ChainWhat it assumes · how to break it
Start
The pound depreciates against the dollar and the euro, as it did after the EU referendum in June 2016.
1
As a result, the sterling price of imports rises, both imported consumer goods such as food and electronics and imported raw materials, fuel and components.
import prices · SPICED
import prices · SPICED
Best link to attack
Assumes: Foreign suppliers and UK importers pass the exchange rate change into sterling prices.
Assumes: Foreign suppliers and UK importers pass the exchange rate change into sterling prices.
But: Foreign suppliers may cut their own prices to keep UK market share, and importers who hedged their currency in advance face higher costs only when the hedges run out.
2
This means UK firms that use imported inputs face higher costs of production, so the SRAS curve shifts left.
cost-push inflation · SRAS
cost-push inflation · SRAS
Assumes: Imported inputs are a large share of firms' costs.
But: For many service firms the main cost is labour, so a weaker pound barely changes their costs.
3
At the same time, cheaper exports and dearer imports raise net exports, so AD shifts right and adds demand-pull pressure.
demand-pull inflation · net exports
demand-pull inflation · net exports
Assumes: The economy is close to full capacity.
But: With a large negative output gap, higher AD raises output and employment rather than prices.
4
Consequently, workers whose real wages have fallen may bargain for higher pay, which raises firms' costs again and keeps inflation above target for longer.
wage-price spiral · inflation expectations
wage-price spiral · inflation expectations
Assumes: Workers have the bargaining power to win pay rises that match inflation.
But: After 2016 wage growth stayed weak and real wages fell, so the rise in inflation did not become a spiral.
End
Inflation rises, mainly through higher import prices and cost-push pressure.
Evaluation chain
- E1However, the rise in inflation depends on how far and how fast the weaker pound passes through into sterling import prices.
- E2Because foreign exporters may cut prices to protect their market share, and UK importers often hedge their currency for months ahead,
- E3so only part of the depreciation reaches shop prices, and it arrives slowly as hedges and contracts expire.
- E4So the effect on inflation is smaller and later than the size of the depreciation suggests, especially in competitive retail markets where firms absorb costs in their margins.
Another way to attack it: A single fall in the pound causes a one-off rise in the price level, so inflation falls back once the pass-through is complete unless the pound keeps falling. The MPC may also raise Bank Rate to stop expectations rising, as it did in November 2017.
Pass-through takes many months: after the 2016 fall in sterling, CPI inflation rose through 2017.
Can you say this chain from memory?
Members can hide the links, test themselves and track which chains they have mastered.
Practise this chainMembers can hide the links, test themselves and track which chains they have mastered.
Questions this answers
- Explain how a depreciation of the pound may affect the rate of inflation in the UK.
- Assess the impact of a fall in the exchange rate on UK consumers.
- Discuss whether a weaker currency is likely to cause sustained inflation.
Diagram
AD/AS: SRAS shifts left as imported input costs rise, and AD shifts right as net exports rise; the price level rises.
Reverse and related
Appreciation → import prices fall → lower cost-push and demand-pull pressure → inflation falls.