit Affects UK National Income via the Circular Flow, and Its Impact on Cost of Living and Living Standards

Answer

Part (a) — Brexit and national income via the circular flow [10]

In the four-sector circular flow of income, national income is in equilibrium when injections (investment, government spending, exports) equal leakages (saving, taxation, imports).

Brexit threatens two injections: exports fall as UK access to the EU single market is jeopardised, and investment falls as firms, fearing disruption, defer projects and FDI declines. With injections falling below leakages, firms employ fewer factors and pay out less income to households; households’ consumption then falls, firms sell less and cut output further, paying out still less income. This is the multiplier effect operating in reverse: the initial fall in autonomous spending produces a more-than-proportionate fall in national income, until injections again equal leakages at a lower equilibrium income.

Part (b) — Does Brexit raise the cost of living and lower living standards? [15]

Cost of living is the cost of maintaining a given standard of living, tracked by the general price level (CPI); standard of living has a material dimension (goods and services consumed) and a non-material dimension (leisure, environment, security).

Cost of living likely rises. The drastic depreciation of the pound raises the domestic-currency price of imported final, primary and intermediate goods, generating imported cost-push inflation — the rise to 3.1% confirms it. To buy the same CPI basket, the average person must pay more, so the cost of living rises and real purchasing power falls. (A caveat: if AD also falls sharply with lower X and I, the price-level rise could be muted; and an individual whose basket differs from the CPI basket experiences a different effect.)

Material living standards — mixed. The negative case: if gloomy expectations cut C and I enough to outweigh any export gain, and imported inflation contracts SRAS, real national income falls and the inflation squeeze erodes purchasing power, while demand-deficient unemployment rises from offshoring — lowering material living standards. The mitigating case: as a developed economy with slow population growth, real GDP per capita may still edge up if output grows faster than population; the composition of income matters (a fall driven by lower investment need not cut current consumption, and lower exports may leave more goods for the domestic market); and as a welfare state, automatic stabilisers (untaxed unemployment benefits) cushion incomes and can improve income distribution.

Non-material living standards. Likely worse: pervasive fear and uncertainty raise stress, with riots, protests and political instability (repeated changes of prime minister) and the risk of a no-deal exit. Against this, some value the regained national autonomy — control over immigration, security and economic policy.

Judgement. The cost of living has almost certainly risen, given the depreciation-driven inflation. The effect on standard of living is more contingent: material living standards may fall if the demand and confidence shocks dominate, but could hold up where real GDP per capita still grows slowly and redistribution improves — so the material verdict turns on the size of the investment and export shocks and the composition of the income fall. What tips the overall assessment negative is the non-material dimension: the psychological toll of uncertainty and political instability, layered on living standards already stagnant since 2008, means that on balance Brexit is likely to lower overall living standards even where measured material output holds up — because how people experience their circumstances has worsened markedly.