Readers Question: A fall in competitiveness will lead to a depreciation in the exchange rate. I read this on this site somewhere, can you explain why this occurs? Thanks.
Imagine UK inflation is 5% and our competitors, such as the EU, have inflation of 2%. This means that each year UK goods will rise at a faster rate than EU goods. Therefore, UK consumers will start switching to EU imports. Also it will be more difficult to export to the EU because our exports are more competitive.
- The increase in demand for imports will increase supply of sterling
- The fall in demand for our exports will decrease the demand for sterling.
- Therefore because sterling is in less demand, the value of sterling will fall.
In theory it is relative competitiveness that determines exchange rates in the long term.
At the moment we are seeing volatile movements in the exchange rate because people are uncertain of future economic trends. However, one issue which has reduced the value of the pound is the decision to increase the money supply through quantitative easing.
Increasing the money supply increases the risk of inflation in the UK and therefore will make sterling relatively less attractive.
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[...] the previous post we examined why a fall in competitiveness will cause a depreciation in the exchange rate. But, what happens in the Euro where you can not depreciate against your main trading [...]
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