Unit 2 Macro: Model answer for revision data question

Here is a suggested answer for the first of the practice questions available from this resource:

AS_Macro_Revision_Trade_Sterling.docx

Question

Using the data and your own knowledge, to what extent might a fall in the value of the exchange rate help to bring about a recovery for the UK economy? (30 marks)

A depreciation in the exchange rate reduce the external purchasing power of sterling against other currencies including the US dollar and the Euro. Recovery is a broadly-based expansion of economic activity shown through a pick up in aggregate demand, real GDP and (hopefully) a rise in employment as the economy recovers from a recession.

Figure 2 indicates that sterling has depreciated against the US dollar in recent years. The steepest fall came in 2007-09 when the pound fell from $2.00 to $1.57, a decline of over 20 per cent. This is a significant change in the exchange rate although sterling has remained fairly stable since then and we are not given data on movements against other currencies including the Euro with whom more than 50% of UK trade is conducted.

That said a 20% depreciation represents a sizeable and important easing of monetary policy which in normal times might have an equivalent effect to a 3-4% reduction in policy interest rates. A more competitive exchange rate can be expected to contribute to recovery in several ways.

First it makes UK exports more price competitive in international markets, and assuming that demand is fairly price elastic, we would hope to see a strong increase in export volumes overseas, creating a fresh injection of demand into the circular flow. Evidence for this is shown in Figure 2 where real export volumes grew by 7.4% in 2010 after a 9.5% fall a year earlier. This could be seen as a lagged response to a sterling depreciation a year or so earlier.

Higher export sales provide a direct boost to demand and the effect on output and jobs will be amplified if there is a multiplier effect. For example a rise in overseas sales of cars will cause increased derived demand for component parts, raw materials and higher profits for many industries involved in other supply-chain activities. A rise in exports might also prompt an increase in capital investment although this effect might be limited because of the high level of spare capacity at the end of recession.

If sterling is weaker, the UK price of imports will increase bringing about a slower growth of demand for foreign-produced goods and services. Import growth was negative in the recession year of 2009 (-12.2%) but rebounded strongly a year later despite the fall in sterling. Perhaps the price elasticity of demand for imports is low, at least in the short term?

Overall, a depreciation of sterling should help to bring about a recovery of output and also a re-balancing of the economy away from consumption and imports towards exports and investment. That at least is the hope of the Bank of England and the Treasury. We see from Figure 1 that, despite a higher deficit in 2010 of 2.5% of GDP, there has been a gradual improvement in the UK’s current account on the balance of payments. The trade deficit in goods has continued to grow (it was £99bn in 2011) but the trade surplus in services is higher (over £70bn last year) and the weakness of sterling has increased the sterling value of the interest, profits and dividends from UK investments overseas.

My view is that a depreciation of the exchange rate has been an important part of the UK economy beginning a long, slow process of recovery and adjustment after the downturn. But several other factors need to be borne in mind.

First, a 20% depreciation increases the prices of imports - from finished manufacture products to the prices of essential foodstuffs and energy supplies. This is one reason why CPI inflation has been persistently above target in recent years. Figure 2 shows an acceleration in inflation from 2.2% in 2009 to more than double this (4.5%) in 2011. Higher inflation threatens to erode the competitive advantage given by the fall in sterling’s external value and it has been a key factor causing real incomes and living standards to fall in the last two years.

Second the fall in sterling has not been sufficient on it’s own to bring about a strong recovery. Figure 1 shows that the LFS unemployment rate continues to rise climbing from 5.7% of the labour force in 2008 to over 8% in 2011. Real GDP growth for the UK has been weak, the economy grew by less than 1% last year and output lags well below the level seen at the start of the recession.

A key problem has been that many of the UK’s major export markets have had deep economic troubles of their own, notably the debt crisis engulfing the Euro Zone. Too few of our exports go to the fast-growing emerging nations including the BRIC and MIST countries where per capita incomes are rising and trade and export opportunities are flourishing.

Despite the weakness of sterling, many British businesses have found it tough to secure the trade insurance and export credit finance needed to complete new export orders, our financial fragility may well be holding back am export-led recovery. Doubts remain too about the non-price quality of many UK products especially in industries where intense global competition requires strong innovation and research investment. Manufacturing industry in particular exports over sixty per cent of output to the rest of the world, but decades of de-industrialisation have led to a situation where this industry contributes less than 12% of GDP and one could argue is no longer of a sufficient scale to reap the rewards of the advantages of a competitive exchange rate.

Sterling’s depreciation came at the right time for the UK economy and without it there is a real danger that we would have suffered a depression and unemployment well in excess of 10%. But the lagged and, so far modest expansionary effects of a cheaper currency are a reminder that no single macroeconomic policy instrument on its own is likely to have a sufficiently big impact to bring about a strong recovery. External demand provides a welcome boost when we are at risk of semi-permanent recession but it needs the injection of higher domestic demand for growth rates of 2% or more to be sustained. Growth is being held back by deep cuts in real living standards and mistimed and poorly judged fiscal austerity from central Government.