Economics Essay 103: Currency Depreciation and Macroeconomic Effects

Assess the view that a depreciation of the pound against other currencies is likely to improve the UK’s macroeconomic performance.

The impact of a depreciation of the pound against other currencies on the UK's macroeconomic performance is a topic of debate among economists. Assessing the view that such a depreciation is likely to improve the UK's macroeconomic performance involves considering both the potential benefits and drawbacks:

1. Export Competitiveness: A depreciation of the pound can make UK exports more competitive in international markets. As the value of the pound decreases, UK goods and services become relatively cheaper for foreign buyers. This can lead to an increase in export demand, boosting exports and potentially improving the trade balance.

2. Tourism and Foreign Investment: A weaker pound can also make the UK a more attractive destination for foreign tourists and investors. With a lower exchange rate, travel and investment in the UK may become more affordable, stimulating tourism and attracting foreign capital inflows.

3. Domestic Industries: A depreciation of the pound can benefit certain domestic industries that rely heavily on imported inputs. As the cost of imports rises due to the weaker currency, domestic producers may find it more cost-effective to source inputs domestically, leading to increased production and investment in domestic industries.

4. Inflationary Pressure: A depreciation of the pound can have inflationary implications. It makes imports more expensive, which can lead to higher prices for imported goods and raw materials. This can contribute to inflationary pressure in the economy, potentially eroding consumers' purchasing power.

5. Imported Inflation: A weaker pound can also lead to higher costs for imported goods and services, which can affect businesses and consumers. Industries that rely heavily on imported inputs, such as manufacturing or energy, may experience higher production costs, potentially leading to lower profitability or increased prices for consumers.

6. Imported Inputs and Supply Chains: A depreciation of the pound can disrupt supply chains that rely on imported inputs, as the cost of those inputs increases. This can negatively impact businesses that rely on imported components or materials, potentially leading to reduced output and profitability.

7. Consumer Spending: A weaker pound can affect consumers' purchasing power, as imported goods become more expensive. This can lead to reduced consumer spending, which is a significant driver of economic growth.

Overall, the impact of a depreciation of the pound on the UK's macroeconomic performance is complex and depends on various factors. While it can provide some advantages, such as improving export competitiveness and attracting foreign investment, it also poses challenges such as inflationary pressure, increased costs for imported inputs, and potential disruptions to supply chains. The net effect on the UK's macroeconomic performance will depend on how these factors interact and the overall state of the economy.

Economics Essay 102: Floating Exchange System

 Explain why the value of a currency may fall in a floating exchange rate system.

In a floating exchange rate system, the value of a currency is determined by market forces of supply and demand in the foreign exchange market. Several factors can lead to a fall in the value of a currency:

1. Changes in Relative Interest Rates: If a country's interest rates decrease relative to those of other countries, it can reduce the attractiveness of holding that currency and lead to a decrease in its value. Investors may seek higher returns in other countries with relatively higher interest rates.

2. Economic Performance and Outlook: Market participants closely monitor a country's economic performance and future prospects. Factors such as low economic growth, high inflation, political instability, or fiscal imbalances can negatively impact the value of the currency. Investors may sell the currency, leading to its depreciation.

3. Trade Balance and Current Account: A country with a persistent trade deficit or a deteriorating current account balance may experience a decline in its currency's value. A trade deficit means that more goods and services are being imported than exported, resulting in a net outflow of the currency.

4. Market Speculation: Speculative activities in the foreign exchange market can also contribute to currency depreciation. If traders anticipate a fall in the value of a currency based on economic indicators or market sentiment, they may sell the currency in the expectation of buying it back later at a lower price.

5. Market Intervention: In some cases, central banks or governments may actively intervene in the foreign exchange market to influence the value of their currency. Intervention to sell or buy the currency can impact its value in the short term.

It is important to note that currency depreciation can have both positive and negative effects on an economy. On one hand, it can make a country's exports more competitive, stimulating economic activity and potentially improving the trade balance. On the other hand, it can increase the cost of imports, leading to higher inflation and potentially reducing consumers' purchasing power.

The value of a currency in a floating exchange rate system is determined by a complex interplay of economic factors, market forces, and investor sentiment. The relative strength or weakness of a currency reflects the market's assessment of a country's economic fundamentals and its position in the global economy.

Economics Essay 57: Exchange Rates

 Explain the factors that might cause a country’s exchange rate to depreciate.

Exchange rate systems can be broadly classified into two categories: fixed exchange rate systems and floating exchange rate systems.

1. Fixed Exchange Rate Systems: In a fixed exchange rate system, the value of a country's currency is pegged to another currency or a basket of currencies. The exchange rate is kept relatively stable through the intervention of the central bank. Examples include currency boards and currency unions like the Eurozone.

2. Floating Exchange Rate Systems: In a floating exchange rate system, the value of a country's currency is determined by market forces of supply and demand. The exchange rate fluctuates freely based on various factors, including economic conditions, interest rates, trade balances, and investor sentiment. Most major economies, including the United States and Japan, operate under a floating exchange rate system.

A reduction in the value of a currency in the Fixed Rate System is called Devaluation while Depreciation happens in a Floating Exchange System. Now, let's explore the factors that can cause a country's exchange rate to depreciate:

1. Interest Rate Differentials: Higher interest rates in one country compared to others can attract foreign investors seeking better returns. This increased demand for the country's currency can drive its value up. Conversely, lower interest rates can make the currency less attractive, leading to depreciation.

2. Inflation Rates: High inflation erodes the purchasing power of a currency, making it less desirable. Countries experiencing higher inflation rates relative to their trading partners may see a depreciation in their exchange rate.

3. Current Account Deficits: A current account deficit occurs when a country imports more goods and services than it exports. This results in a net outflow of the country's currency, increasing its supply in the foreign exchange market. The increased supply can lead to a depreciation of the currency.

4. Political and Economic Stability: Uncertainty surrounding a country's political or economic stability can negatively impact investor confidence. Investors may sell off the country's currency, leading to a depreciation. Factors such as political unrest, policy uncertainty, or economic crises can contribute to a decline in the exchange rate.

5. Speculation: Speculative trading activities in the foreign exchange market can influence exchange rates. Traders may speculate on the future value of a currency based on economic indicators, news, or market sentiment. If speculation suggests that a currency will depreciate, it can trigger selling pressure and lead to an actual depreciation.

It is important to note that exchange rates are influenced by a complex interplay of various factors, and their movements can be volatile and unpredictable. Additionally, government interventions, such as central bank actions or currency market interventions, can also impact exchange rates in the short term.

Overall, the factors discussed above, along with other economic and market forces, can cause a country's exchange rate to depreciate in a floating exchange rate system. However, in a fixed exchange rate system, the exchange rate is generally maintained at a stable level through central bank interventions, which aim to prevent significant fluctuations in the value of the currency.

The £ Sterling’s faded illusion of sovereignty

Philip Stephens in The FT

Margaret Thatcher once told me that she would never allow “the Belgians” to decide the value of the British pound. At the time, the then prime minister was battling her chancellor Nigel Lawson’s plan to fix the value of sterling in the European exchange rate mechanism. For some reason she had identified me as one of the chancellor’s confidants. “The Belgians”, equally inexplicably, was her shorthand for the EU.  

The fight cost the chancellor his job, but a year or so later Thatcher was obliged to relent. Two years after it joined the ERM, sterling crashed out of the system amid a tsunami of speculative selling. 

Thatcher by then had gone, replaced by John Major. Even so, the pound became an inviolable emblem of national sovereignty in the Conservative party’s long war with Brussels. Before too long, another Tory leader, William Hague, was promising to “save” sterling from the euro. Black Wednesday, you could say, mapped the Tory route to the Brexit vote in 2016.

I was reminded of the Thatcher encounter by a report published the other day by analysts at Bank of America. Since the Brexit referendum, the pound has rather lost its lustre as a store of value. It no longer bears comparison, the analysts said, with traditional peers such as the dollar, yen, swiss franc or euro. Instead, sterling may more closely resemble an emerging market currency, such as the Mexican peso. Sterling’s effective exchange rate has fallen by about 14 per cent since 2016, but twin budget and current account deficits promise further trouble.  

In truth, Thatcher’s elevation of the pound into an essential pillar of nationhood belied its postwar role in Britain’s fortunes. For decades, an ever-present threat of devaluation was a ball-and-chain around the ankles of successive prime ministers. In 1945, about half the world’s trade was still transacted in sterling. From then on, it was all downhill.  

The failed effort to defend Britain’s global prestige through preservation of the so-called sterling balances held by overseas central banks and financial institutions left governments at the mercy of international investors and speculators. 

It also produced a series of politically costly devaluations. In 1950, one pound bought about 12 Deutsche Marks. In the absence of the euro, the comparable figure today would be a little above two. 

In effect, pressure on the pound measured the gap between Britain’s determination to hold on to its status as a world power, and the capacity of a stuttering domestic economy to generate sufficient resources to match its overseas ambitions and commitments. The price of propping up the pound was a ruinous stop-go approach to domestic economic management. 

It was no coincidence that the devaluation that was forced on Harold Wilson’s government in 1967 sounded the final retreat from imperial pretensions with the subsequent withdrawal of British forces from east of Suez. 

In the circumstances, one might think that sterling would have lost its talismanic status long ago. The sovereignty so preciously guarded by the Brexiters is an illusion. The truth Thatcher could never admit was that the appearance of national control does not change the facts of foreign exchange markets. The pound’s exchange rate, fixed or otherwise, ultimately depends on the confidence, or otherwise, of foreign investors in the nation’s political stability and economic performance — and, yes, that includes the Belgians. 

Mark Carney, the former governor of the Bank of England, has also remarked on how sterling has “decoupled” from its usual peers. Bank of America’s grim prognosis, however, is not universally shared among financial institutions. 

Some think the pound’s present exchange rate anticipates more economic disruption after the expiry of the Brexit transitional arrangements. In the short term, the conclusion of even a fairly thin trade deal with the EU27 could see a temporary appreciation. 

That said, trade deal or no deal, and even assuming a relatively robust recovery from the coronavirus-induced recession, Brexit will throw up new barriers to trade with Britain’s most important market. This promises in turn lower-than-otherwise economic growth, and a widening of the current account deficit. It is hard to find reasons for a positive view of the pound over the medium to long-term. 

The government, of course, could treat sterling’s move to the sidelines as something of a liberation. For now, it has little problem financing its burgeoning government deficit. Devaluation would also provide at least a temporary route to improved competitiveness. It could even pretend, as Wilson did, that a weak currency does not cut living standards. 

I am not sure this would sit alongside Boris Johnson’s expansive pledge to turn Brexit into the platform for the relaunch of “Global Britain”. The prime minister, I am told, is emotionally sympathetic to grand talk about carving out a new role in the Gulf and beyond. 

But no one knows where the money would come from. 

One way or another, sterling holds up a mirror to the world’s view of Britain. The signals are not encouraging. In the 1970s, the UK earned the sobriquet of “the sick man of Europe”. The danger now is it will become the invalid on Europe’s edge.