1.0 Introduction- Aims and Objectives
The countries national currency is perceived by many as a national identity or nationalism (Muller-Peters, 1998), for instance, in the UK ‘’the pound as a currency and the picture on sovereign notes and coins, as seen as a many as key aspects of their nationality (Begg & Ward, 2016). The main objective of this report is to analyse if the UK government should be concerned with a falling pound. Thus, the aims are to evaluate the impact of currency depreciation on micro and macroeconomics. Coequally, outline and analyse key economic policies such as monetary and fiscal that could improve the ramifications of a currency depreciation. In addition, the report will accentuate the limitations to these policies and conclude findings of the report.
2.0 Main Report- Economic Analysis
Currency Depreciation
In the current era of increased globalisation, currency depreciation undermines the stability and economic growth of a country (The Economist, 2017). Currency depreciation can occur as a result of inflation, social and political uncertainty such as Brexit, global market conditions such as the financial crisis (Tetlow and Jackson, 2018). The impact of currency depreciation sterling has major implications on both two important distinctions in economics, the macroeconomics and microeconomics (WEF, 2017). Therefore, in other terms, the impact would affect the whole UK economy and individual households, firms and consumers as a whole (Begg & Ward, 2016). However, currency depreciation has effects and minor/limited benefits, as outlined in the table below. In addition, a few effects would be discussed in further sections.
Table 1: Benefits & Effects of Currency Depreciation
Source: The Guardian, 2017; The Economist, 2017
2.1 Impact on Microeconomic Economies
2.1.1 Price and Inflation
Inflation is the rate of increase in prices for goods and services (ONS, 2018) and when price increases the aggregate supply of money shifts to the left (Figure 1). The UK inflation target is 2.0%, however, the current inflation rate is at 3.0% (Bank of England, 2018), and therefore it is above the target (Appendix 3).Inflation expectations can influence wage and price-setting behaviour. The firms and consumers concerns are result in increased influence. Additionally, the price rise of the imported goods cause push up in inflation that produce higher prices even in local goods (BOE, 2018). CPI is most affected by air travel, gas and petrol where costs are denominated globally in dollars, are obvious examples where prices are already on the rise (Giles, 2016) (Figure 2). Convenience goods such as food and clothing are also affected by the falling pound sterling (Appendix 4) which directly influences households.
Figure 1: Aggregate Supply Figure 2: £/$ Exchange Rate
Source: Adapted from Mankiw & Taylor, 2017
2.1.2 Output
Production of individual firms such as the manufacturing firms in UK show an increase in imported and exported prices (Figure 3). The sterling exchange rate had depreciated to 20% after the EU referendum vote (ONS, 2017; FT, 2017). Thus, this compelled to an increase in UK manufacturing input cost as a result of rising prices for fuel and raw materials and an increase in output prices for exported goods in sterling currency (ibid, 2017).
Furthermore, the currency depreciation would have a direct effect on consumer price index, for instance, there would be less imported and exported services and goods in sterling terms due to the price increase. However, Whittall & Bird (2017) argued that the economist’s notion of underlining weaker currencies as an instrument for economic growth could not be relied on. Hence, the British car maker Aston Martin, with exports accounted for 80% on its vehicles, proved a decline in export sales from when the pound traded at $1.50 to now $1.27, their sales only accumulated £18,000 on extra profits, taking into account half of the components are imported from abroad (ibid, 2017).
Figure 3: Imported inputs, Export Price Index (EPI)
Source: ONS, 2017; BOE, 2017
2.1.3 Labour Market
The employment rate closed 2017 with 75.2% (ONS, 2018) and has been showing an upward trend. Differently, the unemployment rate reached 4.4% at the end of 2017 (ONS, 2018).
The average weekly earnings (AWE) for employers showed different figures in nominal and real terms. In nominal terms the weekly payment increased by 2.5% while in real terms the figure fell by 0.3%. It is important to highlight that CPIH closed 2017 with an increase of 2.7% (ONS, 2018).
In this way, even though the wage has been increasing in nominal terms; the real wage has fallen, which contributes to a decrease in the purchase power of households. The falling pound may affect the labour market, since companies are concerned about hiring new employees due to rising costs and uncertainty of the Brexit negotiations (Allen, 2017). Additionally, inflation tends to reduce consumption, since the wages are not accompanying the same growth.
2.1.4 Profits
The sterling depreciation has consequences that directly affect different groups in the society. In terms of profits, it is possible to highlight the effect on the tourist and retail sector, stock market and companies (Appendix 5). The fall in the sterling has contributed to the United Kingdom become more attractive to foreigners. This fact might be positive to the tourism sector, leisure industry and retail since there may be more people willing to consume (Blitz, 2016; Chu, 2016; Collinson, 2016). In the long-run, those industries may also benefit with more Britons staying in the UK for holidays due to the phenomenon of “staycation”. According to the ONS (2017), UK residents travelling and spending abroad is the biggest import service (34.4%) to the country, which contributes for a deficit (Figure 4).
Figure 4: Travel Services (1999-2016)
Source: ONS, 2017
The stock market also benefit from a falling pound, once many companies have their revenues overseas. In this way, their gains are in foreign currencies, which contribute to higher profits (Blitz, 2016). Thus, the opposite is applied for companies that are dependent on the domestic market, since they do not take advantage of a weaker exchange rate (Rodionova, 2016).
2.2 Impact on Macroeconomic Economies
2.2.1 Trade
Since the UK’s decision to leave the EU, sterling has dropped 14% against the currencies that the UK trades the most with (Tziamalis, 2017). This resulted in benefit for firms selling goods abroad but loss for importers. Recently, manufacturers complained that strong pound prevent their competitiveness as well as causing a deceleration in the sector (Allen, 2016). Thus, a lower pound make their goods cheaper abroad and help rise weakening demand. Besides, both British consumers and firms loses from falling pound sterling. Many imported items as petrol, food and electrical goods become more expensive when the pound weakens (Pettinger, 2017) and generate increased inflation. If the devaluation continues, consumers will see permanently higher prices (ibid, 2017). For importing firms, the fall in sterling causes higher costs in raw materials. For example, metals costs go up when sterling falls (Allen, 2016).
2.2.2 Fiscal Balance
The fiscal balance is the difference between total expenditure and total revenue, which in the United Kingdom is the same as net borrowing. The public sector revenue encompasses the income received by the government and controlled corporations while the expenditure is the capital and current spending (ONS, 2016).
In the period of April 2017 to January 2018, the United Kingdom presented a deficit of £37.7 billion (almost 4% of the GDP), which means that the government expenditure is exceeding their revenues (Figure 5).
Figure 5- Public sector net borrowing (excluding public sector banks) from 1993 to 2018
Source: ONS, 2018
Even though, the deficit has been presenting a downward trend the public debt, which is the amount of money the public sector owes to the private sector, is increasing. The United Kingdom’s debt in January 2018 was £1.7 trillion, which represents 84.1% of the GDP (ONS, 2018). The public debt is directly influenced by uncertainty in the United Kingdom since Brexit. According to the Financial Times (2017), a falling pound might lead investors to downgrade the country, which might contribute to a decrease in the purchase of bonds. It might lead to a further depreciation, since they will be willing to sell their investments, increasing the amount of pounds in the market.
3.0 Recommendations & Limitations
The Central Bank could adopt the open market operations tool by decreasing the money supply through the sale of government bonds from its portfolio. By increasing the quantity of bonds in the market, it would lead to a decrease in the price, extending demand. However, the uncertainty related to the Brexit negotiations might contribute to investors withdraw their interest in investing in UK may cause an increase the supply of money in the market.
In addition, the Bank of England could implement a contractionary monetary policy by raising interest rates. Hence, it will result to a decrease in aggregate money demand as more people would save and less individuals and firms would obtain money from the bank. This would have an impact in a decrease in money supply and therefore ultimately lead to the aggregate demand curve shifting to the left. This policy would lead to an exchange rate appreciation, since the demand for British pounds would increase because foreigners would like to invest in the country due to higher interest rates. Differently, UK citizens would decrease their investments, since the domestic interest rate is better than foreign assets, decreasing the supply of pounds in the market (Figure 6).
However, the limitation of this policy is the time lag, since consumers might wait to see if it is just a temporary action and also commercial banks might wait to pass this action to the consumers. Additionally, this action might impact the economic growth, since it will affect investment, consumption and trade.
Nevertheless, the BOE can initiate the fiscal policy through the deployment of raising taxes. By raising taxes, government would have more discourage individuals and firms to spend more and therefore a decrease in money supply. However, the limitation is, by how much should the taxes be raised and when.
4.0 Conclusion
The UK government should be concerned with a falling pound since it directly affects the economic growth. Theoretically, the currency depreciation would decrease imports, however the UK manufacturers are heavily dependent on it. Additionally, the great contingent of British exports is based on services that are price inelastic, since they depend on different variables such as quality.
As the price of imports rise with a falling pound, the country does not become more competitive and also the increase in exports should increase production and employment, making the economy grow, which is not happening in the UK.
The inflation also increases due to a falling pound, which affect consumption and investment. It tends to affect confidence leading to instability and uncertainty, impacting growth .