A currency dealer's report shows the market for pounds priced in US dollars. Following new international data on weak UK retail sales and lower expected int...

(a) An exchange rate is the price or value of one currency expressed in terms of another currency. [2] For example, it can show how many US dollars buy one pound.

(b) The dollar price of a pound falls from $1.35 per £ to $1.15 per £. [2] The pound therefore depreciates against the dollar.

(c) The fall in demand for pounds lowers the exchange rate. [6] UK exports become cheaper in dollar terms: a US customer needs fewer dollars to purchase a UK product. This may increase overseas demand, causing UK firms to increase output. Export revenue and labour demand may rise. The effect may be small if foreign demand is price inelastic or UK firms cannot expand capacity.

(d) A lower exchange rate makes imported food, energy, components and machinery more expensive in pounds. [10] Firms using these inputs may pass their higher costs on to consumers, causing cost-push inflation. Imported finished consumer goods also become dearer. As prices rise, households' real incomes may fall.

The central bank may raise interest rates to reduce inflationary demand. Higher rates can also attract capital inflows, increasing demand for pounds. However, higher interest rates may reduce consumer spending and firms' investment, weakening growth. Alternatively, the government could reduce indirect taxes or subsidise key inputs, but this raises public spending or reduces tax revenue. The best policy depends on whether imported inflation is a greater problem than weak growth and unemployment.