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The United Kingdom (UK) formally entered a recession at the end of 2023. Several factors can explain this poor performance. Russia has cut its exports of natural gas due to the ongoing Russia-Ukraine war. COVID-19 has also hurt consumers and exporters and has deterred investors.

(a) Explain how the above-mentioned events have resulted in inflation and a recession in the UK. [10]

Inflation

One of the primary drivers of inflation in the UK has been the reduction in global natural gas supply due to Russia's decision to cut exports of natural gas, exacerbated by the ongoing Russia-Ukraine war. Natural gas is a critical energy source and factor input in the production of goods and services, including heating, manufacturing, and electricity generation. As global supply falls, the price of natural gas rises. This increase in the price of a key input leads to a rise in the overall cost of production for firms across various industries.

The increase in production costs shifts the Short-Run Aggregate Supply (SRAS) curve to the left, from AS₀ to AS₁. This leftward shift of the SRAS results in a higher general price level, rising from P₀ to P₁, as firms pass on their increased costs to consumers in the form of higher prices. This is referred to as cost-push inflation.

Recession

Simultaneously, the COVID-19 pandemic has had severe demand-side effects on the UK economy. Various restrictions, such as lockdowns, social distancing rules, and travel bans, have reduced economic activity in key sectors like hospitality, retail, and tourism. These restrictions have limited consumers' ability to dine out or shop, leading to a significant decline in Consumption (C). Additionally, the tourism and aviation industries, which are major service exporters for the UK, have faced sharp declines in demand as border closures and travel restrictions curtailed foreign visitors, reducing exports (X).

Moreover, COVID-19 has generated pessimistic expectations about future economic conditions, which has deterred firms from investing in capital projects, leading to a reduction in Investment (I). The combination of declining consumption, investment, and exports, along with reduced consumer confidence and heightened uncertainty, has triggered a reduction in Aggregate Demand (AD). The AD curve shifts leftward from AD₀ to AD₁, reflecting lower overall demand in the economy.

This fall in aggregate demand results in a decline in real national income, which contracts from YF to Y0, leading to lower economic output. As the UK experiences a persistent decline in output and rising unemployment, the economy enters a recession, typically defined as two consecutive quarters of negative GDP growth. The reduced demand for goods and services further aggravates the situation, creating a negative multiplier effect, where reduced incomes lead to further declines in consumption and investment.

Conclusion

The interaction between these supply- and demand-side effects creates a stagflationary environment—a situation in which the UK experiences both inflation and stagnating economic growth.