To join the EMU, member states of the EU have to fulfil stringent criteria, namely that longer term interest rates (rather than just current base rates) and inflation have to roughly similar to those of the three lowest inflation member states. The government debt and public finances also have to be relatively sound. Trust in the currency increases if traders know that member states have been filtered out to fulfil certain expectations, thus meaning that they are more reliable.
Lastly, since the EU is the UK’s biggest trading partner and given that the UK has a high propensity to import, the Euro has strengthened. The increase in the demand for products exported out of the EU, into Britain, increases the demand for Euros, thus increasing the value of the Euro. Nevertheless, it must be remembered that this would have a much smaller effect on the value of the euro than the trading by Forex traders considering that billions of Euros/other currencies are traded on the Forex everyday, the trading takes precedence over the increase in imports. Given that the UK has always had a high propensity to import, therefore this effect has not changed significantly since the introduction of the Euro.
Even though the Euro has increased relative to other currencies, it must be noted that the sterling has been fairly strong since the independence of the Monetary Policy Committee; as it is widely known that they prefer to keep a strong pound when setting interest rates. The strength of sterling can be attributed to the high confidence in the value of sterling due to the strong levels of sustained growth that the UK has faced in the last decade and given that the UK managed to avoid a recession at the turn of the century unlike the US.
The structural differences and the fact that the ECB has to set rates with the growth levels and economic situation of all the states in mind, unlike the Bank of England means that the ECB has a more difficult task of setting rates and thus sustaining the value of the Euro. Given that the ECB doesn’t have an asymmetric target means that keeping inflation on line at 2% is also much more difficult and any wide fluctuations could set the Euro tumbling as investors lose confidence. Due to this, the sterling has been stronger than the Euro for the last couple of years.
However, with the recent subprime crisis and tumbling value of the dollar, investors have hedged against the dollar into the Euro and other emerging market currencies such as the Yen; both of which have been reaching record highs against the dollar. Unlike the Yuan and sterling, the Euro is not considered to be overvalued thus meaning that the Euro has made sustainable gains against the Euro as the market has begun to correct itself. Expectations of what the central banks will do has also affected the situation, especially since investors expect the ECB to stick and the Bank of England to cut rates in the near future. Nonetheless, recent speeches by Trichet suggest that the ECB will cut rates to help the US, thus reversing the current decline of the sterling.
Evaluate the likely economic effects of a significant fall in the value of sterling against the Euro.
The Uk’s balance of payments would become more positive as a fall in the value of sterling compared to the Euro would significantly increase exports as the EU would consume more British exports, as they are cheaper. This effect would be intensified given that the EU is the UK’s biggest trading partner. This would also translate to an increased multiplier effect as exports move through the circular flow of income and aggregate demand could potentially shift to the left. This shift however depends on the actual goods that we export to the EU and the relative quantities of those products to everything else we export, so for example if the products had an inelastic price elasticity of demand would mean that the volume of exports would not be significantly higher, thus reducing the rate of the shift to the left in aggregate demand.
A significant fall in the value of the sterling would be inflationary as it is imported through higher prices of foreign goods and services. This has been evident through the higher inflationary costs from China as Chinese inflation rockets to record levels of 8.7%. This will lead to a worsening of the balance of payments and can be shown by the following diagram – the J-curve effect. This will happen in the short run as firms that are locked into long term contracts will be forced to buy at higher prices regardless of the sudden devaluation thus meaning that when there contract ends, there will be a sudden jump. It also depends on the price elasticity of demand of domestic producers as they may not be able to meet the demand for imported goods due to a lack of capacity, suitable skills or availability of substitutes.
Nevertheless, the improvement in the balance of payments may not necessarily occur in the long run due to the Marshall Lerner condition which states that a significant devaluation will only improve the balance of payments if the sum of the price elasticity of demand of exports and imports was greater than one – i.e. it must be elastic. This is because if it were inelastic then total revenue will fall as prices fall. However, Britain is known for having relatively inelastic PEDs for both exports and imports thus meaning that the devaluation would not work.
It could also be inflationary in terms of inflationary expectations as high inflation would erode disposable incomes, marginally affecting the poor considering that inflation is regressive. A particular hike in inflationary expectations, given that there weren’t any significant downside pressures in the economy, would warrant a rate increase by the Bankof England to reduce inflationary pressures and expectations. This would in turn encourage the flow of hot money into the UK to push up the value of the pound as long term inflationary pressures could offset a wage price spiral, where workers demand wages in line with inflation. This is especially of concern in the UK as wage inflation, especially by the public sector is based on RPIX figures rather than CPI figures.
Tourism is the second biggest industry in the UK after the financial services sector. A fall in the value of the pound would lead to an increase in tourism as it would be expected that more people would come to the UK due to things being cheaper relative to the Euro. This would create jobs and boost sales for those in the tourism industry. However, it must be remembered that since Britain is a member state of the EU it allows free movement of labour and EU citizens across its border thus meaning that movement of people would not bring about a significant change.
A devaluation may help export dependent businesses however not all firms in the British economy are structured like this. Some firms would have higher business costs if a lot of their products that went into the production process were imported from the EU. This could lead to cost-push inflation and possible job losses as firms try to protect their profit margins, especially if they can’t pass on higher business costs to consumers in fear of reducing demand. Nonetheless it could be argued that this would be better for businesses as it would force them to become efficient and thus improve their comparative advantage on the global scene. (Inefficient businesses would be pruned – this had to be said for comic value)
These measures and influences would be dependent on the size of the devaluation compared to the Euro, how quickly it occurs and the fall of the sterling relative to other currencies. Currently, the pound is strong against the dollar and thus meaning that a lot of the above mentioned effects would be offset because the US is the UK’s single biggest trading partner in terms of countries rather than states. Given that the pound is also relatively stable against all the other currencies the effects of the fall in the sterling against the Euro would be minimal.
It also depends on how the situation can be rectified and whether the underlying problem is structural or merely one that could be eased by increasing interest rates. Of course the situation of the economy needs to be taken into account, thus meaning that even if the Bank of England wanted to increase rates to increase the value of the pound by attracting flows of hot money into the economy that would not be possible to the significant downside pressures affecting the economy.
