Question

QUESTION 2 (25)
EXCHANGE RATES IN UK
Towards the end of 2009 the pound fell to a six-month low of 1.0628 Euros. Figures released by the UK
government suggested that demand was still low in the country. The pound was also under downward pressure
because of the low value of the interest rate. A recent report suggested these would remain at their historic
low of 0.5% until 2014. Business confidence in general remained frail and there was concern over when the UK
economy would start to recover from its negative growth. There was huge excess capacity in the UK. In addition,
the government had a huge deficit which was expected to cause problems with cutbacks and tax increases in
the future.
Adapted: Gillespie, A. (2013), Business Economics, Oxford University Press
2.1 Discus the key factors that determines the value of a currency in the UK. (10)
2.2 Critically analyse the possible effects on the UK economy of a fall in the value of the currency. (15

Answer 1

2.1   The key factors which determines the value of a currency in UK are :

• Rate of inflation : The exports of UK will become more and more competitive for a lower inflation rate. Thus pound sterling demand also rises with it. Also the goods imported from other foreign countries will have lower competancy and thus people will not prefer those imports.
• Rate of interest : people will start depositing money in the UK banks if the interest rate is higher in UK. People will get a huge amount of profit for their money deposited in the bank. It result in the rise of pound sterling demand.

2.2 when the value of UK currency declines, the goods and services in UK become cheaper in terms of foreign currency and the foreign goods and services will become more expensive in terms of domestic currency.

That is when the value of UK currency (pound) falls, then it will lead to a rise in the prices of UK imports and it will also lead to a fall in the price of UK exports. These changes in the imports and exports will affect the demand. That is there will be a contraction in the market imports and an expansion in the market exports.

This will have an effect on a number of economic indicators. That is it will result in the rise of domestic production and domestic jobs and a decline in the trade deficit.

​​​​It will also affect the macro objectives such as :

• Inflation : A fall in a currency leads to a rise in import prices which causes a rise in cost push inflationary pressure.
• Export demand and trade balance : A weaker currency makes exports cheaper overseas. It also rises export sales and promote a strong trade balance.
• Real GDP and jobs : Rise in exports and fall in imports will increase AD. The export profits are a stimulus to the labour market.

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