"Evaluate the possible impact of a depreciation of the sterling

exchange rate against leading currencies on key macroeconomic

objectives."

A depreciation of sterling would occur inside a free-floating currency

system and has happened on several occasions in the past most notably
in June 2016 when the pound’s external value fell in the immediate
aftermath of the Brexit referendum result. The sterling effective exchange
rate depreciated 20% between November 2015 and October 2016,
including a record 6.5% fall between June and July 2016 following the EU
referendum vote. The effective exchange rate is an index weighted by the
percentage of trade that the UK does with individual countries and trading
blocs.

The impact of a depreciation on macro objectives depends on the scale,

duration and timing of a currency fall and also the strength of the
transmission mechanism from currency movement to other indicators. This
essay will look at three objectives namely, sustained GDP growth, low
stable price inflation and an improvement in the trade balance in
goods and services.

Fig 1: Euro (EUR) to British pound sterling (GBP) average annual

exchange rate from 1999 to 2018
In theory a fall in the currency is a monetary stimulus to an economy open
to international trade and investment. A weaker pound increases the
sterling price of imported products and this increase in relative prices ought
to improve the price and cost competitiveness of domestic suppliers in the
UK. It also allows UK exporters to lower their prices (expressed in a foreign
currency) and hopefully achieve an expansion of overseas sales. The
combined effect of this is to stimulate aggregate demand (where AD =
C+I+G+X-M) and provide a short-term fillip to economic activity. In the
summer of 2016, the fall in sterling helped the UK to avoid the full-blown
recession that some analysts had predicted. Growth slowed but remained
positive and the weaker pound injected extra demand in industries such as
tourism and transport. Manufacturing was assisted with a more competitive
exchange rate although this sector accounts for only ten percent of total UK
GDP.

If exports rise following a depreciation, this can be shown by an outward

shift of aggregate demand (as shown in my analysis diagram) leading to an
expansion of short-run aggregate supply. A weaker currency can act as a
useful shock absorber when a country experiences unexpected turbulence.

Fig 2 Outward shift of aggregate demand can lead to a cyclical

expansion of national output

In evaluation, we can question whether a sterling depreciation actually

helps economic growth in the medium term. There is no guarantee for
example that exporting businesses will take advantage of additional
competitiveness, cut the price of their exports and increase output,
investment and employment. There is some evidence that UK firms have
instead opted to raise the sterling price of exports and therefore enjoy a
higher profit margin on each unit sold. Imports are also made more
expensive and this can harm the profitability and expansion plans of
businesses who rely heavily on raw materials, components and capital
technology sourced from outside of the UK.

A second theoretical effect of a currency depreciation is on the rate of

consumer price inflation. A weaker currency increases the prices of
imported products and can feed through directly to higher prices in the
shops for many items. This cost-push inflation can be shown by an inward
shift of short-run aggregate supply and it has the effect of dampening the
impact of a falling pound on growth. In the UK, the 20 percent depreciation
in 2015-16 was undoubtedly a factor behind CPI inflation rising well above
target. CPI inflation in the UK rose from 0.4% in June 2016 to 2.6% in June
2017 and 3.0% in October 2017 and this was a factor explaining falling real
wages for millions of people in work.

Fig 3 A fall in the currency may lead to a rise in cost-push inflationary

pressures.

However, the exchange rate is not the only external factor influencing
inflationary pressures in the UK. For example in 2015 and 2016, inflation
was also rising in the economies of some of the UK’s major trading
partners and there was also the effect of strong global commodity prices to
consider. The extent to which a currency depreciation does lead to higher
inflation depends on the import dependency for a country - in the case of
the UK, around one third of national output each year comes from imports
of finished and semi-finished products, energy supplies and raw materials.
So the flow-through from a fall in the pound can happen quickly.

My third point concerns the extent to which a sterling depreciation leads to

an improvement in the net trade balance for goods and services. Again in
theory, we might predict that a 20% fall in the £ against the Euro and the
US dollar ($) would increase demand for UK exports and squeeze demand
for imports, thereby improving the trade balance. Such a move might be
welcome for the UK given the structural trade deficit we run overall and the
large trade imbalance with the Euro Zone in particular.

However, theory and reality rarely coincide! Analysis of the J curve

concept (shown in my diagram below) suggests that it can take time for
demand and output to adapt. Instead the immediate effect of a currency
depreciation is usually to increase the price of imports which - if demand is
price inelastic - will lead to a worsening of the trade deficit. The trade
balance will improve over time providing that the Marshall-Lerner
condition is satisfied. This states that net trade will improve if PED for
exports + PED for imports >1. A worry is that, in the medium term, a
sterling depreciation increases the prices that UK firms have to pay for
imported capital technologies which in turn might limit the scope for
increasing productive capacity and raising labour productivity.

Fig 4 The J Curve effect following a currency depreciation

Overall, a depreciation of sterling is likely to provide a short-term stimulus

to some parts of the economy (especially those engaged with international
trade) but risks causing a fall in real living standards for households who
will also see a cut in the purchasing power of their tourist dollar or euro
when overseas. A weaker currency rarely helps to improve the non-price
competitiveness of a country.