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A falling pound – rebalancing the balance of payments

In a recent blog, Falling sterling – bad for some; good for others, we looked at the depreciation of sterling following the Brexit vote. We saw how it will have beneficial effects for some, such as exporters, and adverse effects for others, such as consumers having to pay a higher price for imports and foreign holidays. The article linked below examines these effects in more depth.

Just how much the quantity of exports will increase depends on two main things. The first is the amount by which the foreign currency price falls. This depends on what exporters choose to do. Say the pound falls from €1.30 to €1.18. Do exporters who had previously sold a product selling in the UK for £100 and in the eurozone for €130, now reduce the euro price to €118? Or do they put it down by less – say, to €125, thereby earning £105.93 (£(125/1.18)). Their sales would increase by less, but their profit margin would rise.

The second is the foreign currency price elasticity of demand for exports in the foreign markets. The more elastic it is, the more exports will rise for any given euro price reduction.

It is similar with imports. How much the sales of these fall depends again on two main things. The first is the amount by which the importing companies are prepared to raise sterling prices. Again assume that the pound falls from €1.30 to €1.18 – in other words, the euro rises from 76.92p (£1/1.3) to 84.75p (£1/1.18). What happens to the price of an import to the UK from the eurozone whose euro price is €100? Does the importer raise the price from £76.92 to £84.75, or by less than that, being prepared to accept a smaller profit margin?

The second is the sterling price elasticity of demand for imports in the UK. The more elastic it is, the more imports will fall and, probably, the more the importer will be prepared to limit the sterling price increase.

The article also looks at the effect on aggregate demand. As we saw in the previous blog, a depreciation boosts aggregate demand by increasing exports and curbing imports. The effects of this rise in aggregate demand depends on the degree of slack in the economy and the extent, therefore, that (a) exporters and those producing import substitutes can respond in terms of high production and employment and (b) other sectors can produce more as multiplier effects play out.

Finally, the article looks at the effect of the depreciation of sterling on asset prices. UK assets will be worth less in foreign currency terms; foreign assets will be worth more in sterling. Just how much the prices of internationally traded assets, such as shares and some property, will change depends, again, on their price elasticities of demand. In terms of assets, there has been a gain to UK balance sheets from the depreciation. As Roger Bootle says:

Whereas the overwhelming majority of the UK’s liabilities to foreigners are denominated in sterling, the overwhelming bulk of our assets abroad are denominated in foreign currency. So the lower pound has raised the sterling value of our overseas assets while leaving the sterling value of our liabilities more or less unchanged.

Article
How a lower pound will help us to escape cloud cuckoo land, The Telegraph, Roger Bootle (31/7/16)

Questions

  1. What determines the amount that exporters from the UK adjust the foreign currency price of their exports following a depreciation of sterling?
  2. What determines the amount by which importers to the UK adjust the sterling price of their products following a depreciation of sterling?
  3. What determines the amount by which sterling will depreciate over the coming months?
  4. Distinguish between stabilising and destabilising speculation? How does this apply to exchange rates and what determines the likelihood of there being destabilising speculation against sterling exchange rates?
  5. How is UK inflation likely to be affected by a depreciation of sterling?
  6. Why does Roger Bootle believe that the UK has been living in ‘cloud cuckoo land’ with respect to exchange rates?
  7. Why has the UK managed to sustain a large current account deficit over so many years?
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