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Fixing or Floating
5th February 2008
In our A2 macroeconomics lesson today we were discussing the economics of fixed and floating exchange rates. The UK economy has operated with a floating exchange rate system since September 1992 and our forced departure from the exchange rate mechanism. It was an event of huge political as well as economic importance, ushering in a new system of inflation targeting and (ultimately) the granting of independence for the Bank of England. Leaving the external value of the currency to market forces does have risks, but at the moment the trends in the sterling exchange rate might well have a positive influence on the direction of the economy during a difficult 2008.
Sterling has weakened considerably against the Euro and is now some distance below the $2 mark reached late last year. On a trade weighted basis, sterling has depreciated considerably over the last year. What does this mean? It could well lead to some extra inflationary pressures through higher import prices. But a lower currency provides a welcome competitive boost for export industries and a chance to correct in part the enormous trade deficit in goods and services.
The risk is that slower economic growth in the USA and in the Euro Zone (our largest export market) will dampen the advantage of a more competitive currency.
The presentation used in the lesson is streamed here
Will the depreciation in sterling lead to a J Curve effect - whereby a weakening of the currency initially causes a deterioration in the overall balance of trade in goods and services? The chart below might provide one or two clues and it also takes us back to the devaluation of sterling in 1992 and the subsequent impact on the trade balance
Suggestions for more reading on the UK exchange rate
Geoff Riley
Geoff Riley FRSA has been teaching Economics for over thirty years. He has over twenty years experience as Head of Economics at leading schools. He writes extensively and is a contributor and presenter on CPD conferences in the UK and overseas.