Question

In 2008/09 the British pound depreciated by approximately 25% on a trade-weight basis after the Bank of England reduced interest rates to a historically low level. In your opinion, did the depreciation in sterling damage the UK economy? What are the consequences of a depreciation? Are exchange rate movements necessarily good or bad for a country? Explain

Answer 1

Depreciation in exchange rates doe not necessarily damage the economy. Every coin has two sides so depreciation of exchange rate has its benefits and drawbacks. From domestic standpoint, such a fall would be beneficial for home grown industries having markets abroad because exports become cheaper. However, for industries which are heavily dependent on imported machinery and technology, such a fall would be detrimental.

Exports gain momentum and imports lose momentum, which means that aggregate demand will rise and this will lead to higher economic growth. It helps to lower the trade deficit that a country has. However, one important downside is that it becomes difficult to attract more foreign investments because those investors are highly skeptical and apprehensive about a weakening currency. That would mean it would not be ideal for a government to fund its budget deficit.

This also has an impact on the tourism industry. Foreigners will find it cheaper to visit countries like UK where the currency is undergoing devaluation. However, all of this may increase inflation, because higher exports increase demand while firms have no incentive for cost cutting.

All of the above discussion highlights the fact that exchange rate movements are not necessarily good or bad for a country.