Nargita
Evaluate the effects of a depreciation in the British pound on the UK economy.
A weaker pound can stimulate economic growth for the UK through higher exports. The value of UK
exports in a foreign currency decreases (as overseas consumers now receive more of their local currency in
exchange for a pound), and the lower prices are attractive to the consumers, increasing the quantity of UK
exports. This would lead to an increase in aggregate demand (AD = C+I+G+(X-M)), shifting the curve
outwards from AD1 to AD2 and leading to an increase in real output (from Y1 to Y2). This leads to an
increase in economic growth which can mitigate damaging effects to the economy in the short term. For
example, following the 2016 EU Referendum, the 6.5% fall in sterling helped the UK to avoid the predicted
recession. The weaker pound meant that economic growth stayed positive due to the increase in AD in the
transport sector. Therefore, the depreciation of the pound helps stabilise the economy when required.
However, whether economic growth is stimulated or not due to a weaker pound depends on the state of
the economy at the time. During March 2020, the value of the pound against the dollar fell to its lowest
level since 1985, and there was a -10.5% change in GDP between March and April. The pound fell due to
weak business confidence over questions on how the government would pay for fiscal stimuli introduced
like a £350 billion stimulus package for UK firms. Therefore, capital investment by firms fell. This, coupled
with weak consumption (due to state lockdown measures and fears of the coronavirus) meant that was
weak AD in the economy. AD fell, illustrated by a shift inwards from AD2 to AD1, leading to a decrease in
real output (from Y2 to Y1), reflecting a fall in economic growth. Thus, the impact of changes in the value
of the pound should be adjusted for what period they are in a business cycle.
Another effect would be higher cost-push inflation due to more expensive imports. A weaker pound will
increase the price of imported products, often capital goods that firms use when manufacturing the
consumer goods that they sell. This means that there is a rise in the costs of production for firms, and as
firms are profit-maximisers, they will pass on the higher costs to consumers through more expensive
products. For example, this was seen in periods during 2008- 2013, but was temporary. Therefore in the
short run, there will be a shift inwards of aggregate supply (from AS1 to AS2) due to the higher costs of
production. This leads to a contraction in AD. Therefore, there is an increase in price level from P1 to P2
with the added effect of real output falling from Y1 to Y2.
Nargita
However, there are often other factors causing cost-push inflation besides the devaluation of the pound.
For example, in the 1970s, rising oil prices was a major factor in cost push inflation (from being at 8.8 to 25
in the CPI index in 2 years) at the time. A rise in the price of oil leads to higher transport costs and as a
result all firms would see a rise in their costs. Therefore, it can be more significant, along with other costs
facing firms like labour, than a devaluation in the pound in causing cost push inflation.
In conclusion, I believe that a weaker pound will have more of an effect on economic growth than inflation,
through its effect on imports and exports. Considering the state of the economy at the time, as well as the
state of the UK’s trade links with its major trading partners, I believe a weaker pound can act as a useful
buffer during times of economic crises, ensuring stable economic growth. Also, cost push inflation tends to
be temporary and a depreciating pound isn’t as major a factor towards it as commodity prices like oil
which are globally fixed.