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 rate has both positive and negative effects and I will be looking at each economic variable to see the effect of overvalued exchange rate on the economy.
Balance of Trade
It is usually undesirable to have an overvalued exchange rate for the exporters because a high exchange rate means their exports will look more expensive compared to other foreign products. This causes a fall in demand for exports and as a result the firms located in high exchange rate country become both domestically and internationally uncompetitive. For example, you are in a shop in America willing to buy a shampoo and there are two shampoos. One is imported from the UK and the other from America and the British one costs $10 whereas the US one only costs $5. If you know there is absolutely no difference in the quality of those two products you would prefer to buy the cheaper one. The firms also suffer from cheap foreign imports and if there is no sign of falling exchange rate for a while it will eventually cause trade deficit to occur.
Fig. 3
The graph above shows the UK balance of trade from 2000 up to 2005 and the negative figures on the y-axis indicates trade deficit over the past few years. The x-axis indicates the year and the y-axis indicates pound in billions. From the graph, it seems to be the case that British balance of trade is falling almost by £500 billion each year, which eventually reaches nearly £3000 billion that is 6 times of what it used to be 5 years ago in 2000.
Fig. 4
However, an overvalued exchange rate is not the sole cause of trade deficit as other factors also influences the balance of trade and we can tell that from the graph above. The graph above shows the UK exchange rate against the dollars from 1999 to 2007. The period we are looking at is located between the two red lines and from what we can see the exchange rate only fell by 0.05 by 2005 since 2000, which I believe is too small to influence the trade that much from what we have seen in fig. 3. Nevertheless, I believe the overvaluation is one of the major factors that causes trade deficit.
Despite of such negative effects, it is possible to benefit as well from having an overvalued exchange rate in relation to trade. This is the case especially for those countries that are highly relying on importing foreign materials in order to produce their own products. For example, if it requires materials imported from a foreign country with low exchange rate against the pound in order to produce products in the UK, the producer importing those materials in the UK would benefit from it because he is paying a lot less money than what he would have to pay if the pound had lower exchange rate or was undervalued. Therefore, price for their products would be lower thus they become more competitive.
Inflation & Interest rate
As I stated above, the advantage of having high exchange rate or overvalued exchange rate is that imported materials are cheaper compared to what the firm would have to pay if the exchange rate was undervalued or low. This prevents cost-push inflation in the economy because if the exchange rate were to fall the firms would have to pay more for the required materials and if this is the case the firms would pass down the extra cost to the consumers so that they can maintain their profit margin.
Fig. 5 Fig. 6
The diagram above (Fig. 5) shows the effect of cost-push inflation. When the imported materials become more expensive it causes AS line to shift to the left, which drives price level up because the firms are now passing down the extra costs to the consumers by putting the prices up and consequently the real income falls. It seems to be worse when it’s the oil price pushing up forcing price level to go up as illustrated in fig. 6. Oil is price inelastic therefore the supply curves are vertical and when the exchange rate falls it becomes more expensive shifting the LRAS line to the left. However, there is no tendency of AD line shifting because we cannot live without oil and there are no alternative resources that can replace it therefore the price level goes up significantly. On the other hand, due to a fall in real income and a rise in price level, the workers will now demand higher wages in order to maintain their living standard. So these prove that an overvalued exchange rate can influence the supply side preventing cost-push inflation.
Furthermore, the inflation rate has a direct impact on the interest rate and it is the independent central bank that is responsible for controlling the interest rate in the UK to meet CPI inflation target of 2%. The diagram below shows the UK inflation rate between 2000 and 2005. It’s indicating a steady increase in the price level reaching the highest rate of 1.8% in 2001 but always remaining under the target of 2%.
Fig. 7
The diagram below shows the interest rate in the UK over the last few years. In 2000, the interest rate is at 6% then it starts to fall in the beginning of 2001. This continuous fall in interest rate finally reaches the lowest interest rate just below 4% in 2003 but then starts to rise again, fluctuating in between 4% and 5% in 2004 and 2005. If we analyse these two graphs, there is a sharp increase in the rate of inflation in mid 2001. This can be explained by a fall in interest rate in the beginning of 2001, stimulating the demand in the economy thus causing inflation (CPI) to rise.
Fig. 8
These two graphs are showing similar pattern most of the time and from what I can see the inflation have remained between CPI 1% and 2% throughout the years after a sharp rise in 2001 when the interest rate have remained between 4% and 5%. However, despite of a rise in interest rate in the beginning of 2004, the rate of inflation was continuously increasing finally reaching 1.8% in the end of 2005 from 1.2% in 2004. Whether or not such inflation is the result of overvalued exchange rate or something else, it has been remaining under 2%. So what impact does it have on unemployment?
Unemployment
Although it may seem desirable to possess an overvalued exchange rate it is debatable whether exchange rate should be high or low. A firm becomes internationally and domestically uncompetitive due to high exchange rate causing the demand for their products to fall. The firm would then try to maintain their profit margin by lowering the number of workers causing the level of unemployment to rise, which is undesirable for the economy. However, this does not always seem to be the case as the following diagram shows a fall in unemployment over the last few years in the UK.
Fig. 9
This diagram represents the level of unemployment in the UK between 2000 and 2005. From what we can see, it is clear that a high exchange rate or overvalued exchange rate doesn’t necessarily lead to a rise in the level of unemployment. The unemployment rate gradually fell down to roughly 2.8% by 2005, reaching the lowest unemployment figure at 2.6% between 2004 and 2005. From this, we could say that the overvalued exchange rate and other economic variables such as interest rate did have an impact on the level of unemployment and therefore I assume that these economic factors stimulated demand in the economy.
Theoretically the unemployment figure wouldn’t fall dramatically like above when the exchange rate is high but in this case other factors must have had greater influence on the level of unemployment such as economic growth. Because generally when the exchange rate is high the price level is high too resulting in workers demanding for better wages to maintain their living standard. It could also be that people are more willing to work nowadays for various reasons such as lower unemployed benefit as a result of employers demanding more cheap labours, improved mobility of labour and better education. Moreover, the demand for British products may have risen over the last few years affecting the aggregate demand in the economy. [AD = C + I + G + (x-m)] This equation represents the total demand in an economy consisted of consumption, investment, government spending and balance of trade. In Keynesian economics, any level of unemployment beyond the natural rate is most likely due to insufficient demand in the overall economy. In other words, any changes in these components of aggregate demand would alter the level of unemployment. Therefore, we could say that the aggregate demand has been rising in the UK economy for the last few years causing a fall in the level of unemployment.
Economic Growth
So what are the effects of retaining an overvalued exchange rate such as pound sterling on economic growth? So far I have looked at the effects of high exchange rate on economic factors such as balance of trade, inflation and unemployment and the exchange rate did have number of effects. It makes the firms located in a country with high exchange rate to become both domestically and internationally uncompetitive and as a result, the exports go down and the imports go up causing a trade deficit.
As I have explained earlier, aggregate demand (Yd) is consisted of consumption (C), investment (I), government spending (G) and export minus import (X-M). From this equation, the aggregate demand would fall because the import is greater than the export due to high exchange rate. It is obvious that in this case, the domestic firms are likely to reduce the number of workers as a result since their products are consumed less in the economy and this would certainly affect the economic growth especially in the UK.
On the other hand, the exchange rate can also influence the level of investment, which is one of the components of aggregate demand that determines the level of economic growth. The positive effect on investment is that the investors in a country with overvalued exchange rate such as Britain find it “cheaper” to invest in other foreign countries. In other words, the investors can purchase foreign stocks at lower price. However, the negative effect of having an overvalued exchange rate is that it’s harder for foreign investors to provide capital to the country with overvalued exchange rate in times of heavy borrowing. Moreover, from a foreign investor’s point of view, it costs more to invest in a country with overvalued exchange rate.
Fig. 10
The diagram above is the FTSE 100 index, which represents the share index of the 100 most highly capitalised companies listed on the London Stock Exchange. If we consider the amount of shares bought in the UK as a way to determine the level of investment, we can say that the level of investment had declined by the end 2002 reaching the lowest point since the beginning of 2000. In 3 years the figure had declined by nearly half of the original figure but it started to rise again in the beginning of 2003. Although this fall is not solely caused by the fluctuations of exchange rate, it seems like the exchange rate have had a direct influence on investment between 2000 and 2002. If we take a look at the years between 2000 and 2002 in the exchange rate of British pound diagram (Fig. 4), the exchange rate rose in 2000 reaching 0.7, which is 0.1 higher than the original figure in mid 2000. Then it stays on for about two years and starts to fall in the beginning of 2003. By comparing these two diagrams we can say that when the exchange rate rose, the level of investment fell dramatically and when the exchange rate fell the level of investment started to recover.
Obviously, if the exchange rate has a direct impact on such economic variables it must also influence economic growth in a same way. In other words, a rise in exchange rate would slow down the economic growth and a fall in exchange rate would boost the economic growth.
Fig. 11
The diagram above represents the UK’s economic growth between 2000 and 2005. As I did with investment, I am going to compare economic growth with the fluctuations of the UK currency. In Fig. 11, we can see a sudden fall towards the end of 2000 reaching almost 1.6% by 2002. This can be explained by a sharp increase in the UK exchange rate in 2000. But again it starts to rise in mid 2002 when the exchange rate starts falling. However, the economic growth starts to fall again in 2004, which is rather strange because the exchange rate was continuously falling at this time and according to my prediction if the exchange rate is low the economic growth should be rising rather than falling. Therefore, I believe such situation had occurred either by business cycle or other economic crisis, or perhaps the exchange rate fell too much that it no longer has any effects on economic growth. Whatever the reason, we come to a conclusion that a low exchange rate is not always desirable as it can have negative impacts on the economy. So has Britain actually suffered from an overvalued exchange rate over the last two decades?
The United Kingdom has the fifth largest economy in the world in terms of market exchange rate and the sixth largest by purchasing power parity (PPP). It is also known to be the second largest economy in Europe after Germany. Consequently, it is one of the strongest EU economies in terms of inflation, interest rates and unemployment, all of which has been remaining relatively low in the last two decades. However, it has the higher levels of income inequality than many European countries as well as the world’s third largest current account deficit. The chart below is the trend of GDP of United Kingdom at market prices estimated by the International Monetary Fund with figures in millions of British Pounds Sterling since 1980. It also represents the average pound exchange rate against the US dollar and inflation at a five-year interval.
From the chart we can see that the UK has experienced a significant growth in the level of GDP over the last two decades achieving nearly six times of the original GDP output by 2005. The average exchange rate has been fluctuating a little but overall the rate at which the inflation has been growing seems to have slowed down over the last two decades.
Fig. 12
The chart above shows the annual rate of growth of national output for the UK economy since 1980. There have been two recessions in the last 25 years. The early 1980s downturn was a deep recession, which was the worst downturn in the UK’s post-war history. We can see the descent into recession in 1990 and 1991 and then a recovery, which was maintained throughout the remainder of the 1990s. Further positive rates of growth have been sustained in the first 6 years of the current decade, allowing the UK economy to claim one of the longest periods of expansion in our modern history. After a slowdown in 2005 the British economy looked to be enjoying stronger growth in the first half of 2006.
Evaluation & Conclusion
So far I have looked at the impacts of exchange rate on economic variables and verified the overvaluation of pound sterling through the Big Mac purchasing power parity (PPP). The Big Mac’s price in Britain in terms dollars is the third highest out of all the major countries, which means that the value of the pound is relatively high. I have identified that such high exchange rate is one of the main reason for the trade deficit, which Britain has been suffering from, becoming both domestically and internationally uncompetitive.
However, we must not make such simple assumption that growing trade deficit has been affecting the British economy in a bad way. Although the trade deficit has been growing every year, the service sectors in Britain may be growing. From the analysis on economic variables such as unemployment, we can see a sustained fall in the level of unemployment over the past few years therefore we can say that trade deficit is not necessarily a bad phenomenon, which affects the economy in a bad way. Also we have witnessed well-managed rate of inflation in Britain over the past few years achieving under CPI 2% in the years between 2000 and 2005. Furthermore, the national output in the UK has remained positive almost always achieving above 2% over the last two decades except for the two economic downturns, which they came across in 1980 and 1990. Therefore, I believe high exchange rate is not always undesirable to the economy. In fact, there are both positive and negative effects of high exchange rate, which we have discussed previously. A high exchange rate usually tends to discourage investment and cause exports to become uncompetitive both domestically and internationally compared to foreign imports, but it can on the other hand, prevent inflation from imports.
The data on this coursework shows that when the UK exchange rate is increased against the dollars, the economic growth slows down. I came to a conclusion that there is a direct correlation between exchange rates and economic growth, therefore when there is an increase in the exchange rate the economic growth should slow down in the short-run. Although this is correct according to the data, it could be far too simplistic to make a conclusion because there could be other factors that also affect causing such result. Moreover, I figured out that there is a time lag between the change in exchange rate and the level of investment. I assume that this is due to the occurrence of uncertainties preventing investors from investing for a certain period of time. Britain has a floating exchange rate, which means that they fluctuate according to the foreign exchange market but because of the uncertainties, some countries prefer to adopt fixed exchange rate rather than floating exchange rate. In most circumstances, floating exchange rates are preferable to fixed exchange rate. This is because countries can benefit from automatic balance of payments adjustment. In other words, the currency would depreciate automatically when a country has a balance of payments deficit due to the effect of the depreciation making exports cheaper and imports more expensive, which has an opposite effect to the balance of payments deficit and this allows government freedom to pursue the internal policy objectives. However, in certain situations, fixed exchange rates may be preferable for their greater stability and certainty. This may not necessarily be true, considering the results of countries that attempt to keep the prices of their currency strong or high relative to others, such as the UK or the Southeast Asia countries before the Asian currency crisis. Moreover, it requires the country with fixed exchange rates to hold large amount of foreign exchange reserves, which have an opportunity cost.
In conclusion, although UK has high levels of income inequality and third largest current account deficit, I believe UK has not been suffering from an overvalued exchange rate over the last two decades, which is different to what I predicted in the beginning of this coursework. I came to this conclusion because even though Britain has been suffering from trade deficit, it only faced two economic downturns in the early 1980s and 90s, which were purely caused by the trade cycle not by the characteristics of high exchange rate. Also Britain enjoyed relatively high percentage of economic growth over the last two decades almost always remaining above 2% excluding the time of recession and recovery. Moreover, as we have witnessed on the graphs and data, inflation has always been steady remaining under the target CPI 2% and the level of unemployment has been descending, which shows that the UK economy has been growing in a very positive way. I believe Britain has been able to perform well economically even though there has been a growing trade deficit, on account of political and economic stability and prudence in dealing with the problems they faced over the last two decades.
Bibliography
Web sites
- Big Mac theory and brief explanation on purchasing power parity (PPP) – Last updated Wednesday, 30 January 2008
- Overvaluation and undervaluation - Created by Steven M. Suranovic, Last updated 25 January 2006
- British exchange rate, history of exchange rate and reasons for fluctuations – Created by Paul Krugman
-Advantages and disadvantages of high and low exchange rate – Created by Kieth Feiler and Tim Schilling
- Effects of exchange rate changes
-Consequences of low exchange rate on economic variables
– Created by Valentino Piana, Last updated 2001
- Economic performances
Books
Advanced Economics by Ray Powell in 2005