Readers Question: What will happen to the value of a currency during times of deep recession and high inflation?
There is no hard and fast rule about what will happen to the value of a currency during a deep recession – though, a currency is likely to fall because country becomes aless attractive place to invest. For example, when the great recession started in 2008, the UK experienced a significant depreciation.
The Pound Sterling fell over 25% from 2007 (before the start of the great recession) to July 2009
But the Euro and Dollar were less affected by the great recession.
Note in early 1980, the US went into recession, but during this period the value of the Dollar rose.
It was a similar experience in the UK, in the 1980s, In 1980, there was a rapid appreciation in Sterling (which was one factor contributing to the recession of 1980/81.)
2022 Recession
The Pound Sterling has been sliding during 2021/22 and towards the end of 2022, it looks like UK economy is heading into recession.
Economic theory behind the value of a currency in recession
Suppose one country, e.g. the UK, enters a deeper recession than all its other competitors. How might we expect the currency to behave?
Recession and interest rates. If the UK enters a recession, then we would expect UK interest rates to fall compared to other countries. This would make the UK less attractive for investors to save money. Hot money flows are likely to leave the UK and move to countries with higher interest rates. If people move money out of the UK, they will sell Pounds and buy other currencies, causing a fall in the value of Sterling. Therefore, in theory, we might expect a recession to cause a fall in the value of the currency.
Evaluation
1. In a recession, inflation is likely to fall. Lower inflation will help the country become more competitive, and this may increase demand for the currency causing it to rise.
2. Many factors affect the value of a currency. For example, if the UK had a large current account deficit, then we might expect this trade deficit to put downward pressure on the currency. The fall in the value of Sterling in 2008 was partly related to the UK’s trade deficit and lack of competitiveness. However, if a country like Germany entered a recession, they may be less downward pressure on their currency (the Euro) because Germany has a large current account surplus.
3. It depends on what is happening in other countries. During the great recession, US interest rates fell to 0%, they created money (part of Q.E.) and there were concerns about the size of the US public sector debt. Usually, all these factors (zero interest rates, printing money, high debt) would put downward pressure on the value of the dollar. However, in the great recession, most major economies also had low-interest rates and high government debt. Therefore, many investors still felt that the US was relatively a safe haven compared to other countries. Therefore, the dollar has maintained its value because it is still ‘relatively’ good. If the US had entered a recession on its own, the dollar would have fallen by much more.
4. Confidence. If a country goes into recession, investors may lose confidence. For example, a recession will mean higher debt to GDP ratios, and this may cause concern over the reliability of bonds (especially in case of Euro). But, investors can also retain confidence in a currency, even if the economy is in recession. It depends on prospects for the balance of payments and underlying competitiveness.
What happens to the value of currency if inflation?
If inflation in the UK is relatively higher than other countries, you would expect a fall in the value of the Pound because the Pound is becoming relatively uncompetitive and fewer people will buy British goods.
See also: devaluation, competitiveness and inflation
Related
As an enthusiast with a deep understanding of currency dynamics and economic factors influencing exchange rates, it's crucial to establish my credibility by demonstrating a comprehensive knowledge of the concepts addressed in the article.
The article explores the relationship between currency value, recession, and inflation. Let's break down the key concepts discussed:
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Recession and Currency Value:
- During a deep recession, a country may become less attractive for investors, leading to a depreciation of its currency. This is exemplified by the UK's experience during the 2008 great recession, where the Pound Sterling depreciated by over 25%.
- The relationship between recession and interest rates is highlighted. In a recession, lower interest rates in a country make it less appealing for investors. Hot money tends to flow out of the country, causing its currency to depreciate.
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Economic Theory Behind Currency Value in Recession:
- If a country enters a deeper recession than its competitors, its currency may fall due to lower interest rates compared to other countries. Investors are likely to move their money to countries with higher interest rates.
- The article emphasizes the role of interest rates in influencing currency value during a recession.
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Evaluation of Factors Affecting Currency Value in Recession:
- Lower inflation during a recession may make a country more competitive, potentially increasing demand for its currency and causing it to rise.
- Other factors influencing currency value include trade deficits, current account balances, and competitiveness. For instance, the UK's trade deficit and lack of competitiveness contributed to the fall of the Pound Sterling in 2008.
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Global Context and Confidence:
- The article emphasizes the importance of considering global economic conditions. During the great recession, despite factors like zero interest rates and high debt in the US, the US dollar maintained its value because other major economies faced similar challenges.
- Confidence plays a crucial role. Even in a recession, investors may retain confidence in a currency based on prospects for the balance of payments and underlying competitiveness.
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Inflation and Currency Value:
- If a country experiences higher inflation than others, its currency is likely to fall as it becomes relatively uncompetitive. This is due to decreased demand for the country's goods.
- The relationship between inflation and currency devaluation is highlighted, with a focus on maintaining competitiveness in the global market.
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Related Concepts:
- The article mentions factors affecting the exchange rate, such as interest rates. It suggests that interest rate differentials influence the flow of capital and, consequently, currency values.
- It also briefly touches on devaluation, competitiveness, and their relationship with inflation.
In summary, the article provides a nuanced understanding of how various economic factors, including recession, inflation, and global conditions, interplay to influence the value of a country's currency. It underscores the complexity of currency dynamics and the need to consider multiple variables when predicting currency movements.
