Explain the effect of ‘Brexit’ on the exchange rate of the pound sterling versus other currencies. What are the implications for the short-term and long-term effects? Discuss.
Introduction
It is generally understood as the rate at which the currency of a country is exchanged with the currency of another country. In economics, the exchange rate has great significance, and it affects multiple economic factors. In the contemporary financial system, which is also global in structure, exchange rates change does not remain stable for a very long period. In fact, they continually change, especially because of the change in demand regarding these currencies (Isard, 1995).
Exchange rates are determined in global financial markets, where international buyers and international sellers come together to ascertain the value of currency regarding other currencies. However, the international financial market, where these rates are determined (to an extent), is one of many factors that affect the exchange rate of a currency. Other factors, such as Balance of Payment, Interest Rates, inflation and fiscal policy, also strong affect exchange rates. Therefore, the exchange rate is also a very vital economic indicator that provides information regarding the health of the economy. Therefore, exchange rates are of great interest for economists, as they provide evidence by which economists can project changes in the economy (Kenen, 1997).
Brexit
On June 23rd, 2016, Britain decided that it would not remain part of a political-economic group, the European Union. There were several political, social, and economic reasons that convinced 51.9% Britons to vote to exit European Union (Hunt & Wheeler, 2018).
The decision to leave European Union has affected Britain’s economy in some ways. It is because the economy is strongly affected by perceptions. For instance, when investors learn that the economy may improve in consecutive quarters, they begin investing in the economy. With the increase in the size of the investment, employment and consumption also increase, which swells the size of the overall economy. Therefore, it is natural that because of the Brexit decision, Britain’s economy got affected (Amadeo, 2018).
It is also imperative to understand that the European Union was formed, primarily, to realize identified economic objectives. Therefore, a country’s economy gets stronger and immediately affected when a country enters or leaves this economic union or group. It is also true for Britain, which intends to leave the European Union; however, there is no clarity regarding it. Since there is political ambiguity; therefore, there is slight instability in Britain’s economy. This instability is reflected in the pound sterling exchange rate (Enders, 2018).
In this academic exercise, we will discuss how Brexit has affected Britain’s currency, an indicator regarding the health of the economy. Also, we will also discuss what the factors that are impacting it are and what the implications are for the short and long run.
Exchange Rate since Brexit Decision
Before the Brexit decision, the exchange rate of the Pound Sterling, against the United States Dollar was around 1.50 against the United States’ Dollar. However, after 2016 decision to leave the economic union (European Union), there was a sharp decline in the value of Britain’s currency. This depreciation was caused by the ambiguity that was a result of 23rd June decision. As there was no plan that details the exit process; therefore, business community/investors did not truly know how political changes would affect the economic system. Most of the economic ambiguity revolved around trade as it was a free trade that was supposed to hit extremely hard from the 23rd of June decision (BBC News, 2018). (Note, the European Union relies on free-trade or tariff-free trade to realize various economic objectives. Trade, which is based on comparative advantage facilitates countries in 1) Optimally exploiting economic resources and 2) allow access to new/lucrative markets at a very low cost. Increase incompletion, because of easy access to new/lucrative markets, increase consider surplus, reduce prices, and increase innovation in industries.)
Above graph has been taken from BBC News (2018)
The figure above represents the exchange rate of the pound sterling against United States’ dollar and the European Union’s euro. Before the European Referendum, the pound sterling was strong against both the dollar and euro. For instance, the pound sterling was being traded at 1.3 against euro and 1.5 (almost) against the dollar (US) (for 1 pound sterling, 1.5 US dollars and 1.3 euros). However, soon after the referendum, the pound sterling depreciated against both the dollar and euro. Against the euro, pound sterling remains flat, despite the improvement in Britain’s economy; however, against the dollar, pound sterling has appreciated recently, which suggests that related economic dynamics between the United States and Britain are different from the economics related dynamics between Britain and European Union.
It is apparent that since May of 2017, the pound sterling has continually appreciated. Mostly it is because of trade, rather than other factors. It is apparent from the statistical evidence that interest rates have increased only 0.25 percent since 2017, which would not be a real cause of the appreciation of the pound sterling against the dollar. Therefore, other factors, such as the balance of payment and fiscal decisions, must have played a part in the appreciation of pound sterling against the American dollar. Other reasons may include inflation in the United States, which is a concern for Federal Reserve currently, as the American economy is heating up (Partington, 2018).
The pound sterling is still flat against the euro because the European Union’s economy seems more stable and the inflation rate, in Britain, is greater than the European Union. For instance, in the European Union, the inflation rate is around 1.5%, whereas, in Britain, it is around 2.5%. Therefore, inflation and interest rates could be the causes of the pound’s inability to appreciate at previous exchange rate levels (BBC.Com, 2018).
Economic Implications (Short and Long Run)
Exchange rates affect the economy in some ways, in both short and long runs. On certain aspects of the economy, its impact is more direct and strong, whereas on the other aspects of the economy, its impact is indirect and subtle. For instance, the impact of changes in the exchange rate on imports and exports is direct and evident in the short run, whereas the impact of changes in the exchange rate in employment and output and more subtle and appears mostly in the long run.
Also, appreciation of the currency does not necessarily benefit the economy. For this exact reason, some countries deliberately keep their currency undervalued. In this section of this academy, we will study how changes in exchange rate, of the pound sterling against the US dollar and the euro; will affect Britain’s economy in both short and long runs.
Exports
Exports are generally understood and products and services that are aimed at foreign markets (sold in foreign economies). Exports are an essential component of the economic strategy of all countries. All countries intend to increase the volume of their exports and reduce the volume of their imports. However, some economists are of the view that exports and imports must be balanced (Zero Balance of Payments).
Like in local markets, in international markets too it is the price that affects the quantity demanded. If the price of goods increases, the quantity of goods and services demanded will decrease. When a currency appreciates against the dollar, in the international financial market, the exporting goods and services of that country become pricier and thus less competitive in international markets. It means that because of the appreciation of local currency, the size of exports may be reduced.
Britain’s economy is still being affected by the 2007 financial crisis. In such a situation, an economy would prefer to increase its volume of exports; an increase in the volume of exports will positively affect economic growth, which is a primary concern for any economy/country.
Against the US dollar, Britain’s pound is appreciating, which could cause some challenges about exports. It implies that for United States’ consumers, British products and services would become more expensive. However, against euro, pound sterling has not appreciated to its previous level (the level before referendum), which means that prices for European Union citizens, the prices of British goods and services would be low, making them more attractive.
In the short-run, Britain would be competitive markets; whereas, in American markets, they would be less competitive since the pound has appreciated against US dollar. However, in the long run, the competitiveness of the products and services, by the exchange rate, would rely primarily on the exchange rate of that period.
Imports
Imports are generally understood as goods and services that enter local markets legally. Imports are also essential for the economy, as they directly affect prices, producer/consumer surplus, and innovation (investment in research and development). However, there should not be such a trade imbalance, in which imports exceed exports.
Currently, the pound is not able to appreciate to the pre-referendum level against the euro, which has made imports expensive for British citizens. US imports are also comparatively low in comparison to the pre-referendum level; however, as the pound is appreciating against the dollar, US imports are becoming less expensive, which will affect the balance of payments in both short and long run, if the trend continues.
Employment
Exports are directly associated with output and employment; when exports increase, the general output level increases and so do employment. It is evident that because of the depreciation of the pound, exports may increase. If exports increase, the investment in the economy will increase, causing an increase in employment.
Against selected currencies, the dollar and euro, the pound has depreciated that may positively affect exports. If the size of exports expands, employment will increase, as there would be an incentive for producers to invest in Britain’s economy.
Currently, the unemployment rate, in Britain, is 4.1%, which quite close to full employment level. In such economic conditions, if the size of investment increases, wages will increase, because the increase in investment will shift the demand for labor to the right. However, an increase in wages will reflect prices in the long run; an increase in cost will make products and services less competitive or more expensive.
Consumption
Consumption is considered an engine of growth of capitalist economies. An increase in exports increases employment; therefore, because of the increase in employment consumption size also increases. However, we have discerned that as the British economy is at full level; therefore, an increase in investment will increase both employment wages (real effect would be on wages). As the nominal wages would increase in the short run, real income would also increase. The increase in real income would positively impact consumption, expanding British economy in both short and long runs.
Currently, size of consumption is a serious concern for the British economy because it is quite low since the beginning of the 2007 financial crisis. In recent years, because of expansionary fiscal and monetary policy, inflation has swelled, and it is around 2.5% makes, which is considered healthy inflation rate. However, British authorities would like to see a slight increase in consumption, which could be achieved by the increase in the size of consumption.
Output
As employment, the output is also one of the primary objectives or concerns of an economy/country. The output is positively correlated with employment and inflation; therefore, the output is used as an instrument to meet various economic objectives. Exchange rates affect output, as they affect exports. From our discussion, it is apparent that because of the depreciation of the pound sterling, there may be an increase in exports, which positively affects investment size. If investment increases, the output will increase, which will positively impact all economic indicators of Britain’s economy?
There are some disadvantages of the devaluation of the currency too. It is a fact that there are many products that require foreign parts or raw materials. When the price of these foreign parts or raw materials increases the overall price of the product that uses these expensive foreign parts or raw materials also increases. Therefore, the devaluation of the currency is not necessarily advantageous, as some economies presume.
Conclusion
From the evidence gathered about the exchange rate of the pound sterling against the US dollar and the euro, it is apparent that since the Brexit polls, in which Britain decided to leave the European Union, the value of the pound has depreciated. Several factors have caused this depreciation; however, it is primarily political uncertainty regarding Britain’s trade relation with the European Union, which has caused a depreciation of the pound sterling. Another factor is an increase in inflation in Britain, which is around 2.5%. Based on the evidence gathered, we can project that because of the devaluation of the pound sterling, exports of Britain, exports may positively be affected. Expansion of exports will positively affect employment, wages, consumption, and output. In the short run, investment, employment, wages, and real income will increase, whereas in the long run, the output will get affected.
References
Amadeo, K., 2018. Brexit Consequences for the UK, the EU, and the United States. [Online] Available at: https://www.thebalance.com/brexit-consequences-4062999 [Accessed 6 June 2018].
BBC News, 2018. Pound hits $1.40 for first time since Brexit vote. [Online] Available at: http://www.bbc.com/news/business-42794549 [Accessed 6 June 2018].
BBC.Com, 2018. UK inflation rate drops back to 3%. [Online] Available at: http://www.bbc.com/news/business-42702752 [Accessed 6 June 2018].
Enders, T., 2018. Brexit confusion threatens the UK aviation industry. [Online] Available at: https://www.ft.com/content/b9ff0c10-3c9f-11e8-bcc8-cebcb81f1f90 [Accessed 6 June 2018].
Hunt, A. & Wheeler, B., 2018. Brexit: All you need to know about the UK leaving the EU. [Online] Available at: https://www.bbc.com/news/uk-politics-32810887 [Accessed 6 June 2018].
Isard, P., 1995. Exchange Rate Economics. 1st ed. Cambridge University Press.
Kenen, P.B., 1997. International Trade and Finance: New Frontiers for Research. 1st ed. Cambridge University Press.
Partington, R., 2018. UK interest rate rise is coming, Bank of England tells borrowers. [Online] Available at: https://www.theguardian.com/business/2018/feb/08/uk-interest-rate-rise-is-coming-bank-of-england-tells-borrowers [Accessed 6 June 2018]
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