Examine the factors which might explain the depreciation of sterling against the euro. (20 Marks)

The value of the pound fell from £1 = €1.47 in May 2007 to £1 = €1.18 in November 2008. Examine the factors which might explain this depreciation of sterling against the euro. (20 Marks)

A depreciation of the Pound is when the value of the Pound becomes weaker relative to other currencies around the world. In the example provided, one pound could buy 1.47 Euros in May 2007 however by November 2008 the Pound had depreciated and could only buy 1.18 Euros. There are a variety of factors which could lead to a depreciation of the Pound against the Euro.

Interest rate in Monetary Policy affects the value of the Pound and in the past 2 years the UK has set low interest rates. This is because of the recession and therefore, they wanted to try and boost economic growth. Low interest rates led to a depreciation in the Pound in the following ways. Firstly, fewer Pounds were demanded by foreign investors because they didn’t want to put their money in UK banks as they would get less money if they saved their money in the UK banks with low interest rates. So as Demand decreased, the value of the Pound decreased as well (DIAGRAM SHOWING A SHIFT TO THE LEFT IN DEMAND). Also, Supply for the Pound would increase as people who saved their money in UK banks would take their money out and place it in other banks with higher interest rates. Therefore as supply of the Pound increased the value of the Pound depreciated (SUPPLY SHIFTING TO THE RIGHT IN DIAGRAM).

A trade deficit is when a country’s imports have a higher value than a country’s exports. The UK has a massive trade deficit and this affects the value of the Pound. Imports depreciate the Pound because as domestic UK consumers buy goods from abroad they need to convert their British Pounds for the other currency for example Euros if they are buying Beer from Germany. Therefore, the supply of the Pound will increase as they are exchanging their Pounds for Euros and hence, the value of the Pound will depreciate as Supply of the Pound increases. Exports tend to appreciate the value of the pound because when foreign consumers buy domestic UK goods they must exchange their currency to Pounds to purchase the UK goods. For example, Germans buying British Pharmaceuticals from the UK must exchange their Euros to Pounds and as the demand for Pounds increases the value will increase. However, in a trade deficit the overall effect is a depreciation of the Pound as the value of imports is larger than the value of exports so the depreciation effect is larger than the appreciation effect.

Another factor which could lead to a depreciation of the Pound is speculation. Speculation in the currency market is the buying and selling of a currency based on future prices. During November 2008, global recession had just started. The UK was massively affected by this global economic meltdown and its currency was also affected as a result. Because the UK was regarded as an unstable economy many investors decided not to invest within the UK and speculators also decided to sell the British Pound and buy other more stable currencies. Because of the fall in the demand for the Pound AND the increase in the supply of the Pound within the market, the value of the Pound fell massively and lead to a depreciation of the Pound.  

Eval. The UK can use interest rates (Monetary Policy) to control their economy as they have control of the Bank of England. All the other countries in the Euro Zone cannot use interest rates to control their economies. Anyway, the UK has had low interest rates over the last 2 years and still saw an appreciation in the value of their currency and therefore there must be other more significant factors which are affecting the value of the Pound. Due to this I believe that interest rates may not be a significant factor affecting the value of the Pound plus it could take time before effects are actually seen!

Eval. In my opinion, the UK trade deficit is a major factor which led to the depreciation in the value of the Pound. The UK faces a large deficit in the trade of goods which offsets the surplus in investment income and trade in services. Therefore, I believe this huge trade deficit must be the major factor affecting the value of the Pound… especially because the UK consumers have a high marginal propensity to import. Marginal Propensity to import is when incomes increase and how much of this increased income is used to buy imports. The UK has a high Marginal propensity to import and therefore I believe that the trade deficit is one of the most significant factors which depreciated the Pound.

Eval. I also believe that speculation has a major impact on the value of the pound especially during the critical time of a recession. Most people were scared about their money so they wouldn’t spend their money on investing in things such as the Pound as they are scared about how strong the UK economy was at the time. People would also be naturally scared of their money at this credit crunch time so they would just save their money rather than spend it. Thus, I believe speculation and the recession was a major factor affecting the value of the pound. However, if people decided to save their money in UK banks during this recession time then demand for the Pound would increase and actually the value could appreciate!

To conclude, it is not one factor that affects the value of the pound… it is the interlocking combination of factors and how they affect each other which leads to an overall effect on the value of the Pound. In this case, the Pound depreciated.