British Economy - Term Paper Example

The British Economy Registration Number: Information: Introduction Exchange Rate An exchange rate is the charge at which one currency is exchanged for another. There are two basic kinds of exchange rate systems. Fixed Exchange Rate System Flexible Exchange Rate System Till the year 1971. All the major economies of the world were following the exchange rate system. This system valued money based on the price of gold initially and then it started being based on the value of the US dollar. These exchange rates were desirable for the governments because they were able to provide facility. When foreign trading was done, there was no uncertainty. It was after 1971, that some countries could no longer find it feasible to stick to the fixed exchange rate so most of them transferred to the floating exchange rate. There are still some countries that use the fixed exchange rate (Cowling & Sudgen, 1990). Fixed Exchange Rate A fixed exchange rate system as the name suggests, is a system in which the country in question is striving to prevent the exchange rate of the currency to change with the change is balance payments of deficits. This is a system which needs other accompanying systems to make it work (Pitt, 2001). When this system is to be implemented, the government uses certain measures and implements some specific rules. Usually, these rules include the fact that when interventions in the foreign markets are made, there should be macro-economic adjustments so that the income which is spent on imports is reduced. Along with that, protective tariffs are imposed so that the number of imports can be reduced to a desirable level. This system also includes some rules in which there is a restriction on the amount of foreign currencies that can be bought (Barro, 2008). The fixed exchange rate has an additional two types Semi Fixed Exchange Rates Fully Fixed Exchange Rates Semi Fixed Exchange Rates These are the kind of fixed exchange rates which are given two bands, an upper one and a lower one. These bands are limits with in which the currency exchange rate is allowed to fluctuate. Fully Fixed Exchange Rates These are the kinds of exchange rates which are fixed at certain limit and do not go up or down. The central rate does not allow any fluctuations. The reason why a fixed exchange rate is used is that it provides certain benefits for the exporters. The basic reason why the exporters benefit from a fixed exchange rate is that there is greater certainty of the rates and the income which would be ultimately received from the export. The exporters have to take lesser risks and can guarantee results that would be more or less near to the things which are predicted (Pitt, 2001). The fixed exchange rate also enables the domestic firms and their workers to make them more disciplined. They enforce the idea that the costs of the company should be kept under a strict balance because that is the only way in which the company is able to compete in the international market. When the domestic firms are watching their costs, the government is able to control inflation and that in turn would control the interest rates (Barro, 2008). Role of the United Kingdom Government in Maintaining the Fixed Exchange Rate The years 1876 to 1913, were the ones in which the rate of a currency was established on the basis of that currency’s comparative conversion into an ounce of gold. This method was called the Gold Standard and was used for a long period of time before the World War 1 which saw many countries lose major economic points and saw the values of various currencies go down (Pitt, 2001). In the UK, a fixed exchange rate system was used in the 1950s and the 1960s. This meant that the pound sterling had a specific value against specific currencies. For example, back then, one pound was equal to fourteen German Marks. This type of economy was not benefitting the country. The exports were lesser than the imports and the balance payments had large amounts of deficits. To fix this and to keep the fixed exchange rate system in place, the Chancellor of the Exchequer, James Callaghan decided that the pound’s value be lessened by 14% in 1967. This decision did not help matters much and the pound sterling continued to become lesser and lesser valuable till it hit the lowest in the 1990s when it was found out that one pound sterling was valued at 2.8 German Marks (Taylor & Mankiwe, 2006). To fix this again, the Chancellor of the Exchequer of that time, James Major, fixed the rate at 2.9 Marks so that the country could fix the rates with other European countries. The other countries were trying to make their exchange rates constant at a certain point so that they can leave their individual currencies and join the Euro – a practice which the UK refuses to do even now (Barro, 2008). This practice lasted for only a couple of years, with the new government; the pound left the fixed exchange rate and adopted the floating exchange rate (Cowling & Sudgen, 1990). Floating Exchange Rate System This is an exchange rate system in which the currency is not set a specific value; rather the value is determined by a number of factors like the market demand for the currency and its supply in the foreign exchange market. There are two main factors which affect this exchange rate, the trade flows and the capital flows. In this type of currency, the exchange rates are set for economic goals and not to keep the value of the currency constant at any single point (Taya & Bigman, 2003). The issue with the floating exchange system is that it is hardly ever implemented in its full and complete form. It is usually implemented in the form of a semi floating exchange rate system, a kind of system in which the government does to some extent try to manage the rates at which the currency is being traded. This kind of interest rate has the basic advantage that it does not bind the government in maintaining a specific interest rate. The interest rate can be set while keeping in mind other goals rather than the currency (Copeland, 2005). Effects on the UK Economy of a Depreciation of the Pound A depreciation of the pound means that value of the pound sterling in contrast to the other currencies of the world, becomes lesser than it previously was. The effects which this devaluation might have on the economy and the general condition of the country may take some time to be seen. This phenomenon is called a times lag, it means that the devaluation and the effects have a time difference between them. The last time the pound sterling was massively devaluated was in the 1990s (Levi, 2009). Figure 1: The devaluation of the pound sterling since 1275 (Hewitt, 2007). Some of the basic effects of the devaluation of the pound on the economy of the UK are: 1. Exports 2. Imports 3. Inflation 4. GDP 5. Wages Exports Ironically, the exporters are going to benefit from the lowering of the value of the pound sterling. This is so because an exporter would have more demand for a good which is cheaper in a different currency. The demand for UK exports might increase in this case (Carbaugh, 2007). Figure: The Effect of pound Sterling devaluation on the trade (Riley, 2010). Imports Just like exports would benefit from this, imports would be severely hit. That would be so because the importers would have to pay a larger amount of money for the same good that they have been previously buying. The public in turn would have to pay more for the imported good too. Inflation Inflation is apparent and inevitable where the devaluation of the pound sterling is concerned. This is obviously so because the pound will have lesser value, the people would need to pay more for the same goods. The wages will rise and the production costs will also become more (Levi, 2009). GDP Lesser imports and higher exports would lead to a higher GDP. This means that while the general prices are rising, the economic growth is also rising. When the exchange rates are lower, the interest rates will also be lower as a rule. If rule is implemented, than the consumer should have to pay less in certain areas rather than more. If the consumer is spending more, the development is increasing. Wages If the economy is falling, the workers will obviously demand more pay. This is so because the buying power of the consumer is becoming less. But the wage demands also depend on other factors. If there are more people who are unemployed, the workers may not demand higher wages with the fear of their demands not being met and being laid off (Carbaugh, 2007). Figure: The purchasing power of the Pound Sterling (Hewitt, 2007). The economy will obviously take major hits whenever the value of the pound sterling decreases. It is evident that the devaluation of the pound sterling will be met with inflation and an increase in wages while imports become lesser. Bibliography Barro, R. J., 2008. Macro economics, A modern approach, Thompson South Western, USA. Carbaugh, R. J., 2007. International Economics, Cengage Learning, USA. Copeland, L., 2005. Exchange Rates and International Finance, Pearson Education, USA. Cowling, K. & Sudgen, R., 1990. A New Economic Policy for Britain, Manchester University Press, UK. Hewitt, M., 2007. Hyperinflation around the globe [online] Available at: < http://dollardaze.org/blog/?post_id=00107&cat_id=138> Accessed: 17th March 2011. Levi, M.D., 2009. International Finance, Routledge, UK. Pitt, A., 2001. Sustaining Fixed Exchange Rates, International Monetary Fund. Rilley, G., 2010. Sterling Imports and the Importance of Time Lags [online] Available at: < http://tutor2u.net/blog/index.php/economics/tagged/tag/depreciation/> Accessed: 17th March 2011. Taya, T & Bigman, D., 2003. Floating Exchange Rates and the State of World Payments, Ballinger Publishing, USA. Taylor, M. & Mankiwe, G., 2006. Economics, Thompson Learning, UK. Read More