Revision Essay: Exchange Rate Depreciation and Macroeconomic Objectives

Here is a sample answer to this question: "Evaluate the possible impact of a depreciation of the sterling exchange rate against leading currencies on key macroeconomic objectives."

A depreciation of sterling would occur inside a free-floating currency system and has happened on several occasions in the past most notably in June 2016 when the pound’s external value fell in the immediate aftermath of the Brexit referendum result. The sterling effective exchange rate depreciated 20% between November 2015 and October 2016, including a record 6.5% fall between June and July 2016 following the EU referendum vote. The effective exchange rate is an index weighted by the percentage of trade that the UK does with individual countries and trading blocs.

The impact of a depreciation on macro objectives depends on the scale, duration and timing of a currency fall and also the strength of the transmission mechanism from currency movement to other indicators. This essay will look at three objectives namely, sustained GDP growth, low stable price inflation and an improvement in the trade balance in goods and services.

In theory a fall in the currency is a monetary stimulus to an economy open to international trade and investment. A weaker pound increases the sterling price of imported products and this increase in relative prices ought to improve the price and cost competitiveness of domestic suppliers in the UK. It also allows UK exporters to lower their prices (expressed in a foreign currency) and hopefully achieve an expansion of overseas sales. The combined effect of this is to stimulate aggregate demand (where AD = C+I+G+X-M) and provide a short-term fillip to economic activity. In the summer of 2016, the fall in sterling helped the UK to avoid the full-blown recession that some analysts had predicted. Growth slowed but remained positive and the weaker pound injected extra demand in industries such as tourism and transport. Manufacturing was assisted with a more competitive exchange rate although this sector accounts for only ten percent of total UK GDP.

If exports rise following a depreciation, this can be shown by an outward shift of aggregate demand (as shown in my analysis diagram) leading to an expansion of short-run aggregate supply. A weaker currency can act as a useful shock absorber when a country experiences unexpected turbulence.

In evaluation, we can question whether a sterling depreciation actually helps economic growth in the medium term. There is no guarantee for example that exporting businesses will take advantage of additional competitiveness, cut the price of their exports and increase output, investment and employment. There is some evidence that UK firms have instead opted to raise the sterling price of exports and therefore enjoy a higher profit margin on each unit sold. Imports are also made more expensive and this can harm the profitability and expansion plans of businesses who rely heavily on raw materials, components and capital technology sourced from outside of the UK.

A second theoretical effect of a currency depreciation is on the rate of consumer price inflation. A weaker currency increases the prices of imported products and can feed through directly to higher prices in the shops for many items. This cost-push inflation can be shown by an inward shift of short-run aggregate supply and it has the effect of dampening the impact of a falling pound on growth. In the UK, the 20 percent depreciation in 2015-16 was undoubtedly a factor behind CPI inflation rising well above target. CPI inflation in the UK rose from 0.4% in June 2016 to 2.6% in June 2017 and 3.0% in October 2017 and this was a factor explaining falling real wages for millions of people in work.

However, the exchange rate is not the only external factor influencing inflationary pressures in the UK. For example in 2015 and 2016, inflation was also rising in the economies of some of the UK’s major trading partners and there was also the effect of strong global commodity prices to consider. The extent to which a currency depreciation does lead to higher inflation depends on the import dependency for a country - in the case of the UK, around one third of national output each year comes from imports of finished and semi-finished products, energy supplies and raw materials. So the flow-through from a fall in the pound can happen quickly.

My third point concerns the extent to which a sterling depreciation leads to an improvement in the net trade balance for goods and services. Again in theory, we might predict that a 20% fall in the £ against the Euro and the US dollar ($) would increase demand for UK exports and squeeze demand for imports, thereby improving the trade balance. Such a move might be welcome for the UK given the structural trade deficit we run overall and the large trade imbalance with the Euro Zone in particular.

However, theory and reality rarely coincide! Analysis of the J curve concept (shown in my diagram below) suggests that it can take time for demand and output to adapt. Instead the immediate effect of a currency depreciation is usually to increase the price of imports which - if demand is price inelastic - will lead to a worsening of the trade deficit. The trade balance will improve over time providing that the Marshall-Lerner condition is satisfied. This states that net trade will improve if PED for exports + PED for imports >1. A worry is that, in the medium term, a sterling depreciation increases the prices that UK firms have to pay for imported capital technologies which in turn might limit the scope for increasing productive capacity and raising labour productivity.

Overall, a depreciation of sterling is likely to provide a short-term stimulus to some parts of the economy (especially those engaged with international trade) but risks causing a fall in real living standards for households who will also see a cut in the purchasing power of their tourist dollar or euro when overseas. A weaker currency rarely helps to improve the non-price competitiveness of a country.