ChainWhat it assumes · how to break it
Start
The pound appreciates against the dollar, for example when UK interest rates rise relative to US rates.
1
As a result, the sterling price of imports falls, including imported consumer goods, fuel and raw materials.
import prices · SPICED
import prices · SPICED
Best link to attack
Assumes: Importers and retailers pass the lower costs on to customers.
Assumes: Importers and retailers pass the lower costs on to customers.
But: Firms may keep their prices unchanged and take the lower cost as higher profit, since prices tend to be sticky downwards.
2
This means UK firms using imported inputs face lower costs of production, so SRAS shifts right.
cost-push inflation · SRAS
cost-push inflation · SRAS
Assumes: Imported inputs are a large share of costs.
But: Labour-intensive service firms gain little from cheaper imported inputs.
3
At the same time, dearer exports and cheaper imports reduce net exports, so AD shifts left and demand-pull pressure eases.
demand-pull inflation · net exports
demand-pull inflation · net exports
Assumes: Demand for exports and imports is price elastic.
But: Quality-led exports may hold their sales despite the stronger pound.
4
Consequently, lower inflation reduces inflation expectations and wage demands, which holds down firms' costs further.
inflation expectations
inflation expectations
Assumes: Workers and firms base expectations on recent inflation.
But: If the labour market is tight, wages may still rise quickly whatever happens to import prices.
End
Inflation falls, through cheaper imports and weaker demand.
Evaluation chain
- E1However, the fall in inflation depends on importers and retailers passing lower import costs on to customers.
- E2Because firms are often quicker to raise prices when costs rise than to cut them when costs fall, and may treat lower costs as a chance to rebuild margins,
- E3so shop prices fall by less than the fall in import costs, particularly in markets with little competition.
- E4So inflation falls by less than the appreciation suggests, and the effect is largest in competitive markets for imported goods.
Another way to attack it: If inflation is already low, a strong pound can push it below target and risk deflation, which the central bank would then counter with lower interest rates.
Pass-through takes many months as contracts and currency hedges expire.
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Questions this answers
- Explain how an appreciation of the pound may affect UK inflation.
- Assess the impact of a stronger pound on UK consumers.
- Discuss whether a rise in the exchange rate is good for the UK economy.
Diagram
AD/AS: SRAS shifts right as imported input costs fall, and AD shifts left as net exports fall; the price level falls relative to trend.
Reverse and related
Depreciation → import prices rise → cost-push and demand-pull pressure → inflation rises.