(b) Evaluate the likely result of a change in currency prices on the UK economy
A change in the price of currency will have many impacts upon the economy such as upon Balance of Payments, a change in real GDP, employment and inflation.
Assuming demand is relatively elastic, an appreciation of the currency results in a lower AD, shown by AD1 decreasing to AD2, as lower export demand and greater spending on imports causing a fall in domestic AD. This reduces economic growth, shown by a decrease of Y1 to Y2. Furthermore we would see lower inflation, shown by P1 decreasing to P2 as import prices are cheaper, as well as lower AD leading to lower demand pull inflation and manufacturers having greater incentives to cut costs to remain competitive. This is assuming demand is relatively elastic - if the demand was more inelastic, the result will be vastly different - there will be less of a ...view middle of the document...
Furthermore the overall impact on the current account depends on the elasticity of demand as stated at the start of the paragraph. If demand for imports and exports is inelastic instead of elastic, the current account could actually improve. Exports are more expensive but as demand is inelastic there will only be a slight fall in demand, meaning the value of exports will increase compared to the proportionately greater fall in export demand which causes a larger fall in the value of exports. The impact of the appreciation also depends on the position of the economy in the economic cycle; as if it is in recession then an appreciation will result in a larger fall in aggregate demand lead to rising unemployment. Yet if the economy is in boom, the appreciation of the currency will reduce inflationary pressures.
A devaluation of the currency will lead to demand for exports increasing, as the devaluation makes the exports more competitive and cheaper. It also increases the price of imports, meaning the government may choose to focus on export led growth. Lower imports and higher exports should increase AD, increasing real GDP. Furthermore as devaluation will result in demand for exports increasing, unemployment will decrease as firms higher more to respond to the increase in demand. However inflation is likely to be a result of this AD increase as imports becoming more expensive causes cost push inflation alongside demand pull inflation increasing due to AD increasing – with exports becoming cheaper firms have no incentive to become more efficient which may result in an increase in costs over time. The increase in AD also depends upon the demand being relatively elastic – if it’s inelastic, imports becoming more expensive will not have as great an effect on the overall AD as they won’t change dramatically.
Overall therefore the likely result of a devaluation depends on a multitude of factors including the economy at the time and most importantly price elasticity. However a change in currency prices will most likely have a severe impact across the economy.