AS Macro: Sterling and the UK Economy

This is an updated version of a previous blog post on the macroeconomics of a weaker exchange rate - perhaps important for the AS macro paper on June 7th.

The Bank of England - which is the UK’s central bank - estimates that the pound has depreciated by around 25pc against a basket of other currencies such as the euro and the US dollar since mid-2007. And in 2008-09, sterling registered an even larger depreciation against the dollar than its 1992 exit from the European Exchange Rate Mechanism. In trade-weighted terms, the decline was the biggest since figures were first calculated in the early 1980s.

The fall in the external value of the pound has many possible consequences for an open economy such as the UK. At AS level it is important to identify these effects and explain them concisely using an AD-AS framework. Then support your answer with some good evaluation points and (where possible) supporting evidence.

Why has sterling declined?

There are numerous reasons for this but it seems that sterling appears to have become a “beta-currency” in the markets. It does well when the global economy is strong but tends to fall back in a slowdown or a recession. The depreciation of sterling might be explained by:

i) The steep cuts in policy interest rates by the Bank of England which has reduced the expected rate of return of putting foreign money into UK bank accounts - UK policy rates remain at 0.5% (historically low)

ii) The currency markets have downgraded their expectations for the near-term performance of the UK economy believing that Britain is more exposed than most to the fall-out from the global credit crunch. More recently this has included the exposure of many UK commercial banks to loans to Spain, Portugal, Italy and Greece - countries at risk of defaulting on some of their loans.

iii) Britain continues to operate with a large trade deficit in goods at a time of recession (when we would expect the deficit to diminish because of lower demand for imports). This suggests that sterling as a currency was over-valued in 2007-08 (it climbed well above $2 to the £1) and that some adjustment was over due

What are the consequences of a depreciation of the pound?

Good answers at AS level will focus on the links between changes in the exchange rate and the key indicators of macroeconomic performance such as economic growth, consumer price inflation, the rate of unemployment and the trade balance.

On the positive side:

(a) A cheaper currency makes British export businesses more competitive in overseas markets. Firms selling products in foreign markets can either cut their selling prices to boost the volume of orders. Or they can keep prices constant and enjoy a higher profit margin on each product exported. Evidence suggests that many business people have chosen the latter.

(b) A lower pound ought to bring about a re-balancing of the economy away from a high level of imports (M) towards exports (X) - helping to lower the trade deficit and providing a net injection of demand into the circular flow. There is plenty of spare capacity in the economy for export industries to be able to meet higher demand from abroad - as the output gap is negative.

(c) Linked to the previous point, a rebound in exports will be good news for manufacturing firms selling UK products overseas, the UK tourist industry, farmers (who get their EU subsidies paid in Euros) and other businesses who supply export sectors. A rise in exports can lead to positive multiplier and accelerator effects on the level of real national income.

(d) If the falling pound causes some extra inflation, this may not be a bad thing if it leads to a reduction in the real value of the UK’s national debt.

Overall, a cheaper currency acts as a useful “shock absorber” for the economy and can help to bring the economy out of recession.

On the negative side

(a) A lower pound increases the sterling price of importing technology which can hit investment spending and affect long run productivity and supply (LRAS)

(b) There are some inflationary dangers from a sharp fall in the currency - commodities and components from overseas are also more expensive causing an inward shift in short run aggregate supply. Higher inflation may make it more difficult for the Bank of England to maintain a policy of low short-term policy interest rates. Inflation in the UK is now at its highest level since the early 1990s with RPI inflation over 5% and CPI inflation staying well above 3%

(c) Exports ought to be more competitive with a lower pound - but the timing of the depreciation has not been ideal. In 2009 global trade in goods and services fell away by nearly ten per cent, so demand in many of the UK’s major export markets was weak just at the time when we might have seen a rebound in UK exports. It might be in 2010 that the main impact of the cheaper currency will be seen?

(d) A weak currency can make it more difficult for the government to attract the inflows of foreign money required to buy the huge value of new bonds that the government is issuing to fund it’s £155bn annual budget deficit. There are fears that expectations of a further fall in sterling might lead to a bout of “capital flight” from the UK. Currency weakness can sometimes lead to a currency crisis with a collective loss of confidence in the foreign exchange markets.

My view is that a weaker currency is broadly-speaking good news for an economy during a time of economic weakness. Certainly there are plenty of countries inside the Euro Zone who would quite like to have a more competitive exchange rate to boost their export industries but they have locked their economies to the Euro. Flat UK exports suggest that foreign demand for UK products has not yet responded elastically to the lower pound. Perhaps we are not supplying enough of the goods and services that the rest of the world wants to buy?