This case study will explain the exchange rate depreciation, discuss the likely effect of it on the deficit the trade of goods and services on the current account, the three main costs to the UK economy of a sustained current account deficit; and also the explain the reason why UK current account deficit has not decreased as expected following a significant fall in the sterling exchange rate between mid 2007 and early 2009 according to the above case.
Exchange rate depreciation
The exchange rate is the value of currencies, which determined by foreign currency market. Exchange rate depreciation is meant by a fall in the value of a currency when the currency is floating and market forces its value. It mainly affects the real economy of UK through their effects on exports and imports. The decrease in the price of sterling s in terms of HK dollars could have been generated by a slow down in global economic activity, so decreasing the demand for UK exports, or because of foreign investors lacking confidence in the UK economy and investing elsewhere. This can be seen from the graphs below. There has been a decrease in demand D to D1 for the sterling. This has led to a depreciation in the value of the sterling from $HK16 to $HK13. The quantity of the sterling traded has also decreased from Q to Q1.
Likely effect of a fall in the sterling exchange rate on the deficit in the trade of goods and services on the current account The exchange rate is the value of currencies, which determined by foreign currency market. Current account is an indicator of performance of a country. When the total exports are less than the total imports, current account will be in deficit. When there is a fall in the sterling exchange rate, it may tend to make exports cheaper to foreigners but imports more expensive to domestic customers. This can promote exports and discourage imports concurrently. A rise in exports increases export revenue and a fall in imports reduces import expenditure, and reduces the current account deficit.
A fall in the sterling exchange rate may lead to cost-push inflation. Cost-push inflation is caused by an increase in the cost of production with a resulting change in aggregate supply. When the private company imports raw materials, machinery from foreign countries, the cost of production is increased due the valued of sterling decreased. Firms try to pass on increased costs to the consumers. Thus, the domestic price levels increased which eventually may eliminate the international competitiveness of exports and increase the current account deficit.
The reason why UK current account deficit has not decreased as expected following a significant fall in the sterling exchange rate between mid 2007 and early 2009 A fall in the sterling exchange rate can reduce the UK current deficit through promote exports making the exports cheaper and discourage imports by making the imports more expensive. Thus, earnings from the exports is increased, expenditure on imports and current transfers abroad become is reduced. However, According to the given information, the exports of British goods increased but the imports also increased since 2009, we can see the uk current account deficit has increased in the early 2009,there are some factors making the current account deficit could not be decreased even the sterling exchange rate fall.
If exports and imports are price inelastic, according to the given information, the research paper noted that many UK manufactures compete on brand and quality rather than price so it is less likely for exports to increase and imports to decrease and fall in sterling exchange rate may not have a significant impact on the current account deficit.
According to the given information, the UK manufactures has low ability to replace imports with domestic products. If a country is not able to increase the production of imports substitutes, it is less likely reduce imports and current account deficit following a fall in sterling exchange rate. If the domestic products are lack of quality comparable to imports or high cost of production, a fall in sterling will not be very effective to reduce the current account deficit.
A fall in the sterling exchange rate may lead to imported cost-push inflation. When the private company imports raw materials from foreign countries, the cost of production is increased due the valued of sterling decreased. Thus, the domestic price levels increased which eventually may eliminate the international competitiveness of exports and increase the current account deficit.
Costs to the UK economy of a sustained current account deficit Current account deficit is undesirable and a sign of economic weakness .A large sustained current account deficit occurs when the total import of goods and services exceeds the total export of goods and services for a continuous period If current account deficit is too large as a percentage of GDP and is sustained over a long period of time, it is a matter of great concern.
When the current account deficit is large and sustained, there usually comes a point when lenders think that the borrowers may default on their loans, most countries would not be able to borrow such large amounts at low interest rates, lenders may even stop lending .The UK may in serious difficulties, facing credit crunch, foreign lenders refuse to lend any more, the UK will then be forced to return their current account to equilibrium.
Economic growth measures the rise in the output of goods and services over time; it is measured by the rate of change in GDP. When the current account deficit is large and sustained, the earning from foreign countries is extremely less than the expenditure that the UK spends to foreign countries. Obviously the output of the UK keep decreasing, therefore the economic growth will be lower.
A deficit on the current account increases foreign liabilities. In the beginning a current account deficit could be just a deficit on buying goods. However over time the deficit will be increased by the interest payments on the capital surplus. On the investments foreigners investors they receive interest payments or dividends. These dividends count as a debit on the current account. Therefore the longer the deficit goes on the higher the level of investment income debits will be accrued. This means that in the future the economy will need to attract capital flows just to pay off the investment income. As well as the deficit on goods and services.