Essay question
Here is an essay question, written in the style of AQA Economics A Level.
The British pound sterling has depreciated against the US dollar from 1.70 US dollars per pound sterling in June 2014 to 1.27 US dollars per pound sterling in June 2024. This is a fall of 25% in the value of the pound against the dollar over a decade.
Evaluate the view that a depreciation of the currency is likely to lead to an improvement in macroeconomic performance. (25 marks)
Detailed essay plan
Intro:
- Define depreciation and macroeconomic performance.
- Argue the main effect of a depreciation is higher inflation.
Analysis point 1:
- Exports are cheaper, imports are dearer.
- X-M rises. AD rises.
- Export-led multiplier effect.
- Economic growth.
- Example: Brexit depreciation.
Evaluation point 1:
- The Marshall Lerner condition may not hold for the UK economy.
- So economic growth may not occur.
Analysis point 2:
- Inflation rate may rise.
- Higher cost of imported inputs, so business costs rise, so SRAS shifts left.
- Cost-push and demand-pull inflation.
- Inflation makes some groups worse off, such as public sector workers.
- Examples: sustained depreciation over a decade, Rolls-Royce and Jaguar Land Rover.
Evaluation point 2:
- Large parts of the economy are not dependent on imported inputs.
- So there may be less of a rise in inflation.
Conclusion:
- Overall effects on macroeconomic objectives.
- Short run versus long run impacts of a depreciation.
Full model answer by paragraph
Introduction
A depreciation is a fall in the exchange rate due to market forces. Macroeconomic performance can be measured by the macroeconomic objectives, such as sustained economic growth, low and stable inflation, full employment and a satisfactory current account on the balance of payments. I will argue that a depreciation is likely to be inflationary, harming the UK’s macroeconomic performance to some extent.
Analysis paragraph 1
A depreciation may improve macroeconomic performance increasing in the economic growth rate. On the night following the Brexit vote, the pound fell 10% in value against the US dollar. A depreciation of the pound makes exports cheaper and imports dearer. So export demand increases and import demand falls. This may lead to UK net exports rising. As net exports are a component of aggregate demand (AD = C + I + G + X – M), higher net exports lead to AD shifting right from AD to AD1. This also creates an export-led multiplier effect, where an initial increase in exports leads to an even larger increase in AD, shifting AD for the UK further right from AD1 to AD2. This is because higher exports mean UK firms may make more revenue and profit, so they may use those unds to pay workers more. So workers have more disposable income to spend in local shops, increasing consumption and AD. Altogether, the depreciation of the pound leads to UK real GDP increasing from Y to Y2. creating short-run economic growth for the UK. This depreciation of the pound could therefore help to boost the UK’s low economic growth rate of 0.1% in Q4 2025.
Evaluation paragraph 1
However, this depends on whether the Marshall Lerner condition (MLC) holds for the UK economy. The MLC states that if the absolute values of the price elasticities of demand for exports and imports sum to more than 1 (|PEDX|+|PEDM| >1), then a depreciation leads to higher net exports. The MLC may not hold for the UK economy as some UK exports and imports may have highly price-inelastic demand. An example is the UK’s pharmaceuticals exports from GSK and Astrazeneca, which may be necessities. Therefore the MLC may not hold for the UK, so a depreciation could even lead to a decrease in net exports, AD and a slower rate of economic growth for the UK economy.
Analysis paragraph 2
The sustained depreciation of the pound against the dollar by 25% from June 2014 to June 2024 could contribute to inflationary pressures in the UK. Some businesses may rely on imported inputs. This includes carmaker Jaguar-Land Rover and Rolls-Royce, manufacturer of cars and airplane engines. These companies bring together car / plane parts, including computer chips, from the rest of the world with just-in-time manufacturing processes. A depreciation makes these imports more expensive, so business costs increase. So SRAS shifts left from SRAS to SRAS1. This leads to cost-push inflation, as businesses may choose to pass on some of the cost increase to consumers by raising prices. The price level rises from PL to PL1. We can combine this with AD shifting right, due to higher net exports, a component of AD, as mentioned earlier. On the diagram below, AD shifts right from AD to AD1, increasing the price level from PL1 to PL2 and creating demand-pull inflation. In the UK the inflation rate was 3.4% in December 2025, above the Bank of England’s target range of 2% +- 1 percentage point. This could be partly explained by the depreciation. Higher inflation can reduce the purchasing power of those whose incomes rise more slowly than the inflation rate, such as public sector workers. Savers may also see the real value of their savings eroded, making savers worse off. The SRAS may cancel out any effect on real output from AD shifting right, such that real output remains at Y after both curves have shifted.
Evaluation paragraph 2
However, many businesses in the UK may not be reliant on imported inputs. Labour intensive services such as hairdressing, whose main cost is labour resident in the UK at about 60% of salon costs on average, do not rely as much on imports. So, following a depreciation, their business costs are unlikely to increase. As a result, a depreciation may only lead to a small rise in UK-wide business costs, so SRAS only shifts left to a limited degree. So the depreciation may not be as inflationary as expected.
Conclusion
Overall, a depreciation of the pound is likely to be inflationary, as both AD shifting right and SRAS shifting left contribute to a higher price level. However the effect on economic growth is unclear, with the possibility that the SRAS shift left could neutralise the effect on output from AD shifting right. As a result, the sustained depreciation of the pound from 1.70 dollars per pound to 1.24 dollars per pound over a decade may harm macroeconomic performance overall. This is especially true in the short run. In the short run, buyers of imports, such as firms and consumers, may not be able to break out of contracts or have time to find substitutes. This makes the price elasticities of demand (PED) for imports and exports more inelastic in the short run, making the Marshall Lerner condition less likely to hold, so net exports may not rise in the short run. So AD does not shift right as much, with the SRAS shift outweighing the AD shift. As a result, inflation may rise while economic growth may fall. Yet over time in the long run, as contracts change and consumers find alternatives, the PEDs of exports and imports may become more elastic, so the Marshall Lerner condition is more likely to hold, leading to higher exports following the depreciation. This may reduce the current account deficit which is 2.2% of UK GDP in 2024.
Commentary on the answer
This answer is an effective response to the question on the effects of a currency depreciation.
The answer features:
- Chains of reasoning about the AD and SRAS effects of a depreciation, including the consequences for macroeconomic objectives.
- Use of diagrams, explained in the text, to show the effects of a depreciation on macroeconomic objectives.
- Evaluation points that show the weaknesses in the prior analysis points, with reference to economic theory such as the Marshall Lerner condition.
- A justified answer to the question in the conclusion.
As a result, this answer would likely score full marks or close to this.
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