Growth, inflation and government budgets

The Bank of England have slashed their growth forecast and predicted a rapid fall in inflation over the next two years. At the same time the governments aim at reducing the government budget deficit now appears optimistic due to the slowdown in the Eurozone economies.

This latest news illustrates the relationship between economic variables.

Economic growth leads to upward pressure on prices as demand rises, while slow growth exerts little inflationary pressure. The slowing of the Eurozone economies has affected Britain because Europe is the main market for British exports. Lower export growth has led to a stalling of British growth as net exports are a component of Aggregate Demand. The general uncertainty of the whole crisis is making UK households save and pay off debt rather than spend so reducing Consumption, another component of AD.

The result is that the Government is not gaining as much revenue as they thought (through lower income tax, VAT and corporation tax receipts) and are spending more than they hoped (on unemployment benefits for example). The result is the government budget deficit is larger than predicted.

Of course this is exactly what should happen and is caused by the operation of automatic stabilisers. For the Bank of England there are new problems. Inflation is well above target but threatening to drop below over the next two years. It means that interest rates will not rise anytime soon and more Quantitative Easing is possible.

The Guardian lead article is here

Watch the latest Inflation Report presentation here