ChainWhat it assumes · how to break it
Start
The pound depreciates by a large amount and stays low, as after the 2008 financial crisis.
1
As a result, UK manufactured goods and tradeable services become more price competitive in world markets.
international competitiveness · relative export prices
international competitiveness · relative export prices
Assumes: UK exporters pass the lower pound into lower foreign prices.
But: If exporters keep foreign prices unchanged, they gain profit but not market share.
2
This means profits in tradeable sectors such as manufacturing rise relative to non-tradeable sectors such as retail and personal services.
profit signal · tradeable sector
profit signal · tradeable sector
Assumes: Demand for UK exports responds to price.
But: Demand for many UK exports depends on quality and reliability, so sales and profits rise only slightly.
3
Consequently, firms invest in new capacity in exporting industries, and labour and capital move towards manufacturing and other tradeable sectors.
resource allocation · investment
resource allocation · investment
Best link to attack
Assumes: Firms expect the lower pound to last long enough to justify new investment.
Assumes: Firms expect the lower pound to last long enough to justify new investment.
But: Exchange rates are volatile; if firms think the pound may recover, they will not build new plants that would be unprofitable at a higher rate.
4
Therefore, the share of manufacturing and exports in GDP may rise, rebalancing the economy away from consumer spending and imports.
rebalancing · deindustrialisation
rebalancing · deindustrialisation
Assumes: UK firms have the capacity and skills to expand.
But: Much UK manufacturing capacity was lost in earlier decades, and skills shortages in engineering limit how fast it can expand.
End
The structure of the economy may shift towards manufacturing and other tradeable sectors.
Evaluation chain
- E1However, the shift in resources depends on firms believing the lower pound will last long enough to make new investment profitable.
- E2Because investment in plant and skills pays back over many years while exchange rates can reverse within months,
- E3so many firms take the depreciation as a short-term rise in profit margins rather than building new capacity.
- E4So the change in the structure of the economy is small and slow, and it is more likely when the depreciation is large, sustained and backed by stable policy.
Another way to attack it: A depreciation gives only a price advantage and does nothing to raise productivity. It may reduce the pressure on firms to improve non-price competitiveness, and the large fall in sterling in 2008 was followed by only a modest rise in the share of manufacturing.
Building capacity and training workers takes years, so any change in structure is slow.
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Questions this answers
- Assess whether a depreciation of sterling will help to rebalance the UK economy towards manufacturing.
- Explain how a change in the exchange rate can affect international competitiveness.
- Discuss the factors that determine the international competitiveness of UK firms.
Diagram
No standard diagram. Use data on manufacturing as a share of GDP and on relative unit labour costs.
Reverse and related
Appreciation → tradeable sectors lose competitiveness → resources move to services → deindustrialisation.