Saturday, October 11, 2008

Impact Of Depreciating Pound

Several months ago, the exchange rate was about £1 to US $2. In the recent, pound has depreciated & with £1 UK people can only get US$ 1.75.

Weakening pound is good news for UK’s manufacturing sector which is already in a deep recession. Falling pound means much cheaper to buy from UK. As such this will boost export market. For Britons, weaker pound translates to fall in purchasing power & this should automatically means falling import. The overall effect will be increase in net export (X-M). This will lift AD & raise real GDP

Disadvantage of depreciating pound

(1) Fall in standard of living. As imported goods are now more expensive, British people get to buy lesser goods with the same amount of money they have. Another way to look at it will be, needing more pound to buy the same amount of good. Demand for luxury imported goods will fall, foreign travel will decline etc

(2) Causes inflation. Two ways it can happen. First is imported inflation. Weakening pound causes imported raw materials & intermediate goods to be expensive (although in real term they are not). This hike in costs of production will be passed on to consumers by the way of higher prices. This could be exacerbated if the country where UK import from suffers from high inflation. Second, is demand-pull inflation. As UK goods become cheaper, demand from overseas market will increase & this will boost the export market causing economic growth when AD moves upward

(3) Less incentive to cut costs
. It is argued that some firms may be over relying on the weakness of pound to stay competitive. Yes, UK goods are cheaper now but not because of the lower costs involve in producing them, but rather the structural short-term weakness of pound that artificially makes them look cheap. To maintain long term competitiveness, it is best for those manufacturers to look at issues like lacking R&D, sluggish productivity & other forms of efficiency

What determines exchange rate?

(1) Interest rates. In short term interest rates are important. Many investors, wealthy individuals, large fund managers are shopping around to decide where to save the money. If MPC decides to increase rates, it will attract hot money flows. To save in UK’s financial institutions, they will need to buy pound & this cause pound to appreciate.

In the recent month, pound has been falling due to worsening economic situation in UK. In current period, price level tends to fall. As such people expect MPC to cut interest rate to meet the inflationary target of CPI 2% +/- 1% & also to revive confidence in the economy so that people will begin to spend. This will cause investors to flee pound denominated assets causing pound to depreciate

(2) Speculation. Movement of exchange rate may not necessary follow economic fundamental at least in short term. This is because people are betting on changes in US economy from time to time & this may give rise to demand or fall in the dollar against pound

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