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The British pound fell by over 10% to a 30 year low against the US dollar after the UK voted to leave the European
union. To what extent will this depreciation impact on future economic growth in the UK. (25 marks)
Economic growth measures the rate of change in a country’s output, it’s an expansion in the productive potential
capacity of an economy, an increase in Real GDP. A 10% depreciation means that imports are more expensive, and
exports are cheaper thus impacting upon economic growth in two respects: in the short run, and long run. In the
short run a depreciation will increase demand for exports therefore increasing short run economic growth. In the long
run, however, there isn’t as significant of an impact upon economic growth. This essay will explore the extent to
which a depreciation will have favourable or adverse effects upon future economic growth.
A weak exchange rate relative to the US will cause exports to be cheaper and imports dearer suggesting that the
demand for imports and therefore expenditure on imports will decrease whereas the demand for exports and
therefore revenue generated by exports will increase. As (X-M) is a component of aggregate demand, AD will rise
from AD1 to AD2, thus increasing short run economic growth from Y1 to Y2 as demonstrated below in my analysis
diagram. UK exports are more price competitive relative to US exports, therefore theoretically US consumers will
switch to UK exports. £1= $1.70 a depreciation will cause £1 = $1.53; incomes will increase and thus stimulate growth
further. With export volumes increasing and import volumes decreasing, there are greater injections into the circular
flow of income than withdrawals consequently resulting in a positive multiplier effect; there’s likely to be a
proportionately larger increase upon GDP and thus economic growth. Dependent on the size of the multiplier, this
will create further rounds of spending and income generation, increasing economic growth and national income
further. As labour is a derived demand, more employment will be needed to produce the extra goods and services
demanded thus reducing unemployment in the economy, increasing long run economic growth as the quantity of
labour has increased. Furthermore, as exports are cheaper, this provides an incentive to producers to invest in capital
and labour to take advantage of this depreciation. Investment stimulates long run economic growth as the
productive potential capacity increases, stimulating the accelerator effect. If firms purchase more machinery and hire
more employees they can respond to an increase in demand for UK exports more easily, as there’ll be spare capacity
thus enabling export volumes and revenues to increase. As a result, future economic growth will increase due to
increases in AD, LRAS and injections into the circular flow of income.
In evaluation, the UK heavily specialises in services (approx. 70%) therefore meaning that despite a depreciation, the
UK may not experience economic growth as we don’t have the tradeable goods to do so as we aren’t specialised in
manufactured goods. If the UK were to be more focused on these goods, a depreciation is more likely to have a
greater impact upon economic growth as we’d have the manufactured exports available to do so. The UK has seen a
decline in their manufacturing base, and therefore cannot exploit a depreciation to gain an increase in export
revenues and lower the persistent current account deficit. Additionally, in practice exporting firms may not take
advantage of greater competitiveness through lowering the price of exports, increasing employment, and investment
instead they may choose to achieve higher profitability and margins by raising the prices of exports. As a result of
this, future economic growth will be affected as there’s limited scope for long run economic growth. If the UK doesn’t
increase their manufacturing base in order to increase export volumes and revenues along with greater investment
into supporting a larger manufacturing base, future long run economic growth will not improve or increase.
The impact of a depreciation on the UK exchange rate is heavily dependent upon the price elasticity of demand and
whether the Marshall- Lerner condition is satisfied. The sum of elasticities for net exports in the UK is -0.78 depicting
that demand for exports is inelastic, as the price of exports decrease, demand will increase therefore decreasing
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