And if the foreign exchange market had anticipated a higher cost of finance for sterling borrowers after Brexit you’d probably have seen the same expectation in other financial markets – a steeper yield curve, perhaps, or higher premia in UK banks’ funding markets. That hasn’t really happened. Chart 4: Weaker productivity in tradable sector depresses the exchange rate  Chart 5: Supported by cross-country evidence  PNT /PT SNT /ST  DNT /DT YNT /YT  Source: Penn World Table  A more likely channel, to my mind, involves expected supply. Go back to that relationship in [1] and imagine now that something happens to push up the cost of producing or selling tradable goods. Perhaps productivity 8  in that sector grows less rapidly (relative to that in our trading partners) . Or perhaps tariff and/or non-tariff barriers are imposed on international trade. Either way, if the relative cost of producing or selling tradable 9  output goes up then so must its relative price (Chart 4 ). In effect, the currency falls to help absorb these costs. In doing so it spreads them throughout the economy: even those in the non-traded sector have to work longer to buy the same quantum of imports. 7  Sometimes this point is expressed in terms of the “sustainable” current account deficit but it amounts to the same thing. Cost is inversely related to productivity. 9 Note that a contraction in tradable productivity, which is the denominator in the SNT/ST curve, shifts it to the right.
How they respond is one important determination of economic growth this year. Usually, one of the more positive aspects of an exchange-rate depreciation is that, by raising their profitability, it encourages the expansion of firms in the tradable sector. With the world economy in better health than for some time, there is certainty every incentive to do that today. On this occasion that response might be more muted than usual, however, because it’s not clear how long the sweet spot will last. If the currency market is right the UK’s future trading relationships will be less favourable; if it’s too pessimistic sterling is likely to rebound. Either 2  All speeches are available online at www.bankofengland.co.uk/speeches  2  way, future returns in the tradable sector may not be as healthy as they are right now. This may act as something of a deterrent to longer-term, sunk-cost investments in that sector. In what follows I’ll begin by looking at sterling and what economics has to say about its reaction to the referendum result. I’ll then say something about how depreciations work in small open economies, in particular their impact on profitability and investment in the tradable sector. There’s a short concluding section. Sterling’s response to the EU referendum: some exchange-rate economics So let’s begin with the depreciation and its proximate cause, the outcome of referendum. The link between the two was clear long before the vote itself.