After the financial crisis in 2008, the United Kingdom also carried a record budget deficit of £155bn, and so when the Coalition government came in power in 2010, David Cameron, UK Prime Minister, and George Osborne, the Chancellor of the Exchequer, brought with them the Austerity plan, which would see the UK go on a ‘budget diet’, reducing the government budget deficits, which is a heavily debated topic of discussion in the United Kingdom and the Western world.
Following the financial crisis with the collapse of Lehman Brothers, changes are happening at every level of the economy; former powerful investment banks such as Bear Stearns or Merill Lynch get absorbed by J.P Morgan Chase and Bank of America respectively to avoid bankruptcy similar to Lehman; consumers suffer from high level of unemployment, cost-push inflation, households reducing debt level, saving instead of consuming, entrepreneurs and business owners find it difficult to gain access to loans and credits, causing many small businesses to fail. With the economy in shambles, the UK government took control of Northern Rock’s bank run, nationalised both Lloyd’s TSB (now Lloyd and TSB) and RBS Group, two of Britain’s biggest banks, they also ‘injected’ £375 billion since in attempt to improve liquidity of the economy; the Bank of England itself reduced the base interest rate down to 0.5% from 4.5% in order to spur credit activity, increasing consumptions and investments from households and businesses.
In the Classical Model of the economy, National Income (GDP) consists of four components, consumptions (C), investments (I), government spending (G) and net exports (NX), where consumptions account for the demand for goods and services by the consumers, investment takes into companies’ purchases of capitals for investment projects or productions, government spending includes the amount spent on national defense, public healthcare, social welfare etc. made by the government. The closed economy is given by the production function, Y = f (K, L), this shows the level of output an economy can produce from K units of capital and L units of labour under the assumption that technology is fixed and there is a fixed supply of capital and labour at any given point. The UK economy is not a closed economy, however, the world economy is an example of a closed economy, as inter-planet (or inter-galactic) trades have yet to be established.
In the closed economy model, trade with outsiders do not exist and this is not the case in reality, as countries develop specialties and trade with countries of different specialties, this is absolute and comparative advantage, a theory first mentioned in Adam Smith “The Invisible Hand” and later investigated and developed by David Ricardo. Trading between countries is then represented by the Net Export (NX) component in the National Income, net export is the difference between the exports and imports of a country, the UK has a negative trade balance as it imports a...