Question

3. The United Kingdom (UK) held a national referendum (vote) on whether the UK should remain in the European Union (EU), or should exit the EU. Exiting the EU is likely to have several consequences: (1) increased barriers to trade between the UK and the remaining EU countries; (2) Reduced refugee flows. Use the AS/AD model to describe the short run and long run effect of the UK exit from the EU.

Answer 1

LRAS - SRASI -SRAS -SRAS brice Loual BL- LAD » Real GDP. t

Let us assume that the initial equilibrium in the AD/AS model occurs at point E1 where the aggregate demand, Short run aggregate supply and long run aggregate supply curve intersects. Increased trade barriers with other nations will reduce the overall trade balance of UK and net exports of UK fall and this will shift the aggregate demand curve of UK inwards to AD'. Reduced refugee flows will reduce the labor force of the economy and this will shift the short run aggregate supply curve leftwards to SRAS' and thus new short run equilibrium occurs at point E2 where the level of real GDP in the economy has fallen to OY' . This will increase unemployment rate in the short run but in the long run wages will decrease and this reduction in the cost of production will shift the SRAS curve rightwards to SRAS'' and new long run equilibrium occurs at point E3 where price level falls in the economy and economy has returned to its initial potential level.