Britain is experiencing the worst trade deficits in centuries; according to Padgham (2007), the figures released in December 2006 represented the biggest trade deficit the country has witnessed in over three hundred years. As a proportion of Gross Domestic Product (GDP), the present trade deficit is estimated at 4. 3 percent, almost at par with the 1970s peak of 4. 9 percent. However, unlike the mid 1970s when the trade deficit caused a Sterling crisis in the foreign exchange market, the present trade gap ‘barely caused a ripple’ in the foreign exchange market.
To explain this difference in market reaction to a similar situation using the foreign exchanges, it is important to adequately understand how the foreign exchange market works, and the factors that influence the movement of the foreign exchange market. Exchange Rates, also known as Foreign Exchange Rates is usually a comparison of two national currencies, and it can be succinctly defined as how much one national currency is worth (or will exchange for) in terms of the other currency.
However, for a national currency to be exchangeable it must be convertible, i. e. it should be capable of being bought and sold in exchange for the other currency. For example, the Pound Sterling can be readily sold and bought with the US Dollar, thus it is exchangeable. And the market where such transactions take place is known as the Foreign Exchange Market. Moreover the most significant feature of exchange rates is the determination of the worth of a currency relative to the other, as this is the basis of the whole exercise.
This is known as the ‘nominal exchange rate’. The nominal exchange rate is an expression of how many units of a currency will exchange for a domestic currency, this figure is usually dynamic changing in response to the country’s trade balance. Thus, the nominal exchange rate represents the strength of a national currency relative to another (Cheung, Menzie & Ian, 2004). To buttress this argument, it is pertinent to state that the nominal exchange rate is influenced by the forces of demand and supply of the currency in the foreign exchange market.
To understand how a country’s trading activities affect or influence the foreign exchange market, it is important to realise that the demand for and consequently, the supply of a currency depends on a country’s trading activities. For example, the demand for the British Sterling could come from two sources: first, goods and services produced in Britain and for sale in other currencies i. e. British exports, and second, households and firms from other countries’ investment in Britain i.
e. Foreign Direct Investment. These two activities require individuals or corporate bodies from other countries to sell their national currency in exchange for the British Pound Sterling. From this above explanation it is apparent that trading activities i. e. importing and exporting activities from a country influences the value of the country’s currency in the foreign exchange market. To create a better picture the following explanation is necessary.
Using Britain as an example, when the country sells (export) more of its domestically produced goods and services than it buys (imports), there is trade surplus, and since there are more foreigners buying the British Sterling (from the increased export) then the demand for the Sterling outweighs the supply and there is a resultant appreciation of the Sterling in the foreign exchange market. However, when the reverse is the case i. e.
imports outweighing export, there is trade deficit and the supply of the Sterling outweighs demand resulting in depreciation of the sterling and a resultant fall in the national economy. This was exactly what happened in the mid 1970s. Britain was consuming (importing) more than it was selling (exporting), with the trade deficit peaking at 4. 9 percent of GDP, the resultant net increase in supply and decrease in demand of the sterling caused a significant depreciation of the sterling and a fall in the economy.
However, unlike the 1970s, the present trade gap has not generated any significant reactions from the foreign exchange market. To understand why this is so, we will have to go back to the factors that influence the exchange rate of the sterling i. e. demand and supply. It was mentioned earlier that the exchange rates of the sterling and by extension its value in the foreign exchange market depends on the forces of demand and supply.
Also, the two primary sources of demand of the sterling were identified as goods and services produced in the UK and sold to other countries, and individuals and corporate bodies investing in Britain, either in financial assets or in factories and organisations. One could deduce that in the 1970s, the trade deficit induced such serious crisis with the sterling because the increase supply of the sterling that was caused by the trade deficit was not balanced by an equal or more demand for the sterling from foreign direct investments.
However, as indicated by Padgham (2007) in his article, the recent trade deficit does not constitute a significant influence on the value of the sterling, since balance of payments shows that more payments are flowing into Britain through direct investment, which is enough to counter the effect of the trade deficit. The demand for the sterling in the foreign exchange market comes from both trading activities and direct investment, there could only be crisis when a trade deficit is reinforced by a fall in foreign investment flowing into the country.
So, despite the widening gap in the country’s trading record, the increased in payment flowing into the country is enough to counter the effect of trade deficit. This can be explained thus: goods and services exported create a demand for sterling in the foreign exchange market, while goods and services imported creates a supply of sterling. Also, direct investment in the country creates a demand for sterling. Although, the trade deficit causes more supply of sterling relative to demand, the demand for sterling from direct investment flowing into the country ‘mops up’ the excess sterling supplied from over importation.
Furthermore, unlike the short term influence of trade on the foreign exchange market, foreign direct investments are long term in nature, and as Padgham stated “investors are not going to pull out at a moment’s notice and leave the country in the lurch” and since there is great demand for British assets and firms, there a likelihood that the inflow of direct investment will continue, and as a result, the widening trade deficit will have little or no effect on the sterling in the foreign exchange market. Q2.
Apply the Keynesian Cross model to analyse how an appreciating exchange rate and a widening trade deficit causes Paul Dales to expect that the UK GDP growth rate will fall `due to a significant drag from net trade’. (Word count 905) It is apparent that the Gross Domestic Product (GDP) growth is a reflection of the performance of all economic parameters, consistent growth in GDP depends on economic growth in all frontiers, thus, if one aspect of the economy is continually experiencing decline, such as trading activities as in the British experience, there is a sound possibility that the overall GDP growth could be compromised (Sheehan, 2003).
Furthermore, considering the assertion by Philip Shaw that the countries current account – ‘which includes lucrative investment income as well as trade in goods and services’, has not experienced surplus since early in the 1980s, it becomes even more likely that the continuous drag of the trading sector on the overall economy growth coupled with an appreciating exchange rate of the sterling will eventually impact on GDP growth.
The Keynesian Cross model can be used to better support the position. The Keynesian Cross model relates total consumption and income with national growth. For example it holds that the volume of national expenditure determines the level of national income and national product i. e. the rate of consumption or spending in a nation determines the wealth and prosperity of that country.
According to this model, the trio of national expenditure, national income and national product are the major reflection of a country’s growth and the three must balance out. National expenditure, when measured in terms of money, is represented by the aggregate national spending on goods and services. National income on the other hand, is the total income and profit earned by households and corporate bodies in the country, while national product represents the value of all the goods and services produced in the country.
An increase or decrease in one of these components of the Keynesian Cross model influences (and is influenced) by the other two, for example, any increase in national expenditure will be due to a rise in real spending and a higher price level of goods and services, on the other hand, an increase in national income will be due to both a real rise in income as a result of more factors of production being utilised and an increase income to compensate for increased price levels; while any increase in national product will be due to an increase in total output and a higher price level for goods and services.
These three aggregates, according to the model measure the total economic activity. Therefore, changes in the three aggregates must be consistent with each other, if one of the components continually lags behind it is capable of influencing the others, and by extension the economic performance. And such is the scenario here.
The widening trade deficit and the appreciating exchange rate of the sterling are capable of compromising the overall GDP growth, and the ‘significant drag from net trade’ on the GDP mentioned by Paul Dales in the Padgham (2007) can readily be explained with reference to the national product and national expenditure component of the Keynesian Cross model. First, the widening trade deficit implies that the country is not producing (or at least selling) as much as it is consuming. The rate at which the country is buying goods and services from other countries surpasses the volume of goods and services being sold out to other countries.
The result is that the country is spending more than it is earning. With regard to the Keynesian Cross model, this implies that the volume of national expenditure exceeds the national income and national product. Under normal circumstances, the increasing trade deficit is supposed to cause a depreciation of the country’s currency in the foreign exchange market. Such depreciation of the sterling would result in inflation, making imported goods and services more expensive, while at the same time making the goods and services of the country more affordable to other countries.
This arrangement will force down imports, while at the same time increasing exports, thus stabilising trade balance. The implication of this reactionary phase is that the economic activities is stabilised; the national product will increase due to increase export, the national expenditure will increase partly due to increase in price levels caused by the inflation, and partly due to increase incomes to compensate for the increase price levels, also, national income will increase essentially due to increased incomes to compensate for the higher price levels.
Under such arrangements, the change (growth) throughout the economic activities is consistent. However, in the case of the UK, the widening trade deficit has not had the necessary effect on the foreign exchange, apparently due to the influx of direct investment into the country. The appreciating exchange rate of the sterling is more likely to further worsen the trade deficit. This is because appreciating (strong) national currency relative to other countries makes foreign goods and services cheaper and thus encourage imports.
On the other hand, domestic goods and services become more expensive and less competitive in the international market and export less profitable. The implication is that why it is easier to buy from abroad, it becomes more difficult to sell domestic goods and services, due to a stronger currency. Such arrangement can only further widen the trade deficit. When export falls, national product and national income falls, although national expenditure increases, the effect of the drop in national income and national product over a long period of time is sufficient to cause a fall in the overall GDP growth of the country.