The Dollar Under Pressure

Model answer: A current account deficit occurs when the value of a country's imports of goods, services, income flows and current transfers exceeds the value of its exports over a given period — resulting in a net outflow from the circular flow. One item recorded on the current account: the export of UK financial services to overseas clients (invisible export / services credit).

Model answer: Diagram: X-axis = quantity of UK exports; Y-axis = price in USD. Upward-sloping export supply curve (from UK producers), downward-sloping export demand curve (from US buyers). Sterling appreciation from $1.25 to $1.38 means a UK good priced at £1,000 now costs $1,380 rather than $1,250 — the supply curve shifts leftward/upward in dollar terms. At the higher dollar price, US demand contracts — export volume falls (–4.2% per Source A). Revenue effect: volume falls more than price rises if PED is elastic, worsening the export account. Source A confirms: UK current account deficit widened from –2.9% to –3.4% of GDP, consistent with export deterioration.

Model answer: Chain 1 — Debt relief (2 marks): Dollar depreciation means each unit of domestic currency now buys more dollars → real cost of dollar-denominated debt service falls in domestic currency terms → fiscal space increases → government can redirect spending from debt repayment toward investment in education, infrastructure, health → improved LRAS and human capital accumulation. Source A: Brazil's debt-to-GDP ratio falls 2.1pp per 10% dollar depreciation. Chain 2 — Commodity revenue compression (2 marks): Commodity prices are dollar-denominated → falling dollar tends to compress commodity prices in dollar terms → commodity-exporting developing economies see export revenues fall → AD falls → multiplier effect → GDP growth slows → fiscal revenues contract → development spending constrained. Chain 3 — Import cost and inflation (2 marks): Developing economies that import capital goods and intermediate inputs in dollars face lower import costs → production costs fall → supply-side benefit; inflation moderated → real wages rise → domestic consumption increases → positive AD effect.

Model answer: It is a problem case (4 marks): Persistent deficit implies net demand leakage → negative multiplier effect on domestic GDP. Must be financed by capital/financial account surplus → accumulates foreign-owned UK assets (debt or equity) → future income outflows worsen primary income account further. Risk of sudden stop: if foreign investors lose confidence, capital outflows → sharp exchange rate depreciation → imported inflation → cost-push price level rise. Source A: UK deficit –3.4% GDP in 2025, worsened by sterling appreciation reducing export competitiveness. It is not necessarily a problem (4 marks): UK can sustain deficit because sterling is a freely floating currency — automatic adjustment mechanism exists. Deficit may reflect productive investment inflows (FDI), not consumption-driven borrowing → raises future productive capacity and export potential. Financial services sector generates surplus on services account (invisible exports) that partially offsets goods deficit. Flexible labour and capital markets allow re-allocation. Evaluative conclusion: seriousness depends on composition (investment vs consumption), financing terms, duration, and whether it reflects structural uncompetitiveness or short-run cyclical factors.

Model answer: Benefits (3 marks): Depreciation improves export price competitiveness → volume of exports rises (provided PED > 0) → export revenues rise if Marshall-Lerner holds → current account improves over 12–18 months → positive AD and multiplier effect → GDP growth, lower unemployment. Second benefit: import substitution → domestic industries that compete with imports gain market share → investment and employment in tradeable sectors. Third: real exchange rate adjustment allows internal rebalancing without nominal wage deflation. Costs (3 marks): Imported inflation — UK imports c. 30% of consumer goods; depreciation raises sterling import prices → higher CPI → real wage squeeze → lower consumer spending → stagflationary pressure. UK's experience after 2016 Brexit vote: 15% GBP depreciation triggered inflation rising to 3.1% (2017) while real wages fell. Second cost: J-curve effect → short-term current account deterioration before improvement; adjustment may not materialise if Marshall-Lerner condition not met. Third: uncertainty and volatility → firms postpone investment; financial account instability if confidence falls. Evaluation (5 marks): Net effect depends critically on: (1) whether Marshall-Lerner condition is satisfied — UK long-run PED for exports estimated at 0.5–1.0, imports 0.8–1.2 → combined c. 1.4–2.2 → Marshall-Lerner likely satisfied in long run; (2) time horizon — J-curve means short-run costs precede benefits; (3) starting macroeconomic conditions — depreciation more beneficial when economy has spare capacity (output gap) → inflation impact limited; (4) degree of pass-through — UK producers may not fully raise prices, absorbing some via margins. Conclusion: on balance, for a supply-side flexible economy operating with an output gap, depreciation benefits likely outweigh costs in the medium term — but this is not unconditional.