The British Economy - Essay Example

Introduction 2 Brief Overview of UK Economy and British Pound 3 Fixed Exchange Rate System and Role of UK Government 4 Floating Exchange Rate System and Role of UK Government 6 Conclusion 9 Reference 10 Introduction The influence of globalisation on trade and business is the most prominent development for human civilization as it has led to increase the importance of international trade and related activities. The world economies are inter-depended on each other and hence, they have realized the importance of international trade and business. Therefore, free trade policies and trade pact between world economies have encouraged the activities of international trade. However, in order to facilitate these activities and to increase efficiencies, new concepts, theories and method have been developed. In this process, the accuracy and efficiency has enhanced but complexities have also increased significantly. International trade has a great economic importance as it helps to bring economic prosperity to a country. International trade activities include import and export which influences foreign and domestic exchanges. Besides, certain economic risks are also associated with international trade and hence, government always try to control international trade related activities (Seyoum, 2000, p.8). This paper will attempt to deal with foreign exchanges policy of UK. Earlier, the UK pound was used to be determined using the fixed exchange rate policy by comparing to other foreign currencies. However, due to certain shortcomings of fixed exchange rate policy, the UK Government has shifted to floating exchange rate policy. This paper will present explanations on fixed and floating rate policies and how the UK Government plays crucial role in controlling and deciding the foreign and domestic currency policies. Brief Overview of UK Economy and British Pound UK is one of the leading economies in Europe and it belongs to the category of first world country. It is a “leading trading power and financial center, is the third largest economy in Europe after Germany and France” (CIA, 2011). Since last two decades, the Government is playing very crucial role in growth of agriculture, services and industrialization. Its GDP as per purchasing power parity was nearly $2.189 trillion and GDP as per official exchange rate was nearly $2.259 trillion. The per capita GDP was nearly was $35,100 with real GDP growth rate of 1.6% in 2010.Regulatory authorities including the central bank (Bank of England) is responsible for managing and controlling the economic affairs. The inflation and unemployment in 2010 were 3.3% and 7.9%. During the financial crisis of 2007-2008, the UK’s economy was heavily affected. However, currently, the economy is recovering at higher speed as policy makers have taken necessary steps for improving the overall economic condition (CIA 2011). Nearly 75% and 23.8% of total GDP is contributed by the services sectors and Industries. The major services sectors include -financial, distribution, business, communication, hotels, transport etc. Currently, the country is suffering from high trade deficit due to higher import comparing to lower export. During 2009, net export of goods and services were recorded $351.3 billion; whereas, net imports of goods and services were higher i.e. $473.6 billion (U.S. Department of State, 2010). As per the updated information, the value of 1 British pound is compared to other major foreign currency in the given below. Table 1: British Pound and Other Foreign Currency (Source: MSN Money, 2011) Fixed Exchange Rate System and Role of UK Government The foreign exchange rate is very important for controlling the major aspects of economy like import, expert, interest rate, inflation etc. The foreign currency market is exposed to different types of risk that affect the entire economic policy like inflation, interest and unemployment etc. There are two types of foreign currency policies i.e. fixed and floating. Earlier, UK Government used to follow the fixed exchange rate system. Fixed exchange rate system is traditional method of controlling the exchange rate of an economy. However, this policy is still in practise in many countries. Fixed exchange rate system is helpful for a country in maintain its domestic currency with a narrower band. Fixed exchanged system provides higher rate of certainties to the multinational companies as export and import activities can be carried out using pre-determined currency rate that leads to reduce the currency fluctuation risks. Moreover, it is also an important tool for government in maintaining desirable inflation and interest rate as it is easier to calculate the consequences due to fixed currency rate. The economy following fixed exchange rate system, determines its currency based on value of gold or other foreign currency e.g. US dollar. However due to certain major shortcoming of fixed exchange rate system, the UK has shifted to floating exchanges rate system. Some of the major disadvantages are given below. In fixed exchange rate system, the scope for following flexible monetary policy is very limited. Monetary policy backed with fixed exchange system does not helpful in targeting domestic inflation (University of California, n.d.). All the macro economic factors are not fixed and hence, fixed exchange rate causes conflict in policy framing. It also leads to reduce the foreign exchange reserve within the economy. The overall effect of fixed foreign exchange rate is that economy management becomes less efficient and less effective. Prior to 1996, The UK Government used to follow the fixed exchange rate system. However, due to the above stated issues, the Government has decided to follow the floating exchange rate. In May 1996, the Bank of England presented a report that contains the arguments for choosing proper foreign exchanges policy. While considering the foreign exchange system for UK, certain factors were taken into account like economic flexibility, mobility of factors, economies homogeneity, ability to manage shocks, stability reliability etc (Latter, 1996). Earlier, the country used the US dollar to determine the fixed rate of per British pound. Floating Exchange Rate System and Role of UK Government Another popular method for determining the currency rate is known as floating exchange rate system. This exchange rate system is more flexible and practical as the price of domestic currency is determined by the demand and supply of that currency in international market relative to other currency. Floating exchange rate system helps to determine the price of a currency automatically as currency are traded in the forex market. While following the floating exchange rate system, it become very easier to control the other macroeconomic factors like inflation rate, interest rate etc. The central bank can influence the foreign exchange market by buying or selling the foreign currencies. The macroeconomic factors like interest rate, foreign currency, inflation etc are interlinked with other. The primary aim of the Bank of England is to minimise the inflation rate and hence, its uses the floating exchange rate policy in achieving the inflation rate. The following diagram shows the monetary policy framework for achieving the target inflation and contribution of exchange rate in this respect. Figure 1: Monetary Policy Framework (Source: Bank of England-a, n.d.) As per the above framework, exchange rate plays primary role in determining the official rate. The Bank of England has declared that due to two primary reasons it operates in foreign exchange i.e. for “managing the UK's gold and foreign currency reserves on behalf of HM Treasury” and for “managing the Monetary Policy Committee's smaller pool of foreign currency reserves” (Bank of England-b, n.d.). For controlling the floating exchange rate, the country has able to achieve sufficient amount of international reserves comprising assets, foreign currency and gold. The following table shows the UK’s holdings of international reserves. Table 2: UK’s International Reserves (Source: HM Treasury, 2010) UK Official and The Bank of England are the major authorities that control the foreign exchange market of UK. Therefore along with HM treasury, the Bank of England also reserves a significant amount of international reserves. The following charts are showing the reserves of UK Government and holdings of Bank of England. Table 3: UK Government’s Gross Reserves and Net Reserves and Bank of England’s Gross holdings (Source: HM Treasury, 2010) Band of England acts as a government’s agent and it also “conducts wholesale foreign currency transactions for government departments and a smaller number of its customers” which help the government in maintaining the floating exchange rate market (Bank of England-c, n.d.). Conclusion This paper has discussed UK’s economy and role of government in controlling the foreign exchange policy. The foreign exchange rate is a vital component in achieving the target inflation rate and hence, UK Government and the Bank of England have taken necessary steps to regulate foreign exchange market by implementing effective strategies. UK used to follow fixed exchange rate system but due to certain major drawbacks, the country is now following the floating exchange rate system. As per the floating exchange rate system, the value of a currency is determined by the demand and supply and hence, Bank of England influences the demand and supply by buying and selling the international reserves. In order to enhance the flexibility and liquidity, the UK official and the Bank of England has significant amount of international reserves. Reference Bank of England-a. No date. How Monetary Policy Works. [Online]. Available at: http://www.bankofengland.co.uk/monetarypolicy/how.htm. [Accessed on February 18, 2011]. Bank of England-b. No date. Foreign Exchange Markets. [Online]. Available at: http://www.bankofengland.co.uk/markets/forex/index.htm. [Accessed on February 18, 2011]. Bank of England-c. No date. Foreign Exchange Markets. [Online]. Available at: http://www.bankofengland.co.uk/markets/forex/index.htm. [Accessed on February 18, 2011]. CIA. January 20, 2011. The World Factbook. [Online]. Available at: https://www.cia.gov/library/publications/the-world-factbook/geos/uk.html. [Accessed on February 18, 2011]. HM Treasury. December 2010. UK Official holdings of international reserves. [Pdf]. Available at: http://www.hm-treasury.gov.uk/d/pn_67_10.pdf. [Accessed on February 18, 2011]. Latter, T. May 1996. The Choice of the Exchange Rate Regime. [Pdf]. Available at: http://www.bankofengland.co.uk/education/ccbs/handbooks/pdf/ccbshb02.pdf. [Accessed on February 18, 2011]. MSN Money. February 18, 2011. Currency exchange rates. [Online]. Available at: http://uk.moneycentral.msn.com/investor/market/rates.asp?Region=0&Compare=3. [Accessed on February 18, 2011]. Seyoum, B. 2000. Export-import theory, practices, and procedures. Routledge. University of California. No date. Monetary Policy under Fixed Exchange Rates. [Pdf]. Available at: http://weber.ucsd.edu/~jlbroz/Courses/PS245/handouts/fixed_rates_macro_policy.pdf. [Accessed on February 18, 2011]. U.S. Department of State. December 14, 2010. Background Note: United Kingdom. [Online]. Available at: http://www.state.gov/r/pa/ei/bgn/3846.htm. [Accessed on February 18, 2011]. Read More