On June 23rd 2016 the world watched as voters piled into polling stations up and down the country to vote on whether the UK should leave the European Union. However, whilst everyone knows the result, the question many are still asking is how has and how will the decision for the UK to leave the EU affect the currency market?
In the immediate aftermath, the surprising win for the Leave campaign shocked the markets as investors sold off Sterling to hold a safer currency, causing a sharp 7 cent loss on GBP/EUR and more than 12 cent loss for GBP/USD.
Since the result Sterling has been on a downward trajectory against the Euro, as uncertainty surrounding the Brexit negotiations and the final form it will take weighs heavily on the currency. With GBP/EUR struggling to hold any real long-term strength the pairing is currently sitting at close to 9-month lows.
It is no secret that in more recent times the significant devaluation of GBP since the Brexit vote has pinched the wallet of consumers throughout the UK whether it be in terms of a more expensive weekly food shop or a higher cost for that little bit of summer sun abroad. However, how will these price increases affect the UK economy going forward?
Introducing the IS-LM Model
In order to analyse how this increase in the cost of goods and holidays may affect the UK economy we must take a look at the IS-LM (Investment and Savings – Liquidity Preference and Money Supply) model.
A powerful macroeconomic tool used throughout economics to help economists in the analysis of possible future monetary and fiscal policy decisions. An increase in the price level of goods and services in an economy will increase the demand for money, shown in figure 1, shifting the MD curve from MD1 to MD2. While the supply of money (MS) must remain fixed in the short term, as any change in money supply takes time to feed into the economy, it is an increase in interest rate that will create the new general equilibrium point, shifting from GE1 to GE2.
As there has been an increase in the interest rate from i1 to i2, the opportunity cost of holding liquid assets over securities or other financial instruments increases, therefore shifting the LM curve in figure 2 from LM1 to LM2 and resulting in an economy operating under a higher interest rate level (i2) and lower national income (Y2) at general equilibrium point GE2.
Can the Bank of England really raise interest rates?
Whilst our model proposes an interest rate hike as the best solution in the short term, personally I do not believe this is sustainable in the medium to long term.
With car financing increasing by 15% over the past year and the amount owed on credit cards surpassing that of 2007 pre-credit crunch levels earlier this year, an increase in interest rates would further raise household debt interest payments, adding even more pressure on an already tight disposable income.
If the European Central Bank (ECB) and the US Federal Reserve (FED) tighten their monetary policies we could see further weakness for GBP against EUR and USD as investor capital flows out of the UK and into other economies offering a higher rate of return, I could not rule out GBP/EUR and GBP/USD hitting 1.07 and 1.25 levels in the coming months if significant moves are not made by the Bank of England.