The effect of fluctuation in the Pound on the UK economy.

Toby O'Neill

What are the impacts of appreciation?

While an appreciation of a currency may sound positive, it can cause various issues for an economy. Firstly, a stronger pound can cause slower economic growth. This is because the price of exports rises, reducing international competitiveness for UK goods and services, and potentially reducing foreign demand for UK products. Whilst the costs of imports fall - meaning an increase in consumption in the UK of foreign goods, this will lead to a decrease in GDP due to a fall in the balance of trade. 

A rise in the price of exports can induce cyclical unemployment. Since demand for exports is often linked to employment in export industries (due to the derived demand), it may result in firms laying off workers, as they cannot afford to employ the same quantity of staff. This will generate an increased unemployment rate in exporting and domestic industries because they cannot maintain competitiveness with importing firms overseas.

However, with a stronger pound comes several benefits for the UK economy. It can lower demand-pull inflation (caused by excessive spending) and lower cost-push inflation (caused by higher production costs). Although a greater deficit in the balance of trade may appear negative, cheaper imports can increase living standards as an increased consumption of foreign goods and services can increase happiness and increase materialistic standards of living. To add to this, in the future, we may even see efficiency gains for domestic producers as they look to increase competitiveness and cut costs -  through innovation. This can be beneficial in the following months for both producers and consumers.

What about depreciation?

For various effects seen with appreciation, we could see the opposite for depreciation of the pound. In effect, we may see the trade balance in a surplus because of cheaper exports and pricier imports. The greatest positive of a depreciation could be the increased growth in the economy due to greater demand for UK exports. From this employment will rise in exporting and domestic industries, as jobs are created to match the higher demand.

However, depreciation also has drawbacks. Higher demand in the economy can cause demand pull and cost push inflation to rise, leading to general rises in prices for the UK. Depending on how significant the rises in inflation are, this could theoretically counter progression in economic growth due to reductions in consumer spending, and with other factors, it could lead to recession.

How have these fluctuations affected the UK in recent years?

The most notable fluctuations in recent times include Liz Truss’ radical drive for growth, leading to the pound spiralling down to one of its lowest values against the dollar - $1.12:£1. More recently, Rachel Reeves’ trip to China left both borrowing costs close to the highest and the pound value at one of its lowest in 16 years (because of rising international borrowing costs) with the current value of the pound (against the dollar) at $1.22:£1.

On the 6th of September 2022, Liz Truss’ catastrophic tenure as Prime Minister began with CPI inflation at 10.1%. Just 49 days later, she left 10 Downing Street with inflation rates at 11.1%. 

But how impactful was this 1% rise?

 Due to inflation being so high, consumer’s purchasing power had fallen, leading to huge cuts in consumption and real GDP. With a 3.8% reduction in growth (relative to 2021), this meant less money circulating in the economy, resulting in lower revenues and returns for businesses as they were forced to downsize to retain profits or contain losses. Also, we saw a steady increase in unemployment rates from September 2022 through 2023 rising from 3.8% to 4.3% in the 3rd quarter of 2023. However, with the context of Russia’s invasion of Ukraine, this period was deemed transitory and partially due to the unstable commodity and energy prices, it could be difficult to separate how much of this was Liz Truss’ fault.

Following the chancellor, Rachel Reeves’ visit to China last month, the pound depreciated near to an all-time low. In this month’s monetary policy report, CPI inflation is forecasted to rise quite sharply to 3.7% in the third quarter of 2025. This will reduce discretionary spending for consumers (spending on goods they could survive without) throughout the coming year, and potentially reduce aggregate demand in the economy since consumption is expected to fall. 

Whilst the UK growth is projected at +1.7% for 2025, the reduction in discretionary spending of UK consumers may tank this figure slightly. This is however relative to inflation rates and how much they rise. This low growth forecast has influenced forecasted unemployment rates to rise to 4.75% from the current rate of 4.4%, which would be the greatest rate since the pandemic in 2020, leaving another big obstacle for the new Labour government to counter.