Exchange rates: Does a weak currency help or harm… | tutor2u Economics
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Exchange rates: Does a weak currency help or harm the economy?

  • Levels: AS, A Level, IB
  • Exam boards: AQA, Edexcel, OCR, IB, Eduqas, WJEC

Does a falling currency help or harm the economy?

Notes from a BBC Radio 4 Analysis programme broadcast in February 2019

Sterling fell by more than ten percent in the immediate aftermath of the Brexit referendum in June 2016. To what extent is a depreciation of a currency (within a floating exchange rate system) beneficial to prospects for the macroeconomy?

According to Bank of England Governor Mark Carney "Depreciations are how you make the economy poorer" but economist Roger Bootle from Capital Economics argues that depreciations of the exchange rate have served the UK economy well in the past, for example when the pound fell out of the European exchange rate mechanism in September 1992.

Euro (EUR) to British pound (GBP) monthly exchange rate from December 2014 to January 2019

Sterling's drop in June 2016 was the result of an increase in uncertainty and a drop in confidence after the referendum result. The currency will depreciate when there is less demand or more supply for a currency from investors and also when the value of exports relative to imports falls.

Weak pound - higher prices

A depreciation effectively reduces the real purchasing power of consumers in the economy affected. This is because imports become more expensive - ranging from imported food and fuel to the value of the currency when consumers travel overseas.

The consensus estimate is that retail prices in the UK are around 2 percent higher now (2019) than they would have been without the depreciation of sterling in 2016. Imports into the UK are around 40 percent of the annual value of GDP.

Higher prices also tend to have a disproportionate impact on lower income households who spend more of their monthly budget on essentials such as foodstuffs and fuel.

Upsides to a weaker currency

On the other side, a weaker currency increases the real purchasing power for overseas tourists coming to the UK. There has been a surge in foreign visitors coming to the UK which has added to aggregate demand.

A weaker currency also increases the price competitiveness of UK exporters - providing that export businesses choose to lower their foreign prices rather than simply take a higher profit margin from each unit sold.

A rise in export sales is an injection into the circular flow of income and spending and can lead to a positive multiplier effect on output, profits and planned capital investment.

"Having a flexible exchange rate can be a useful safety valve in the event of a crisis" - in other words, a weaker currency can help to stabilise demand, output and jobs in the wake of a negative external economic shock.

Countries such as China and Japan know that exchange rates matter for economic performance and they prefer their currency to be low/competitive as a way of stimulating their industries.

Evaluation

But a fall in the external value of sterling does not necessarily lead to an improvement in the UK's current account deficit which is the sum of the net trade balance, net primary and net secondary income.

One reason is that many exports - for example car manufacturing and processed foods - also require imports supplied from other countries. Higher import costs can erode some of the advantages of a weaker pound.

It also takes time for businesses to enter new export markets when the currency depreciates. It may take several months - perhaps longer - for new export contracts to be won and production then expanded to increase output for overseas markets.

And in many international markets, non-price factors such as quality and design might be even more important in determining sales rather simply the unit price.

The reason why the exchange rate has fallen - namely a drop in overseas confidence - might also dampen the appetite of foreign buyers to trade with UK companies.

Overall a lower exchange can be a mixed blessing for the economy. We haven't seen a significant boom in exports from the UK since the summer of 2016.

Advantages:

  • A net injection of aggregate demand at a time of economic uncertainty
  • Stimulus to export industries who become more price competitive
  • Has an effect similar to a fall in monetary policy interest rates

Drawbacks:

  • Higher consumer price inflation which hits lower income households harder
  • Fall in real incomes has had a big knock-on effect on high street spending & retailers
  • Rising input costs for businesses which has a negative effect on profit margins

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