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What are the mechanisms by which a weakening world economy would impact on the UK market? In this context, how does the declining exchange rate of the pound against the Euro contribute to the future prospects of the UK economy?

Executive summary

The weakening world economy impacts on the UK market through a combination of inflation rates, import and export volume, and credit markets. As the pound declines against the Euro, exports become more competitive, hence boosting the profits of exporting companies, but imports become more expensive, hence reducing the amount of goods consumers can purchase.

Introduction

The current financial crisis originated in poor quality mortgage lending practices by US banks, who were willing to extent loans to borrowers unable to repay them as these loans could be sold as bonds to make profits for the bank (Hutton, 2008). The risks from these mortgages, and hence the losses from defaults, have been spread across the global economy through the bond markets. As such, the world economy is now weakening. This piece will examine the mechanisms by which this weakening impacts on the UK economy, and how the declining exchange rate of the pound is contributing to this impact.

Main body of the work

Last year, in the midst of rising UK inflation rates, one of the members of the Monetary Policy Committee of the Bank of England stated that the world economy is one of the most significant influences on the inflation rate in the UK. This is because of the global markets which exist for commodities such as corn, wheat, iron, aluminium and oil, as well as for manufactured goods. As such, as the world economy weakens, so the demand for these commodities falls and hence so does their price. This can lead to falls in the rate of inflation in the UK, which is now a net importer of many commodities including food and oil (Bank of England, 2007). Indeed, the open and global nature of the UK economy means that global economic factors “can cause inflation to fluctuate around its target level in the short term, and also inject volatility into the real economy” (Bank of England, 2007). This implies that a weakening world economy will tend to increase the volatility of inflation rates in the UK, hence affecting the overall economy.

In addition, the US Department of State (2008) reports that the UK directly exports $415.6 billion or goods each year, and directly imports $595.6 billion, from its $2.15 trillion total economy. However, Brittan (2003) reports that the sales made by UK affiliates in foreign companies are around five times the volume of the direct UK exports. This implies that the UK economy is strongly dependent on the world economy, both for direct exports and the additional cash inflows from the affiliates. Whilst the affiliates and other overseas owned subsidiaries do not have a direct impact on the UK economy, any fall in sales for them will reduce corporate earnings, hence reducing government tax revenues and investor returns. As such, as the world economy weakens global consumption will tend to fall. The main mechanism by which this will be transmitted to the UK will be in the form of reduced profits and tax revenues, thus putting pressure on companies to make efficiency savings, and making it harder for the government to balance the budget (Brittan, 2003). In the long term, this implies higher levels of unemployment and higher taxes or lower government spending in the future.

Finally, it is not only the UK’s inflation rate and corporate profits which are affected by the global economy, but the credit markets as well. Hutton (2008) argues that the current slump has been caused by falling US property prices, which have hurt the returns on residential mortgage backed bonds and caused large losses to businesses which invested in them. These bonds were sold on to investors around the world, hence the world economy is now suffering from a lack of credit and an unwillingness of banks to lend. This affects the UK economy through two mechanisms. Firstly, UK banks have lost significant amounts of money, and are unwilling to lend to businesses, who thus find it harder to invest in growing their business, and consumers, who thus find it harder to make purchases on credit, and must focus on paying back their expensive existing debts. In addition, many UK businesses depend on the global credit markets for financing and refinancing, either directly or indirectly. As such, the current la