Exchange Rate System: Implications on British Pound - Essay Example

?EXCHANGE RATE SYSTEM – IMPLICATIONS ON BRITISH POUND Introduction Based on the degree to which the government controls the exchange rate system, different exchange rate systems have been defined including fixed, free floating, managed float and pegged exchange rate system (Madura, 2008). Like other industrialised states, the UK economy adopted the fixed exchange rate system to manage pound when this system was introduced. However, to strengthen the value of pound, the UK government adopted the floating exchange rate system. Therefore, from 1944 to 1972, UK adopted the fixed exchange rate system to manage pound and from 1992 to 2001, UK government adopted the floating exchange rate system (Tutor2u). In this essay, the fixed exchange rate system and the role of UK in maintaining the pound under the fixed exchange rate system has been discussed. Moreover, to analyse the current exchange rate system adopted by UK, floating exchange rate system has been discussed. Finally, the impact of depreciation of British Pound on the UK economy has been analysed by using relevant data, graphs and tables. Fixed Exchange Rate System In the fixed exchange rate system, the rates fluctuate within narrow boundaries and if the exchange rate starts to move higher, the government maintains the rate within the boundaries (Madura, 2008). In 1944, Bretton Wood Accord introduced the fixed exchange rate system and until 1970s, most of the major world economies were participating in the fixed exchange rate system (Burton & Brown 2009). Burton & Brown (2009) explains that after the introduction of the system, the major industrialised countries met to develop a new international financial system. Under the fixed exchange rate system, economies agreed that if the trade deficit of an economy increased then they would be able to manage supply of currency in international markets. In the fixed exchange rate system, the government increases the supply of currency when the trade deficit of the country increases. The increased supply of the currency inserts the downward pressure on the exchange rate however, to maintain the pre-decided exchange rate, the central bank of the country purchase the excess supply of its currency. For example, if Britain economy faces trade deficit, the increase in the supply of pounds relative to dollar inserts downward pressure on pound value whereas, decrease in supply of pounds relative to dollar inserts upward pressure on value of pound. The government has the power to intervene in the fixed exchange rate system. Under a fixed exchange rate system, the government is able to manipulate the market value of the other currency in terms of its domestic currency. However, manipulations can be only done to an agreed-exchange rate. UK government has been playing a significant role in maintaining pound under a fixed exchange rate system. The UK government has always been intervening to keep the agreed-exchange rate within certain boundaries. For example, when the agreed-exchange rate of pound and dollar fluctuated then to keep the rate fixed, the UK government bought or sold pounds with dollars until the market value of the two currencies converged to an agreed level. Floating Exchange Rate System Floating exchange rate system is the system when there is no flexibility in the exchange rate system and the values of exchange rate system are determined by the market forces and they are independent of the government intervention (Madura, 2008). British government adopted the floating exchange rate system in 1992 and after adopting the floating exchange rate system, the Bank of England was no longer able to influence the currency markets. In other words, after adopting the floating exchange rate system, the influence of the government in controlling the exchange rate system finishes. In this exchange rate system, the value of the currency is only determined by the demand and supply of the currency in the foreign exchange market, therefore, market forces play role to influence the value of the currency. These market forces usually include the trade flows and the capital flows of the country and the better performance of the economy derives the value of the currency. Impact of Depreciation of Pound on UK Economy Depreciation and appreciation of pound has a strong influence on the UK economy. In order to analyse how the depreciation of UK pound has influenced the UK economy, the impact of depreciation has been studied on UK inflation, balance of trade, exports and standards of living of British people. Table: Exchange Rate of Dollar/Pound 2009 and 2010 2009 ER 2010 ER Top of Form January 1.44261 January Top of Form 1.61631 Bottom of Form February 1.44168 February 1.5623 March 1.41886 March 1.50496 April 1.47026 April 1.53265 May 1.54106 May 1.46595 June 1.63621 June 1.47505 July 1.63638 July 1.5281 August 1.65421 August 1.56609 September 1.63398 September 1.55565 October 1.61854 October 1.58587 November 1.6592 November 1.59741 Bottom of Form December 1.62417 Bottom of Form December 1.55881 Bottom of Form Source: x-rates The following table shows the value of pound against dollar in the years 2009 and 2010. The monthly averages have been calculated for the two currencies. The values are available on < http://www.x-rates.com/d/USD/GBP/hist2009.html>. It is evident that until January 2010, one pound was equal to 1.62 dollars and in February 2010, one pound was equal to 1.56 dollars. The depreciation of UK pound has been very significant in 2010. Graph: Exchange Rate of Pound-US Dollar in 2009 and 2010 The following graph shows the annual inflation rates in the UK in 2009 and 2010. The Graph is available on . The graph shows that in 2009, the CPI inflation was 3 percent however, in 2010, the inflation increased and until December 2010, the CPI index reached to the level of 4 percent. Therefore, depreciation of pound increased inflation in the UK economy. Graph: Average Inflation Rates – 12 Months Percentage Change in 2009 and 2010 Source: Office for National Statistics The following table shows the balance of trade of UK available at < http://www.statistics.gov.uk/cci/nugget.asp?id=199>. In June 2009, the trade deficit of UK was around ?3.3 billion and the exchange rate was 1.63 which means that 1 pound was equal to 1.63 dollars whereas, in June 2010 when pound depreciated to a level of 1.47, the trade deficit widened to ?4.4 billion. Therefore, the depreciation of pound widened the trade deficit of the UK. Graph: UK Balance of Trade in 2009 and 2010 Source: Office for National Statistics The government of UK has been depreciating the value of pound to decrease the trade deficit because the depreciation of pound reduces the prices of UK exports in the international markets thereby, increasing the demand of exports and reducing the trade deficit. Levi (2009) argues that depreciation of pound increases the value of UK exports and the quantity of pounds demanded and if the value of exports does not increase to compensate for inelastic import demand then the depreciation of pound influences the balance of trade negatively. Moreover, the increase in the value of exports by depreciation of UK pound can be effective only in the short-run and in the long-run the trade deficit expands as a result of pound depreciation. The depreciation of dollar reduces the purchasing power of the British consumers to buy the imported products therefore, the demand of imported goods fall. The depreciation of UK pound has also influences the standard of living of the UK consumers. With the depreciation of pound, the imported goods became expensive for the British people therefore, the demand of the luxury imported goods declined. Moreover, the travelling of British consumers also declined because depreciation of pound made the travelling expensive for the British consumers (Low, 2008). Bibliography Levi, MD 2009, International Finance, Edition 5, Taylor & Francis, USA. Madura, J 2008, International Financial Management, Edition 9, Cengage Learning, Mason. Burton, M & Brown, B 2009, The Financial System and the Economy: Principles of Money and Banking, Edition 5, M.E. Sharpe, New York. Low, L 2008, Impact of Depreciating Pound, viewed 20 February, 2011, < http://econsguide.blogspot.com/2008/10/impact-of-depreciating-pound.html>. Office for National Statistics, Economy: Inflation, viewed 20 February, 2011, < http://www.statistics.gov.uk/cci/nugget.asp?id=19>. Office for National Statistics, UK Trade, viewed 20 February, 2011, < http://www.statistics.gov.uk/cci/nugget.asp?id=199>. Tutor2u, Fixed and Floating Exchange Rates, viewed 20 February, 2011, < http://tutor2u.net/economics/content/topics/exchangerates/fixed_floating.htm>. X-Rates, Monthly Exchange Rate Average, viewed 20 February, 2011, < http://www.x-rates.com/d/USD/GBP/hist2010.html>. Read More