How much has the pound inflated? The pound had an average inflation rate of 2.04% per year between 1751 and today. Producing a cumulative price increase of 23,997.49%. This means that today’s prices are 240.97 times higher than average prices since 1751. According to the Office for National Statistics composite price index.
The Pound’s appreciation has increased imports by making them cheaper for the UK. Giving consumers a greater variety of low-priced foreign products. Also, UK’s terms of trade (ratio of the price of exports to price of imports) started to fall post mid-December, 2019, suggesting an increase in the value of imports.
The UK currently faces a trade deficit.
However, medium-term charts predicted the “1.20 level to be tested” shortly. The appreciation of the Pound is contrary to economic theory. Since a trade deficit usually puts a downward pressure on a currency. This shows that there are other major factors, such as speculation, that are countering the effects of the trade deficit. The sustained appreciation of the Pound has caused severe problems for the UK economy.
Diagram 2: Recessionary gap in the UK economy : How much has the pound inflated?
Diagram 2 shows a leftward shift of the Aggregate Demand curve from AD1 to AD2 due to a fall in net exports following the appreciation of the Pound. This shift has slowed down economic growth in the UK, with Y2 being less than potential output Ye. Moreover, as UK firms like Tesco decrease their production, unemployment levels rise in the country. Average Price Levels deflated significantly from Pe to P2. Causing problems such as lower consumer spending and real-wage unemployment. To prevent further appreciation, the UK can propose to remove tariffs on EU imports.
Diagram 3: Tariffs on UK imports : How much has the pound inflated?
Diagram 3 shows the world supply curve shifting downwards from World Supply + tariff to World Supply due to a removal of tariffs by the UK on EU imports. This caused the price of the imports to lower from P2 to P1, resulting in an increase in the level of imports. And subsequently the supply of Pounds (S1 of £ to S2 of £ shifted on Diagram 1, which led to a depreciation of the Pound).
This will subsequently increase the UK’s export competitiveness. And make imports more expensive for domestic buyers, causing net exports to now rise and the Aggregate Demand to increase. This removal of tariffs thus helps in the long run by increasing economic growth. As a result, reducing unemployment, and decreasing deflation, which are three important macroeconomic objectives.
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Even though the removal of tariffs will prevent continual appreciation of the Pound, this action comes at several costs. UK residents will benefit from a wide variety of low-priced foreign products. But these products might compete with UK domestic firms. Thus decreasing their revenue in the short run and causing further unemployment in the long run. Moreover, an excess of cheap imports may prevent infant industries in the UK from growing, causing unemployment to exacerbate further.
Although the removal of tariffs is beneficial for foreign producers and UK’s trade relations. The action puts pressure on the government’s budget. This, in the long run, can hinder government investment in R&D and therefore reduce long-term economic growth. Moreover, this solution rests on an assumption that all trade protection from EU imports will be eliminated. Quotas and administrative barriers still might prevent the level of UK imports from rising much.
The UK government can instead sell its Pound reserves by buying foreign currency. As a result, increasing the supply of Pounds and facilitating depreciation. Lastly, although this method still puts pressure on the government budget. It can simultaneously facilitate infant industry growth. Furthermore, achieve the three macroeconomic objectives, and allow for an exact, desired level of appreciation to be achieved.
