To what extent has Britain suffered from an overvalued exchange rate over the last two decades?

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                        Colin Yoon WiH

To what extent has Britain suffered from an overvalued exchange rate over the last two decades?


Contents

Introduction – Pg. 3

Exchange Rate – Pg. 4

Balance of Trade – Pg. 6

Inflation & Interest Rate – Pg. 8

Unemployment – Pg. 10

Economic Growth – Pg. 11

Evaluation & Conclusion – Pg. 14

Bibliography – Pg. 16


Introduction

        During the course of my investigation I will be doing a research on whether Britain has suffered from an overvalued exchange rate of pound sterling over the last twenty years. Firstly, I will be looking at the determinants of exchange rate in order to find out the factors affecting the exchange rate of a currency such as pound sterling against another. In this way, I will be able to figure out if UK’s currency, pound sterling, is overvalued or not. Secondly, the history of both British exchange rate and economy will be analysed and looked at to see whether Britain has actually suffered from the overvalued exchange rate for the last two decades.

        I am planning to begin this coursework by defining exchange rate and explaining its effect on the economy. This includes the impact of the exchange rate on balance of payment, interest rate and economic growth, as well as other economic variables and vice versa. Moreover, the reasons for the fluctuations on the pound exchange rate against other currency will be verified and discussed as an example to see the connection between economic variables and exchange rate. In addition, it will be vital to clarify on the basis of what we consider a currency to be overvalued. For example, a tourist might think British pound is overvalued whereas people from Britain might think foreign currencies are undervalued, therefore it is important to understand how we define overvalued exchange rate.

        My hypothesis in this coursework is that British pound is overvalued and consequences are Britain has been suffering from it for the last two decades in terms of balance of payment. In other words, there must be side effects of having overvalued exchange rate such as trade deficit. Despite the UK’s position in terms of GDP, the fact that UK’s currency holds the highest exchange rate ahead of every other country’s exchange rate is a clear evidence to support my hypothesis. However, during this research I must make a clear distinction between strong value of exchange rate and overvalued exchange rate as it can be artificially controlled for the purpose of government policy.


Exchange Rate        

The exchange rate between two currencies specifies how much one currency is worth in term of the other. It is similar to how demand and supply works for normal goods. A currency will tend to become more valuable whenever demand for it is greater than the availability of supply and this implies that the demand for British pound must be high. The diagram illustrated below (Fig. 1) is the supply and demand diagram of pounds against Euros traded on the foreign exchange market and there is equilibrium at the exchange rate of €1.60.

               Fig. 1                                                  Fig. 2

However, a high level of demand for pound, in other words, an increase in the demand for pound will force up the exchange rate. The demand for pound usually comes from people who are investing in the UK from abroad and so need pound, or from firm who are buying UK exports. Therefore, in order to invest or purchase UK products, pound need to be purchased to be able to pay for the goods. On the other hand, the supply curve indicates people from UK selling pounds to purchase foreign goods or invest in another country.

In general, any changes in economic variable will force both demand and supply curve to shift. For example, if boom were to occur in the UK, the expectations would be high and it would attract overseas investment into the UK. However, pound must be purchased in order to invest in the UK and as a result demand for pound would rise causing a rightward shift on the demand curve as illustrated in the diagram above (Fig. 2). In effect, this rightward shift of demand curve increases the amount of money that must be paid to purchase pound.

So does an increase in the value of pound caused by demand outstripping the level of supply, always represent an overvalued exchange rate? Firstly, we would need to define overvalued exchange rate before making a decision on whether British pound is actually overvalued or not.

Overvalued exchange rate refers to the actual exchange rate being set below the equilibrium exchange rate, causing a currency to look more expensive compared to the others. But on the basis of what do we mean by overvalued exchange rate? Some people might think UK’s exchange rate is overvalued, with respect to purchasing power parity (PPP) or relative to the rate presumed needed to balance the current account. Purchasing power parity (PPP) is a theory that uses a long-term equilibrium exchange rate of two currencies to equalise their purchasing power. One way to estimate the overvaluation of an exchange rate is to look at McDonald’s Big Mac, which is produced to more or less the same recipe in about 120 countries. The table below represents Big Mac prices in local currency as well as the prices in dollars for 30 countries and how far each currency is undervalued or overvalued against the dollar is then calculated on the far right column.

        

The table above is from a magazine in 2001 called The Economist and there are currently three countries with overvalued currency against the dollar, Switzerland, Denmark and Britain. Countries highlighted in green are the ones that possess overvalued exchange rate and the ones with red lines are the countries that I am looking at. The average price of a Big Mac in America is $2.54 whereas in Japan, it’s worth about ¥294 or $2.27 at current exchange rate. The third column calculates purchasing power parity (PPP), dividing the yen price by the dollar price gives a Big Mac PPP of ¥166. Comparing this to the actual exchange rate against the dollar in 17th of April 2001, it shows that yen is undervalued by 6%. If we look at Britain the price of a Big Mac is at £1.99, which is equivalent to $2.85 and this is clear evidence that British currency, pound sterling is overvalued with respect to purchasing power parity at 12%.

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Although Japan was ahead of Britain in GDP ranking in 2001 and its currency was undervalued in terms of purchasing power parity (PPP) against the dollar, British currency, pound sterling was overvalued despite their lower position than Japan in GDP ranking. Furthermore, there were two other countries with even higher overvalued currency than Britain. Denmark and Switzerland recorded their currency overvaluation at 15% and 44% regardless of their economic performance. Therefore, we come to a conclusion that British currency, pound sterling is actually overvalued.

So what are the effects of having an overvalued exchange rate? In general an overvalued exchange ...

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