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Effects of exchange rate changes

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GDP compared to other currencies

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We have spoken quite a lot about Brexit in this unit because it affected in so many different parts of the UK and global economy.

In the figure we see sharp drop in several of the exchange rates during 2016, this being attributed to the UK’s decision to leave the EU. Some of the reasons we see this drop include:

Financial Institutions’ Preferences - There is a decreased preference for pound-denominated investments by financial institutions. These institutions dominate currency markets, with 57.8% of UK foreign exchange turnover in 2019 (BIS).

Interest Rates - The Bank of England’s interest rate cut and increased quantitative easing after the Brexit vote contribute to the pound’s decline.

Uncertainty and Political Instability - The uncertainty increased the perceived risk of holding pound-denominated assets, as investors worried about future trading relationships with the EU and potential negative impacts on UK businesses. As a result, many investors reduced their holdings of pounds or delayed investments, contributing to the currency’s sharp decline immediately following the referendum result.

Investor Expectations - The pound’s fall occurred before Brexit was implemented (remember the actual trade deal was introduced in January 2021), reflecting the rapid incorporation of changing investor expectations into currency markets.

Effects of exchange rate changes

Individuals

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A weaker pound means imported products become more expensive, so people might notice higher prices at supermarkets, especially for out-of-season produce or international brands. The general cost of living increases and individuals might find their money doesn’t stretch as far as it used to for daily expenses.

Also the cost of foreign holidays and overseas online purchases would also increase. A weaker pound means less spending power in other countries.

Firms

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A stronger pound can make exports less competitive and reduce profit margins on foreign sales, while a weaker pound increases the cost of imports. This affects businesses’ competitiveness both domestically and abroad. While international trade offers growth opportunities, it also exposes companies to currency risks that can affect their market position.

A survey of 1,000 UK small and medium sized firms revealed that 25% had received foreign currency payments in the last month, and 42% reported losing money due to currency fluctuations.

However, as British goods become cheaper for foreign consumers, UK exporters may experience a significant increase in demand, resulting in higher export sales volumes, boosts of revenues and market share in international markets.

A depreciated pound makes the UK a more affordable destination for foreign visitors, possibly leading to more tourists coming to the UK.

The increased costs of imports due to the weaker pound may shift UK consumer demand towards domestically produced goods, increasing sales, profits and market share for UK firms that compete with imported products in the domestic market.

UK Trade Balance

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An overvalued currency reduces the cost of imports and makes exports less competitive, which can widen the current account deficit or reduce the surplus.

Conversely, an undervalued currency enhances export competitiveness and raises import costs, thereby increasing the current account surplus or narrowing the deficit.

UK Economy

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When the pound weakens, overseas citizens receive more sterling for their foreign currency, which make UK exports more attractive to international buyers. The increase in exports can lead to a rise in national income and economic growth, as it injects more money into the circular flow of income within the UK economy.

Unemployment rates may fall as firms experience increased demand for their products and services, prompting them to hire more workers to meet this demand.