Discuss the likely impact of a depreciation of the pound on the UK's economy.

A currency depreciation occurs when the value of one currency, in this case the pound sterling, falls in value in terms of another currency, such as the US dollar or Japanese Yen. A depreciation in the value of sterling, such that occurred after the Brexit vote of June 2016, will make UK exports cheaper abroad and therefore likely cause an extension of demand for UK exports. This will increase the UK's international competitiveness and result in an improvement in the UK's net exports and current account deficit ceteris paribus. Net exports, that is the the total value of exports minus the total value of imports, is a component of aggregate demand and thus an increase in the value of net exports will likely result in an increase aggregate demand. To demonstrate the effects of this we can use a short run AS-AD diagram. Originally the UK has a Gross Domestic Product (GDP) Y1 at price level P1. An increase in aggregate demand will cause a rightward shift in the AD curve from AD1 to AD2. This will result in an increase GDP from Y1 to Y2 and and increase in the price level from P1to P2 . An increase in the quantity produced may cause a reduction in demand deficient unemployment as UK exporters employ more labour to increase supply. This may result in higher household incomes and thus a greater standard of living. * AD- SRAS Curve would be placed here The effect of this however is largely dependent on the price elasticity of demand (PED) for UK exports abroad. If the demand for UK exports is inelastic, then a fall in price will result in a relatively smaller increase in the quantity demanded therefore the effect on the UK's current account would be less than if exports were price elastic. This occurred following the depreciation of the pound sterling succeeding the Brexit vote. The value of UK exports has largely remained constant despite a large fall in the value of the pound against other major currencies. Furthermore the J curve effect will play a significant role in any fluctuations in currency exchange rates. This is when, after a currency depreciation, the current account will actually worsen in the short term as foreign producers and consumers take time to adjust to the cheaper prices of UK goods and services. This means that a currency depreciation may take time to have a positive effect on an economies current account. The effect on employment may also be limited as firms production techniques may be capital intensive and so an increase in output may be provided by employing extra capital rather than labour. This is especially true in manufacturing industries where lower skilled workers are replaced my more efficient capital.

Answered by Charlie C. Economics tutor


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