The Role of the Exchange Rate
The main advantage the UK has had over the Economic and Monetary Union (EMU) countries over nearly two decades is that the exchange rate has had a major role in the macro economy. That is, when required and in timely fashion (in the absence of structural impediments), the exchange rate acts as an economic stabiliser in terms of price adjustment, trade imbalance alignment and a variety of other significant absorption properties. Without this, other adjustment mechanisms will be required to perform this function, for example, unemployment and inflation – two very important but costly adjustment processes which have long-term effects.
Whilst the exchange rate as an adjustment tool may have the effect of importing inflation in the short term, would a persistently low sterling exchange rate value have the effect of persistent inflated prices in the long term? EMU countries have experienced a single exchange rate policy for all countries, thus in the advent of economic shocks, the exchange rate has not been able to stabilise all countries imbalances simultaneously.
Rather, the catching up process by some member states has meant that the speed at which the exchange rate can perform its vital function has been significantly slower, allowing other costly stabilisers such as unemployment and inflation to play a part in many countries. Transparency (one of the suggested advantages for the EMU) has come at a cost, one which has been to the detriment of a generation of people in some countries.
Although the exchange rate does allow for UK traders to export cheaply, assuming that there is a continuous demand for goods and services abroad, this carries the effect of the higher inflation in the presence of structural impediments for UK exporters. Put simply, with uncertainty and fears for the UK economy, the low value of the pound will persist in the long term. This research paper seeks to explain the long-term economic performance for the UK if the exchange rate continues to perform at persistently low levels.
Figures 1 and 2 show the pound/euro exchange rate since April 2016. The chart begins two months before the Brexit vote. The rates are taken as average rates for the month. The euro/pound rate shows an average of 1.27 for the month before the referendum. Since then, sterling has lost 15% of its value (at the time of research, September 2017) and 11% against the US dollar. Indeed, in the preceding 12 months before Brexit, the uncertainty had caused sterling to depreciate significantly, trading below its expected market value.
In the wake of a structural impediment in the UK, the problem is that the exchange rate remains undervalued. Due to economic uncertainty, it is unable to float freely to levels required to perform its adjustment functions., and this will inevitably have long-term economic effects.
In response to the depreciation of the exchange rate, the UK export market, in the absence of structural impediments, should show signs of an immediate increase in exports. However, in economic theory there exists a phenomenon called the J-curve effect where exports decrease slightly before they show an increase. This increase in exports should occur until the equilibrium exchange rate is achieved. This will be due to a variety of reasons including the cost of imports for manufacturers which assists the exchange rate in establishing its own equilibrium.
Brexit has brought about the switching of capital out of sterling and into other traded currencies. In the absence of an exchange rate equilibrium level, the exchange rate remains low with imports becoming more expensive even though exports remain buoyant. However, there is a level where the increase in imports becomes unsustainable.
Inflation must be defined in two forms – cost and demand inflation. In the advent of real wages decline in the last five years, cost inflation has led the way as far as inflation increases are concerned. Oil prices have played their part in the increase whilst retailers have pushed the costs of imported inflation on to consumers at the same time. Manufacturers continue to bear the input costs – costs for the components which make up their final goods. Thus, demand plays a lesser part in the inflation story.
Data and Empirical Investigation
The aim here is to provide a breakdown of the long-term economic performance for the UK with sterling’s exchange rate performing at persistently low levels. It is known that the immediate impact of an undervalued currency is imported inflation. An undervalued currency gives rise to lower investment, and with already historically low UK interest rates, the rate of return invested would be lower – particularly given the uncertain economic landscape.
This data are taken quarterly from the OECD statistical database from 2005 until the present. Of interest is the performance of real GDP, wages and inflation in the long run. The long-term economic performance for all indicators is examined. Firstly, a statistical regression model to examine the long-term performance of co-integrated indicators is used. Simply put, this model states that there is a long-run relationship between all the indicators and that the indicators are all influenced by one another.
In statistical measurements, the establishment of a long-run relationship is mandatory, otherwise the examination cannot be performed. Lastly, in order to establish the effect of the exchange rate shock (the exchange rate at persistently low levels), the Impulse Response Functions (IRF) is used. This is a statistical method showing the reaction to various indicators of a shock, and its impact and duration – the duration being the time it takes for the economic indicator of interest to return to equilibrium. This methodology is not used for forecasting – rather, it is a strong indication of the pathway an economic indicator follows in the wake of an economic shock. That said, an exchange rate which fails to perform the function of an absorption property is said to be a source of a shock itself, and therefore the IRF methodology is a powerful one for this purpose.
The types of data used in the regression model are: domestic real GDP; foreign real GDP; industrial production; wages; inflation and; the nominal effective exchange rate. The results show that in the long run, real GDP does show positive signs- however, the UK’s economic performance is not significantly better than current levels. Growth rates are expected to be slightly below the 1.5 percent level. It is important to remember that in the manufacturing sector, for as long as there is foreign demand for UK goods, the persistently low exchange rate will be a factor in improving the trade balance via exports. Indeed, results show that in the long run, the demand for UK goods and services remains buoyant. However, manufacturing only accounts for a smaller percentage of real GDP figures and the service sector, which is currently in continuous decline, will contribute to lower economic growth figures in the wake of a persistently low exchange rate.
In the long run, the results also show that industrial output increases in line with foreign demand. However, growth here will be muted. In terms of inflation, the UK will continue to import higher prices from abroad, but the price increase will be gradual over the Brexit negotiations. Surprisingly, it is shown that wages will increase moderately. However, this increase will be in the region of a little over a single percentage point – a problem currently facing the UK labour market. The long run does not show large swings in either direction – what it does show is the firmness of the direction the economy will take.
The Response to Persistent Exchange Rate Shocks
The impulse responses track the path of an economic indicator after the shock has happened. IRFs indicate the impact when a one-time shock happens and assumes that this will be the only shock. The aforementioned methodology calculates cumulative responses to a one-time shock – that the shock continues into the long run, and then dies out once the effects of the shock subside. The single solid blue line shows the path from the initial shock at point zero.
The time scale is expressed in quarters and is shown on the X-axis with the percent change on the Y-axis. The dashed orange lines are upper and lower bands, and these do not straddle the X-axis, indicating that the results are reliable. It is important to understand that the persistence of the exchange rate (although a one-time shock is induced) is a continuous phenomenon. Thus, the shock can be seen as if it was a series of aftershocks; even though the graph shows that the effects of the shock die out after ‘x’ quarters, if a low exchange rate persists then the ‘peak’ value of the graph will continue over time.
Figure 4 shows the cumulative responses to an exchange rate shock to real GDP. As can be seen from the long run regression, the effect of the exchange rate shows moderate real GDP growth. One can expect growth in the long run to peak at about 1.6% per annum with a long run growth showing slightly below 1.5%. Again, the manufacturing industry does not draw a significant advantage from the persistently low exchange rate owing to the higher costs of imported inflation.
In figure 5, the inflation rate, in the long run, continues to rise and peaks between quarter 3 and quarter 4. This is mostly due to the effects of imported inflation and cost inflation (for example, increases in oil costs) during this period.
Figure 6 shows the effects of wage growth for in the wake of persistent low exchange rates. Domestic demand remains sluggish with the rate of growth rising to 1.5% in the long run. The IRFs back up the regression from the previous section very well. The resultant factor form the UK’s persistently low exchange rate is that growth will be sluggish with no significant advantage gained.
Dr. Victor Chukwuemeka
Write something about yourself. No need to be fancy, just an overview.