A example of an appreciation in the value of the Pound 2009 – 2012
- Jan 2009 If £1 = €1.1
- June 2012 £1 = €1.27
- In this case we can say there was a 15% appreciation in the value of the Pound against the Euro – between Jan 2009 and June 2012
Effects of an appreciation on the UK economy
- Exports more expensive. The foreign price of UK Exports will increase Europeans will find British exports more expensive. Therefore with a higher price, we would expect to see a fall in the quantity of UK exports.
- Imports are cheaper. UK consumers will find that £1 now buys a greater quantity of European goods. Therefore, with cheaper imports we would expect to see an increase in the quantity of imports.
- Lower (X-M) With lower export demand and greater spending on imports, we would expect fall in domestic Aggregate Demand (AD), causing lower economic growth.
- Lower inflation. An appreciation tends to cause lower inflation because:
- import prices are cheaper. The cost of imported goods and raw materials will fall after an appreciation, e.g. imported oil will decrease, leading to cheaper petrol prices.
- Lower AD leads to lower demand pull inflation.
- With export prices more expensive, manufacturers have greater incentives to cut costs to try and remain competitive.
Impact of appreciation on AD/AS
Assuming demand is relatively elastic, an appreciation contributes to lower AD (or a slower growth of AD), leading to lower inflation and lower economic growth.
Impact of an appreciation on the current account
Assuming demand is relatively elastic, we would expect an appreciation to worsen the current account position. Exports are more expensive, so we get a fall in eXports. Imports are cheaper and so we see an increase in iMports. This will cause a bigger deficit on the current account.
However, the impact on the current account is not certain:
- An appreciation will tend to reduce inflation. This can make UK goods more competitive, leading to stronger exports in the long term, therefore, this could help improve the current account.
- The impact on the current account depends on the elasticity of demand. If demand for imports and exports is inelastic, they the current account could even improve. Exports are more expensive, but if demand is inelastic, there will only be a small fall in demand. The value of exports will increase. If demand for exports is price elastic, there will be a proportionately greater fall in export demand, and there will be a fall in the value of exports. Continue Reading →