Outline the effect of a rise in the value of sterling against the euro on the level of aggregate demand.
Also outline the effect of a fall in UK interest rates on the level of aggregate demand.
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1. Effects of a rise in the value of the £ against the euro on AD
In general, the value of the £ tended to rise against the euro between 2002 and 2004, since which time there has been something of a trend decline. A rise in the value of the £ against the euro is called an appreciation of sterling - hence the £ now exchanges for more units of the euro. This has the effect of making the price of UK exports to the eurozone more expensive, and the price of the eurozone's goods and services imported into the UK less expensive than previously. This assumes that both exporters and importers adjust the price they are charging in line with the appreciation; they might instead choose to leave prices unchanged.
Assuming that the price of exported goods is raised in line with the appreciation, then fewer UK goods will be sold in the eurozone. The extent to which the quantity sold decreases depends upon the price E of D for UK exports – the greater the value of PED, the greater the % decrease in sales of exports. Similarly, the lower price of goods imported from the eurozone increases the quantity bought here; the greater the value of PED for imports, the greater the % increase in purchases. The MARSHALL-LERNER THEOREM states that an appreciation of the currency will improve the current account of the balance of payments if the SUM of the PED for X and M is less than 1, and will worsen the current account if the sum is greater than 1. In practice, the sum of thetwo elasticities is likely to be greater than 1, and so the current account will worsen.
In the short run (perhaps up to 2 years), however, the UK's current account is likely to improve before it worsens, because of the J CURVE EFFECT. In other words, it takes time for the quantities sold and purchased to respond to the new prices, largely because export markets and sales are not immediately lost while cheaper imports will not start flooding in until some time haws elapsed.
If the Marshall-Lerner condition is fulfilled i.e. the sum of the two elasticities exceeds 1, then the resulting eventual worsening of the current account represents a net WITHDRAWAL from the circular flow of income, since (X-M), which has fallen, is part of the Aggregate Demand equation. This then results in lower real GDP and lower domestic employment. There will also be a downward MULTIPLIER effect on output and employment. Much, however, depends upon the elasticity of the domestic aggregate supply curve. If the economy is operating at or around full employment, or if the AGGREGATE SUPPLY schedule is very inelastic, the appreciation (and fall in AD) will simply result in LOWER INFLATION, without much fall in real GDP.
An appreciation also lowers the cost of imported goods and services. This is particularly significant for UK firms that rely on imported energy or raw materials, since it reduces their costs, and may therefore result in lower final prices. This then has a downward effect on the Consumer Price Index, which might eventually result in the Bank of England lowering interest rates to ensure that the inflation target is met. This would of course then stimulate both C and I, both components of AD, and thus increase AD. All of the above effects are likely to be significant for the UK, as nearly 60% of UK overseas trade is conducted with the eurozone. The appreciation might also attract less FDI to the UK because of the loss of the competitive price advantage, though mich would in practice depend upon whether foreign investors saw the appreciation as permanent.
2. Effects of a fall in interest rates on AD
Monetary policy is designed to influence one or more components of Aggregate Demand (AD), which in turn reduces or increases inflationary pressure in the economy. The various ways in which interest rates affect aggregate demand and the rate of inflation are called transmission mechanisms. The most significant transmission mechanisms (in the case of an interest rate reduction) are:
1. A reduction in the proportion of disposable income saved by both consumers and firms (lower interest returns, thus raising the opportunity cost of saving); this increases consumer spending and investment, and thus AD.
2. An increase in the amount of new borrowing by consumers and firms; this increases both consumer spending (C) and investment (I), and thus AD.
3. A reduction in the amount of income needed for debt servicing (monthly repayments on variable interest loans and mortgages); this increases the disposable income of consumers and firms, and so both C and I increase, and thus AD also increases.
4. Lower interest rates mean that mortgage finance becomes more attractive; this should lead to an increase in the demand for private housing, and thus to more housing market transactions and to an increase in the rate at which house prices rise; the greater asset price increase means that the wealth of homeowners rises at a faster rate than was expected, which in turn may increase consumer confidence and spending (and thus AD) – especially if further reductions in interest rates are expected.
5. Lower interest rates will tend to make the £ less attractive to investors and speculators on the foreign exchange market; the resulting speculative outflows drive down the value of the £, thus increasing the price of imports and decreasing the price of exports. If the Marshall-Lerner condition is fulfilled (sum of the PED for X and M exceeds 1) then the (X-M) component of the AD equation will rise.
All the above positive effects on AD will then have upward multiplier effects, increasing real income still further, and increasing AD still further.
In practice, however, small interest rate changes (usually of 0.25%) do not tend to have a dramatic effect on the economy, and so the actual effect on AD might be quite small. Moreover, interest rate changes may have limited or delayed effects for a number of reasons:
1. Mortgage lenders do not always adjust their own rates fully or immediately in line with base rate changes.
2. A growing proportion of mortgage holders are borrowing at fixed rather than variable rates, and are therefore not affected by base rate changes.
3. Credit card and store card companies are remarkably reluctant to follow base rate cuts.
4. Businesses with plenty of spare capacity are unlikely to invest more in response to a small interest rate cut.
5. Cuts in rates reduce the incomes of savers, which partly offsets the benefit to borrowers.
Time lags are critical – in practice consumer and business confidence have a far greater effect on spending decisions – and, in particular, average house price increases and firms’ profits.
I hope these answers are helpful.