Beta Currencies and PMD

Beta Currencies

The continued depreciation of sterling - most notably against the Euro - continues to dominate the economic headlines. One Euro now buys 95 pence and parity is much more likely than I thought when I wrote about the exchange rate last week.

For your exams remember that you need to have a clear handle on

Why the currency is falling (causation) What the main demand and supply-side effects of this are (consequences) The possible policy responses (intervention)

With the latter keep in mind that the government and the central bank does not have a target for the external value of the pound although they recognise that it plays an important role in influencing the components of aggregate demand (C+I+G+X-M and also changes in short run aggregate supply (SRAS) e.g. through movements in the prices of imported goods and services.

Another approach for critical analysis of the exchange rate’s fall is to use the acronym PMD

P - plusses - i.e. what are the main advantages of a fall in the currency?

M - minuses - what are the negative effects for the UK economy at this time and for different agents (businesses and consumers)

D - depends - “it depends on” is one of the best evaluation phrases you can use - sterling has fallen by more than 20 per cent (on a trade weighted basis) over the last year. This is a significant depreciation - but the effects DEPEND on many factors - here are a few:

Do exporters reduce their overseas prices or choose instead to keep prices the same and make a higher profit margin? Do foreign consumers switch their demand to UK exports if and when our exports become more price competitive? Will the negative real income effect of a global economic downturn offset the competitive advantage from having a lower exchange rate? Will higher import prices help to prevent deflation in the UK next year?

Ambrose Evans-Pritchard has an article in the Telegraph today which argues that “Sterling fall is a life-saver for UK economy”

“Stephen Jen, currency chief at Morgan Stanley, said sterling is a “high-beta” currency, meaning that it is highly-geared to the global economic cycle. It shoots up during good times and plunges during bad times. It should return to health if and when the world emerges from economic winter.”

A related piece claims that the Sterling slide is the worst since 1931

“The pound has now fallen by 23pc against a basket of other currencies, according to figures from the Bank of England. The fall is sharper than the devaluations in 1992, after leaving the Exchange Rate Mechanism, 1976, when the International Monetary Fund was forced to intervene, and 1949, when a host of countries slumped against the dollar. The devaluation is only matched by the moment in 1931 when, under Ramsay MacDonald, the UK was forced to abandon the gold standard, plunging by more than 24pc against the dollar. The parallel is significant, since many economists have attributed the gold standard exit as one of the main reasons the UK enjoyed a relatively mild depression in the 1930s, while the US suffered mass unemployment and saw its economy shrink by a third.”