Low Exchange Rates | AQA A-Level Economics Model Essay

Assess the view that a depreciation of the pound against other currencies is likely to improve the UK’s macroeconomic performance (25 Marks).

The exchange rate is the price of one currency in terms of another. The UK's macroeconomic performance is judged overall by the UK's four main objectives, which are price stability, low unemployment, economic growth and a stable balance of payments. To see whether a lower value of the pound is good or bad, we can evaluate how it affects the four objectives.

Keep the introduction simple with a few relevant definitions and explain that you would judge its effect on macroeconomic performance by considering how low exchange rates impact the four objectives

If the pound depreciates, this may be good because it may lead to more exports because the UK currency is cheaper relative to other country's currencies, making UK goods relatively cheaper and therefore encouraging more countries to import from the UK. It also discourages the UK from importing because it is more expensive to buy other currencies. Overall, if exports go up and imports go down, the balance of payments on the current account will improve and the current account deficit (exports minus imports) will fall.

Also, if exports are higher and imports are lower, this will also affect AD, causing it to shift to the right because AD = C + I + G + (X-M), so if X-M is higher overall, then AD will also be higher, ceteris paribus. If AD shifts from AD1 to AD2, then we will an increase in the price level from PL1 to PL2, and also the output, GDP, and employment levels will increase from y1 to y2, as seen in the diagram below.

DIAGRAM OF AD SHIFTING TO THE RIGHT.

Overall, we have seen ways in which a lower pound can benefit the UK's macroeconomic performance. For example, it can lead to lower unemployment and higher economic growth due to AD shifting to the right, as well as a lower current account deficit.

However, although the current account deficit and unemployment both improve, we saw that inflation increased from PL1 to PL2, which can be detrimental to the economy because if prices are rising and wages are staying the same so disposable incomes fall. We have seen this in the UK now with the low exchange rate and high inflation leading to the cost of living crisis.

So far, we argued that if the pound goes down, imports are more likely to decrease and exports are more likely to increase. However, this is not always the case. For example, imports and exports might be more inelastic. Then, if the pound goes down, overall we will still have to continue to make the imports we are making such as oil and raw materials because they can't be adjusted easily so then overall the current account deficit will get worse because the value of imports get bigger and the value of exports may get smaller. The value of imports potentially gets bigger when the pound goes down because although the quantity of imports stays the same or slightly decreases, the relative price of them increases so the overall value of imports gets bigger. If net exports get worse, then AD will shift to the left. If AD shifts to the left, the price level decreases and output and employment will fall from y1 to y2, as seen in the diagram below.

Overall, if the pound goes down and imports and exports are inelastic, then unemployment will rise and inflation will go down. These are characteristics of an economic downturn and possibly a recession so overall it is important to avoid a pound depreciation, especially if imports are inelastic.

It is difficult to tell whether imports and exports are inelastic. Ideally, we want our exports to increase if exchange rate goes down and our imports to go down, so that the current account deficit doesn't get too big. A strong supply side would allow the UK to produce goods and services domestically without depending on imports especially when they are expensive, however there will always be a time lag for this change to happen. The Marshall-Lerner condition suggests that a currency devaluation will only lead to an improvement in the Balance of Payments if the sum of demand elasticity for imports plus exports is greater than one, and the J-curve illustrates imports are very inelastic in the SR because of a lack of consumer knowledge about exchange rates, so a current account deficit will always worsen before improving.

Finally, a depreciation of the pound does not only affect AD. It can also affect SRAS. SRAS is the total planned output at different price levels in the economy. If the pound is lower, this would affect short-run aggregate supply because the value of the pound is less so raw materials and products that businesses need from abroad will be more expensive, so costs of production will be higher, so SRAS will shift to the left.

SRAS LEFT DIAGRAM.

On the diagram, SRAS1 shifts left to SRAS2 causing an increase in price level from PL1 to PL2 and output falls from y1 to y2. This would mean that unemployment may rise due to the lower output and higher costs that UK firms are facing, and inflation will rise. This is cost-push inflation because it is caused by a decrease in SRAS rather than an increase in AD. Overall, this is bad for the UK economy because it will negatively affect the objectives and it would be difficult to fix because it is a supply-side issue, so it may need supply-side policies or exchange rate, which can have impacts on the rest of the economy.

This supply-side shock might be bad in the short run but good in the long run because it encourage the UK to improve their supply side and be better prepared for currency changes. For example, it can encourage the UK to manufacture more products rather than relying on other countries, and over time it will improve.

Overall, the outcomes depend on how the UK responds. to the weaker pound, and this depends on a couple of factors. Firstly, it depends on whether imports are elastic or inelastic, and secondly, it depends on how strong the UK supply side is. If imports are elastic and the UK supply side has spare capacity, then a lower pound will lead to more AD, more employment, and more economic growth. However, if imports are inelastic and the UK supply side is weak, then a weaker pound will lead to a fall in AD and SRAS, cost-push inflation, and much lower output. This can happen especially in the short run if the UK are not prepared for an exchange rate shock.

Plan:

1. if ER goes down, imports goes down, good for economy (AD up)
2. if ER goes down, imports stay same but more expensive. bad for economy (AD down)
3. same but mention sras (SRAS down).