ChainWhat it assumes · how to break it
Start
The Monetary Policy Committee raises Bank Rate, for example from 4% to 5%.
1
As a result, UK interest rates rise relative to rates abroad, so UK bank deposits and bonds offer a higher return.
interest rate differential
interest rate differential
Assumes: Other central banks do not raise their rates too.
But: If the Federal Reserve and ECB raise rates at the same time, the gap and the inflow are small.
2
This means hot money flows into the UK, raising demand for sterling, so the pound appreciates.
hot money · floating exchange rate
hot money · floating exchange rate
Assumes: Capital flows follow interest rates.
But: Expectations about growth and political risk can dominate; if markets fear a UK recession, the pound may even fall.
3
Consequently, UK exports become more expensive in foreign currency and imports become cheaper in pounds.
SPICED
SPICED
Assumes: Firms pass the exchange rate change into prices.
But: Exporters may cut their sterling margins to hold foreign prices steady.
4
Therefore, if demand for exports and imports is price elastic, export volumes fall and spending on imports rises.
Marshall–Lerner condition
Marshall–Lerner condition
Best link to attack
Assumes: Demand for exports and imports is price elastic.
Assumes: Demand for exports and imports is price elastic.
But: In the short run demand is inelastic because of contracts (the J-curve), and many UK service exports compete on quality rather than price.
End
The current account deficit widens.
Attack the whole chain: The rate rise also cuts AD and incomes, so UK households and firms buy fewer imports. This income effect works against the price effect above and may outweigh it.
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Questions this answers
- Explain how a rise in interest rates might affect the exchange rate.
- Assess the likely impact of higher interest rates on the UK current account.
- Discuss the effects of an appreciation of sterling on the UK economy.
Diagram
Foreign exchange market for sterling: demand for £ shifts right; the price of £ in dollars rises.
Reverse and related
Bank Rate cut → pound depreciates → current account improves, subject to Marshall–Lerner.