ChainWhat it assumes · how to break it
Start
The pound appreciates strongly, for example because of large inflows of hot money.
1
As a result, UK exports become dearer in foreign currency and imports become cheaper in pounds.
SPICED · price competitiveness
SPICED · price competitiveness
Assumes: Firms pass the exchange rate change into prices.
But: Exporters may cut their sterling prices to keep foreign prices steady, protecting sales at the cost of lower margins.
2
Therefore, foreign buyers switch away from UK goods and services, and UK buyers switch from domestic output to imports.
expenditure switching · PED
expenditure switching · PED
Best link to attack
Assumes: Demand for UK exports and imports is price elastic.
Assumes: Demand for UK exports and imports is price elastic.
But: Many UK exports, such as financial services, pharmaceuticals and luxury cars, sell on quality and brand, so demand for them is price inelastic.
3
This means net exports fall, so aggregate demand falls.
AD = C + I + G + (X − M) · net exports
AD = C + I + G + (X − M) · net exports
Assumes: The Marshall–Lerner condition holds, so the value of net exports falls.
But: In the short run the import bill falls in pounds before volumes adjust, so net exports may rise at first.
4
Consequently, the AD curve shifts left and the multiplier reduces real GDP by more than the initial fall in net exports, so economic growth slows.
multiplier · real GDP
multiplier · real GDP
Assumes: The multiplier is large.
But: The UK's high marginal propensity to import and to pay tax make the multiplier fairly small.
End
Real GDP falls relative to trend, so economic growth slows.
Evaluation chain
- E1However, the fall in AD depends on demand for UK exports being price elastic, so that dearer exports lose sales.
- E2Because many UK exports compete on quality, brand and reliability, and much export demand depends on income growth abroad,
- E3so export volumes may fall only slightly after an appreciation, especially if trading partners' economies are growing strongly.
- E4So growth slows by less than the size of the appreciation suggests; the damage is greatest for price-sensitive exports such as basic manufactured goods.
Another way to attack it: Cheaper imports raise households' real incomes and cut firms' input costs, so consumption may rise and SRAS shifts right. These effects can offset part of the fall in net exports.
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Questions this answers
- Explain how an appreciation of sterling might affect aggregate demand.
- Assess the likely effect of a rise in the exchange rate on UK economic growth.
- Discuss whether a strong pound is good for the UK economy.
Diagram
AD/AS: AD shifts left as net exports fall; real GDP falls from Y1 to Y2.
Reverse and related
Depreciation → net exports rise → AD rises → growth rises.