economics effects of exchange rate changes

Changes in the exchange rate can have a powerful effect on the economy - but these effects take time to show through. There are time lags between a rise or a fall in the exchange rate, and changes in variables such as inflation, GDP and exports & imports.

Much depends on

The scale/size of any change in the exchange rate

Whether the change in the currency is short term or long term

How businesses and consumers respond to exchange rate fluctuations

WINNERS AND LOSERS FROM EXCHANGE RATE FLUCTUATIONS

In recent years the sterling exchange rate has risen appreciably against a range of other leading currencies - not least the Euro since its inception in January 1999. Who are the main gainers and losers from a rising exchange rate?

An appreciation of the exchange rate has economic consequences both in the short and long term. As the economy adjusts to a higher exchange rate, some of the main beneficiaries and losers start to emerge. But textbook economics does not always provide clear cut answers to this question:

Advantages of a strong pound

A high pounds leads to lower import prices - this boosts the real living standards of consumers at least in the short run - for example an increase in the real purchasing power of UK residents when traveling overseas

When sterling is strong, it is cheaper to import raw materials, components and capital inputs - good news for businesses that rely on imported components or who are wishing to increase their investment of new technology from overseas countries.

A strong exchange rate helps to control inflation - domestic producers face stiff international competition from cheaper imports and will look to cut their costs accordingly. Cheaper prices of imported foodstuffs etc. will also have a negative effect on the rate of consumer price inflation.

Disadvantages of a strong pound

Cheaper imports leads to rising import penetration and larger trade deficit e.g. the £28bn trade deficit in goods in 2000

Exporters lose price competitiveness and market share - this damages profits and employment in some sectors - notably manufacturing industry in the last three years

If exports fall, this has a negative impact on economic growth. Some regions are affected more than others. The strength of sterling in the last five years is one of the factors highlighted when economists analyse the north-south economic divide in the UK

Many business organisations have identified the strength of the exchange rate as a major economic problem over recent times.

Economists working for the ITEM club argued in the summer of 2001 that the pound should be lower by at least 10% in order to prevent manufacturing industry falling into an economic slump.

However it should be noted that business can adapt to a high exchange rate. There are ways in which industries can adjust to the competitive pressures that a strong pound imposes. Some of the options include:

Cutting export prices (lower profit margins) to maintain competitiveness and market share
Out-sourcing components and raw materials from overseas
Seeking productivity / efficiency gains to keep unit labour costs under control
Investing resources in new product lines where both domestic and overseas demand is more price inelastic and less sensitive to exchange rate fluctuations. This involves producing products with a higher income elasticity of demand, where non-price factors are more important in securing orders.
Moving production overseas

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