Exports are an injection into the circular flow of income.  Goods and services are sold to foreigners who have to buy £s in order to purchase them.  Imports occur when UK residents buy goods and services from abroad. 

The Effect of Exchange Rates

The value of exchange rates affect the demand for exports and imports.  An appreciation of the pound (pound becomes stronger) will lead to exports becoming more expensive and imports cheaper.  This will harm exporters and increase the leakages from the circular flow of income. Were the pound to depreciate the opposite effect would occur.  In order to avoid confusion remember SPICED!

The economic effects of changes in exchange rates take time to occur, this is due to time lags between a change in the pound and changes in the balance of payments.

The extent to which exchange rates affect exports and imports will depend upon the elasticity of demand for the products and the nature of the contracts that have been agreed. 

After a depreciation of the pound demand for exports will grow faster if the demand for UK goods overseas is elastic.

After a depreciation it may not be possible to switch away from imports as they maybe part of a long term contract, essential for production or cannot be made in the UK and have an inelastic demand.  Then we end up spending more when the exchange rate falls in value causing the balance of payments to worsen in the short run a process known as the J curve effect. 

Assuming that the economy begins at position A with a substantial current account deficit and there is then a fall in the value of the exchange rate. Initially the volume of imports will remain steady partly because contracts for imported goods will have been signed.

However, the depreciation raises the sterling price of imports causing total spending on imports to rise. Export demand will also be inelastic in response to the exchange rate change in the short term, therefore the earnings from exports may be insufficient to compensate for higher spending on imports. The current account deficit may worsen for some months. This is shown by the movement from A to B on the diagram.

Providing that the elasticities of demand for imports and exports are greater than one, in the longer term then the trade balance will improve over time. This is known as the Marshall-Lerner condition.  In the diagram, as demand for exports picks up and domestic consumers switch their spending away from imported goods and services, the overall balance of payments starts to improve. This is shown by the movement A to C on the diagram.

Trends in Exchange Rates

The last major depreciation in the value of sterling came in the early-mid 1990s following sterling's departure from the exchange rate mechanism. The pound was devalued by nearly 15% against a range of currencies in September 1992 and continued to drift lower in value for the next three years.

Objectives Of Government Macroeconomic Policy