ChainWhat it assumes · how to break it
Start
The pound depreciates, for example against the euro and the dollar.
1
As a result, UK exports become cheaper in foreign currency and imports become dearer in pounds.
SPICED · price competitiveness
SPICED · price competitiveness
Assumes: UK firms pass the exchange rate change into foreign prices.
But: Exporters may keep their foreign prices unchanged and take the gain as higher sterling profit margins, so export prices abroad do not fall.
2
Therefore, foreign buyers switch towards UK goods and services, and UK buyers switch from imports to domestic substitutes.
expenditure switching · PED
expenditure switching · PED
Assumes: Demand for UK exports and imports is price elastic.
But: Many UK exports, such as financial services and pharmaceuticals, compete on quality and reputation, so demand for them is price inelastic.
3
This means net exports rise, so aggregate demand increases.
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 rises.
But: In the short run volumes respond slowly while each import costs more in pounds, so net exports can fall at first (the J-curve).
4
Consequently, the AD curve shifts right and the multiplier raises real GDP by more than the initial rise in net exports, so economic growth rises.
multiplier · real GDP
multiplier · real GDP
Best link to attack
Assumes: There is spare capacity in the economy.
Assumes: There is spare capacity in the economy.
But: Close to full capacity, the rise in AD mainly raises the price level, and dearer imported inputs shift SRAS left, which reduces real output.
End
Real GDP rises, so short-run economic growth increases.
Evaluation chain
- E1However, the effect on real GDP depends on how much spare capacity the economy has when the pound falls.
- E2If the economy is already close to full employment, firms cannot easily raise output to meet extra export demand,
- E3then the rise in AD mainly pulls up the price level, while dearer imported inputs push SRAS to the left.
- E4So growth rises little, and much of the depreciation shows up as inflation rather than higher real output; the effect is largest when there is a negative output gap.
Another way to attack it: Dearer imports also cut households' real incomes, so consumption, the largest part of AD, may weaken. If the depreciation reflects a loss of confidence in the economy, investment may fall at the same time.
Export and import volumes respond over one to two years, so the boost to growth comes later than the fall in the pound.
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Questions this answers
- Explain how a depreciation of sterling might affect aggregate demand.
- Assess the likely effect of a fall in the exchange rate on UK economic growth.
- Discuss whether a government should seek a weaker currency to boost growth.
Diagram
AD/AS: AD shifts right as net exports rise; real GDP rises from Y1 to Y2. Show SRAS shifting left as well for evaluation.
Reverse and related
Appreciation → net exports fall → AD falls → growth slows.