1. Effects of Exchange Rate Movements
Sterling and Base Interest Rates
Trade-weighted index value for sterling in the foreign exchange market, daily value
6.0 6.0
5.5 5.5
5.0 5.0
4.5 Base Interest Rates 4.5
Percent
4.0 4.0
3.5 3.5
3.0 3.0
2.5 2.5
2.0 2.0
1.5 1.5
110 110
105 105
100 100
95 95
Sterling Exchange Rate Index (trade-weighted)
Index
90 90
85 85
80 80
75 75
70 70
Jan Mar May Jul Sep Nov Jan Mar May Jul Sep Nov Jan
07 08 09
Source: Reuters EcoWin
The trade weighted exchange rate index has depreciated by twenty-five per cent over
the last fourteen months. This is a significant change in the nominal exchange rate
with both demand and supply-side effects: In this lesson we will consider some of
the ways in which a fall in the exchange rate affects other macroeconomic variables:

2. Who gains and who loses from a fall in the external value of sterling?
Example Winner? Comment
Loser?
UK farmers
British farmers are in receipt of CAP
subsidies which are fixed annually and
paid in Euros at an exchange rate set at the
level in September 2008.
Publishers
Pearson is a multinational publisher which
marks school tests, produces learning
materials and publishes the Financial
Times and Penguin books. The group
generates 60% of its sales in American
dollars. The exchange rate has moved from
$2 to the pound in 2007 to $1.44 at the
2008 year-end.
Tourism
Bed and breakfast businesses in London
A glass manufacturer
NJ Bradford is a business based in the
West Midlands which supplies glass across
a number of industries. Their main
competitors come from China offering
cheaper decorative and toughened glass
products.
Abattoirs in the Republic of Ireland
In the Republic of Ireland, more than 60
per cent of all food products are exported.
A UK airline
That buys most of its fuel from the
international petroleum markets and pays
in US dollars.
Estate agents selling prime London
property
British people living in France and
Spain on sterling pensions

3. Sterling's fall hasn't helped trade deficit
Source: Jeremy Warner, The Independent, Wednesday, 14 January 2009
If the weak pound was meant to provide a boost for British industry by making our
manufacturers and service providers more competitive, there is scant evidence of it so far.
To the contrary, the latest figures show a further widening in the trade deficit, with the ratio
of export volumes to import volumes excluding oil deteriorating to its worst level since
December 2007, when the pound was still relatively strong.
Trade adjustments can take time to work their way through the system. There's a massive
inventory correction going on across the world economy at the moment, and until it has
played out, it is impossible to know what the long-term consequences of the currency
collapse might be. In a world where it is an absence of demand and credit rather than an
innate lack of competitiveness which is the root cause of our economic ills, it is not at all
clear that a devalued sterling is going to help us very much.
I'm glad to see I'm not alone in believing a weak currency to be not the unalloyed good the
Bank of England and other British policymakers seem to think. As Simon Ward, chief
economist at the asset management company New Star, points out, many manufacturers will
have been constrained from taking advantage of greater price competitiveness by a lack of
credit. Sterling's plunge will undoubtedly have contributed to this absence of credit by
accelerating the withdrawal of foreign funds from the UK banking system. Credit in the UK
has come to rely heavily in recent years on constant infusions of foreign capital. These have
now largely gone.
Meanwhile, import prices have been rising steeply, pushing up costs for UK manufacturers
at a time when there is little demand for what they are producing. The Government hopes to
ease the credit crisis with further guarantees for small business lending. Depending on the
cost of this guarantee to the banks – the Government will extract a heavy price from the
banks to safeguard the taxpayer from rising levels of default – this seems welcome enough,
but it also smacks of "too little, too late".
It's not just small companies but big ones too which are now suffering from the dearth of
credit. Banks around the world are calling in their loans as they seek to shrink their balance
sheets. Even relatively debt-free and, in normal times, perfectly viable companies are
finding themselves affected by the phenomenon. In circumstances where they cannot
refinance, many companies may find themselves forced to the wall or into an alternative fire
sale of assets.
The idea that devaluation is good for the UK economy is drawn largely from experience of
the last recession, when recovery didn't finally seem assured until Britain was ignominiously
jettisoned from the ERM. In fact, the economic recovery that then began had nothing
whatsoever to do with a recovery in exports. Rather, it was led by domestic demand, which
was starting to recover even before Britain left the ERM and was greatly enhanced by
interest rate cuts thereafter.
What's more, Britain had had two years of recession by the time this demand-led recovery
began. There was much more slack in the economy to absorb the inflationary impact of
sterling's fall than there is today. Ultimately, devaluation only works in making an economy
more competitive by leading to a downward adjustment in real wages and therefore living
standards. If of a puritanical frame of mind, you might think this entirely justified after years
of credit-fuelled excess, but I see no reason to celebrate our new-found pauperism.

4. Dollar-Sterling Exchange Rate
US dollars per £1, daily closing exchange rate
2.1 2.1
2.0 2.0
1.9 1.9
1.8 1.8
GBP/USD
1.7 1.7
1.6 1.6
1.5 1.5
1.4 1.4
1.3 1.3
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Jan
08 09
Source: Reuters EcoWin
Euro - Sterling Exchange Rate
Value of one Euro, daily closing exchange rate
1.00 1.00
0.95 0.95
0.90 0.90
0.85 0.85
Pence per Euro1
0.80 0.80
0.75 0.75
0.70 0.70
0.65 0.65
0.60 0.60
0.55 0.55
01 02 03 04 05 06 07 08 09
Source: Reuters EcoWin