Exchange rates as a shock absorber

Economies are subject to 'shocks'. Classic ones include the jump in the price of oil in the 1970's, the rise in commodity prices in the 2000's and the Gulf wars. When they occur there is an unexpected 'shock' to Aggregate Supply or Aggregate Demand (AD). This can result in inflation, unemployment or both in the domestic economy.

The diagram below shows the effect of a shock to AD, say the shock of Brexit to the UK economy reducing consumer and business confidence. This would reduce Consumption and Investment expenditure, shifting AD to the left.

One of the benefits that an economy with a floating exchange rate has in this situation is that the currency can depreciate and act as a 'shock absorber'. The shock of Brexit has led many to believe that the UK economy will perform less well in the future and this, they reason, will mean the UK currency, the pound, will be worth less as a result.

This has led to a lower demand to buy pounds and increased selling as people seek to hold their wealth in other currencies that are less likely to loose value. The falling pound (see two posts ago for that) has an important benefit for the UK economy. 

The lower value of the pound means that UK exports now cost less in foreign currency and import prices in the UK will rise. As a  result there will be a rise in the volume of exports and fall in the volume of imports (the law of demand). As long as the Marshall-Lerner conditions hold (and they will) this will mean a rise in the value of Net Exports (X - M) which is a component of Aggregate Demand. This will, at least partially, offset the fall in AD - absorbing part of the shock.

Many argue that this is exactly why the UK was wise not to join the Euro.

The BBC cover this story here

This is very much an IB post, and touches on macroeconomics and international trade. It is particularly useful as an example of the argument around single currency areas where asymmetric shocks are likely.