AT the moment, there is a lot happening to exchange rates, interest rates and government borrowing in the UK, and it is quite hard to connect all of the together. Hopefully, the analysis below helps.
If you are looking for a longer, more in-depth, explanation, this is excellent: https://tinyurl.com/4ss2vf8p
What has been happening to the value of the Pound?
It fell at the end of last week after the announcement of the mini-budget. £1 is now worth $1.08. In fact, the Pound has been falling for a number of years now - in 2016, £1 was worth $1.55.
This is what has happened to it over the past year:
What makes a currency fall in value?
Generally, a currency falls in value if those who have it, wish to sell it (an increase in supply). This could be for a number of reasons, but the most important is if financial investors no longer wish to keep their money invested in a country since they believe the chance of making profits is not as good as in other countries.
Why do investors want to move their money out of the UK?
They lack confidence in the UK economy. This is due to its poor performance in recent months, but has been added to by worries about Friday's mini-budget.
The budget contained a number of tax cuts, which will be paid for by increased government borrowing. The freeze on energy bills also has added to this. Even though the UK government has a very good track record at always meeting its repayments, government debt is about to increase massively. This year, interest repayments on government borrowing will be £50 billion; it is forecast to rise to £100 billion next year.
Markets and investors are worried that, even if the government can repay this, it will have an opportunity cost (e.g. government spending cuts) that will negatively affect the UK economy. There is also worry that the expansionary measures of the mini-budget (raising AD) may contradict the raise in the base rate by the Bank of England (reducing AD) so that neither growth nor inflation will improve.
Another sign of this concern is that interest rates that the UK government has to pay for the 10 year gilts (bonds) that it issues have risen from 1% at the beginning of this year to 4% now.
Additionally, whenever there are global worries over economic performance, investors prefer to move their money into US dollars as it is seen as the safest currency to have in a crisis.
What are the effects of the falling Pound?
It makes the costs of imported goods rise. Consumer goods from abroad will be more expensive, adding to inflation, while imported raw materials will cost more, also adding to inflation as UK firms are forced to raise their prices. This would be negative at any time, but especially now with UK inflation already 9.9%.
It does also make the price of UK exports in other countries fall. However, at this time, this is not having too much of an impact - many other economies (like the USA) have their own inflation problems which is meaning their consumers cannot buy as much of anything as before with their income, including UK exports.
What's the link between the exchange rate and interest rates?
When a central bank raises its base rate - and therefore other interest rates in that country rise too - it usually attracts investors to put their money into that country, as they will now receive a greater return on deposits (money saved). By moving their money into the country, they demand more of the currency, causing the exchange rate to strengthen.
Even though there have been a series of rises in the base rate of interest by the Bank of England (the current rate of 2.25% is the highest since 2008), other countries have also been raising theirs. In fact, the rate in the USA is above 3%. Thus, there has not been as much upward pressure on Pound exchange rates from this as the textbooks might predict.
