UK Recession of 1991-92
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During the 1980s the govt allowed the economy to expand at a significantly higher rate than its long run trend growth rate. This was because they felt there had been a “supply side miracle”. They argued that its supply side policies enabled the economy to grow at a faster rate than before.
Therefore the govt kept interest rates low and cut income tax, especially for high earners.
Also during the 1980s, there was a boom in the housing market. The rapid increase in house prices lead to an increase in consumer wealth and consumer spending. There was a big increase in consumer confidence.
Unfortunately it proved wishful thinking that the economy experienced a supply side miracle; most of the growth was caused by consumer borrowing and spending. This was reflected in a large current account deficit and inflation
The effect of growth above the long run trend rate was cause inflation and a large current account deficit.
To reduce the double digit inflation the government joined the Exchange Rate Mechanism in 1990, it was felt that by joining inflation would be brought under control.
Unfortunately this was another mistake by the govt because they entered at a rate too high. Market forces kept speculating the pound would fall. To maintain its value the govt had to
- Use its foreign currency reserves to buy sterling (the UK lost £21bn in the ERM)
- Increase interest rate to 15%
Despite these measures the speculators were stronger than the govt and the UK was forced to leave the ERM and devalue.
However the experience of interest rates of 15% had
- Caused a fall in AD and a steep recession
- Caused a fall in house prices as people couldn’t afford mortgages any more. This fall in house prices reduced AD further.
- Many people who had borrowed money in the 1980s now faced very high interest rates
- Confidence fell sharply
One consequence of this recession was to eventually give the MPC of the Bank of England control over setting interest rates and take power away from politicians who proved incompetent in setting interest rates
Essays and Revision Notes on Economic Growth
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