Question

Excercise 11.7

Suppose the UK left the European Union, and that this move meant that UK Exports to the EU faced the common external tariff. As a result, UK exports drop sharply. (its imports would also decline, but assume for the sake of the excercise that the decline of exports is larger) Explain the effect of this exogenous decline in aggregate demand on GDP, interest rates and exchange rate in the UK, given that the central bank lets the pound float. How would your answer change if the UK had a fixed exchange rate with the euro?

6th edition Macroeconomics: A European Text

Authors: Burda & Wyploz

  

Answer 1

Reduction in net exports will cause the aggregate demand (AD) curve of the UK to shift downward to the left. The reduction in the AD will cause the price level in the UK to decline. Reduction in the price level will cause the real money supply in the UK economy to rise. On the other hand reduced demand will cause income in the UK to fall. So, the gross domestic product (GDP) will fall in the UK.

Increased supply of real money and decline in the income will cause the transaction demand for money to fall while the speculative demand for money will increase. This will put pressure on the interest rate to fall in the UK. Reduction in the interest rate given the fact that UK pound is floating will put pressure on it depreciate. This will happen as decline in the interest rate will result in capital outflow. The depreciation of the pound will make UK exports comparatively cheaper and imports comparatively expensive compared to the initial condition.

So, although the GDP will fall, it will not fall as much as in the case where the UK has fixed exchange rate.

This is because in the case of fixed exchange rate the Central Bank would had to intervene in the foreign exchange market to ensure that the pound doesn’t depreciate. For this, the UK government would have to reduce the money supply by buying pound and supplying the Euro. As a result, the aggregate demand (AD) would have declined more.