Weak Sterling and effects on Economy

Readers Question: Is there any other political influence on the falling rate of sterling, something like monetary policy or political uncertainty? And why did some news reports say inflation and weak sterling could be helpful to UK economy? Thanks.

The value of a currency is primarily influenced by economic factors. E.g. weak sterling can be blamed on

  • Weakness of Economy leading to lower interest rates
  • Cut in interest rates from 5% to 0.25% making Sterling deposits less attractive than saving in European banks.
  • Sterling was overvalued before.

Also, in the long term, comparative inflation rates and competitiveness play an important role in determining exchange rates.

These are the main factors. But, confidence plays an important role. If investors lose confidence in the economic fortunes of a country then the currency will tend to slide as people don’t want to hold it.

Confidence can be lost at the prospect of

  • High and unsustainable levels of government borrowing
  • Unsustainable current account deficit (imports greater than exports)
  • Prospect of inflation through ‘printing money’ / quantitative easing.
  • Political uncertainty can lead to economic uncertainty, especially if markets fear new government will let inflation get out of control thereby debasing currency.

Why Weak Sterling Helps Economy.

  • Weak Sterling makes exports cheaper. Increasing exports.
  • It makes imports less attractive encouraging domestic consumers to buy more domestic produced goods.
  • In a recession this boost to aggregate demand can be beneficial.

Weak sterling tends to cause inflation because:

  1. Imports more expensive
  2. Export demand rises.

However, if the economy is in recession with threat of deflation this is seen as a not a problem.

My feeling is that the depreciation in the Pound has helped limit the extent of the recession. So far the depreciation has not been inflationary.