If the pound appreciates...

Question 1

If the pound appreciates against other major currencies (Inflation)

Answer 1

• Fall in Pm -> Lower CoPs for some industries which now face cheaper raw materials/component parts/semi-finished goods -> reduces pressure on domestic prices (SRAS shifts right). Direct effect on CPI.
• Commodity prices: many prices are denominated in $ so an appreciation against the $ reduces £ price of oil etc.
• Slowdown in exports (assuming elastic demand) -> falling AD. Extent of the fall depends on PED for X and M. Falling AD can reduce inflationary pressure but may also lead to a negative output gap emerging.
• Wage bargaining effects: High exchange rate puts more pressure on businesses to control CoPs in order to remain competitive internationally - downward pressure on wage inflation?

Question 2

If the pound appreciates against other major currencies (Economic Growth)

Answer 2

• Short run: dampened output as X falls and M rises (AD diagram showing lower equilibrium output).
• Possible effects on inward investment from abroad and thus growth/jobs?
• Long run: lower domestic investment (via negative accelerator effect) -> negative impact on LRAS and long run growth potential

Question 3

If the pound appreciates against other major currencies (Unemployment)

Answer 3

• Reduced demand and output -> potential job losses (labour is a derived demand). Some temporary, some permanent (e.g. If some imports take up permanently higher market share)?
• Different industries likely to experience different effects as some more exposed to currency fluctuations
• Sectors where high % of total output is exported and demand is highly sensitive to price changes = larger impact on employment.
• Some service industries, where little is exported (or imported for production) = less effect on employment.

Question 4

If the pound appreciates against other major currencies (Trade/Current Account Balance)

Answer 4

• SPICED. X falls, M rises (assuming elastic demand). Deterioration of the trade balance with increased import penetration.
• Reverse J-curve effect may mean improvement in short run.
• An appreciation means that foreign currency profits are relatively lower when converted back to home currency (foreign currency has depreciated if home currency has appreciated), so net primary income may decrease - further worsening the current account.
• If inward investment flows are negatively affected by exchange rate shift, this will lead to a worsening of the financial account of the BoP. This may present a financing issue for the increased current account deficit. Remember BoP must balance.
• EV: Movements in the exchange rate affect Px and Pm but non-price factors are often important too e.g. quality, design, branding, service.

Question 5

General Evaluation Points:

Answer 5

• How businesses and consumers respond to exchange rate changes - PED of X and M very important.
• Length of time lags as consumers and businesses respond - J-curve effect and M-L condition for BoT changes. Bank of England estimates 2 years for effects to feed through to prices by which point the ER could be entirely different.