Readers Question: Could deflation lead to devaluation of the UK Pound?
Deflation in the UK means prices fall. This hasn’t happened since the 1930s, but, if it did happen, it could lead to a further depreciation in Pound Sterling.
Firstly, deflation would mean interest rates would likely fall to 0%. This fall in interest rates would make it less attractive to save in the UK, reducing hot money flows. UK investors would save oversees. The recent fall in the Pound Sterling is due in part to the deterioration of the economy and expectation of lower interest rates. Deflation would imply a serious downturn and interest rates would fall close to 0%. This would have a big impact on reducing demand for sterling.
However, if the UK has falling prices and other countries have inflation, then in theory UK goods will become more competitive and this might increase demand for sterling. If the deflation is caused by increase in competitiveness and better productivity this should increase demand for UK Exports and therefore help sterling rise.
I believe the interest rate factor would outweigh the increased competitiveness though and Pound Sterling would fall.
Benefits of Depreciating Pound
British Exports will become more competitive. However, in the current climate, the fall in the value of the pound has not really helped exports. This suggests that demand is relatively inelastic and also it reflects the slowdown in global growth. In other words despite lower prices of UK exports the demand isn’t really there. However, in theory the depreciating pound should help boost exports and growth
Cost of Depreciating Pound
In theory, the depreciating Pound could cause inflation (rising AD, more expensive imports). However, since the UK is in a recession, inflationary pressures are muted.
Readers Questions If so, could there then be a case for the UK joining the Euro (if devaluation meant parity with Euro)?
I don’t support the idea of joining the Euro at moment