Question

On June 23, 2016, 51.9% of British voters decided to leave the European Union. The media quickly dubbed this “Brexit”.   Using supply and demand graphs for both the market for pounds in the United States and the market for dollars in Britain, please show and explain how Brexit has caused the pound to depreciate.

Answer 1

When the Brexit was announced, it caused the British Pound to depreciate against the dollar. The reason for depreciation was as follows -

1. A Brexit would cause economic uncertainty related to the United Kingdom and uncertainty is not liked by investors. This caused the investment to move from the United Kingdom to the United States where economic growth is stable and interest rate are higher as compared to the United Kingdom.

2. The Brexit or an actual exit of the United Kingdom from the European Union is likely to have several implication on trade among other factors related to the private sector interaction with other countries. This has caused the Pound to depreciate with the markets discounting these uncertainties.

3. As funds flow from the United Kingdom to the United States, there is demand for the dollar. Therefore, the dollar gains on a relative basis as compared to the Pound.

The impact of these factors is shown in the chart below.

As the demand for the dollar increases, the demand curve for the dollar shifts to the right from Do to D1. This translates into an increase in the quantity of dollars demanded from Qo to Q1.

At the same time, the $/ £ exchange rate implies that more pound is needed to buy one dollar. In other words, the pound depreciates against the dollar and this is represented by movement in the exchange rate from Eo to E1.