Monetary Policy Case Study

UK's Sterling Appreciation: The External Factors

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Abstract:
Is it calm after storm; or calm before storm for the UK's central bank, the Bank of England (BoE)? The BoE has weathered the aftermath of abandoning the Exchange Rate Mechanism (ERM) in 1992 and subsequent free float of sterling. But it is not yet due for smooth sailing, for another currency crisis seems to be round the corner with sterling rising steeply against dollar. Already the manufacturing sector has taken the brunt and few other pieces of the UK economy are preparing to follow. But the BoE believes that UK economy, which had withstood many trials and tribulations of the world economy through mid 1990s and early 2000s, is flexible enough to counter all variations of sterling against all major world currencies.This case study helps debate whether a currency appreciation arises out of extraneous factors (assuming a stable domestic economy) and not always from country's economic fundamentals.

Pedagogical Objectives:

• To understand the concept of exchange rate equilibrium
• To understand the factors that determine the currency demand
• Impact of interest rate and inflation on the exchange rate
• Effects of a currency's appreciation/depreciation on the economy
• To analyse how extraneous factors would contribute to a currency's appreciation

Keywords : Pound Sterling, Exchange Rate Mechanism, Currency Appreciation, Supply-led Growth, Reserve Currency, Capital Inflows, Consumer Price Inflation, Exchange Rate, Macroeconomics Case Studies, Interest Rates, Terms of Trade, Current Account Deficit, Credit Crisis