In other words it’s a matter of supply not demand. Chart 6 gives a stylised description. In a competitive market the demand curve facing an individual firm (and those in a relatively small country) is essentially flat. Domestic events don’t have much effect on the global price. When the currency falls, pushing up prices and profits of outward-facing firms, the response of export volumes depends on the slope of the supply curve: to what extent do firms in the tradable sector have the capacity to raise output and, where that is insufficient, the willingness to invest in more? Chart 6: For a small open economy tradable demand is highly elastic  Chart 7: Depreciations push up the sterling price of goods exports as well as those of imports  Source: ONS and Thomson Reuters Datastream. * excluding oil and erratics. 8  All speeches are available online at www.bankofengland.co.uk/speeches  8  Now commodities may be an extreme case. They’re essentially homogenous – one country’s output is much like another’s. But even in non-commodity goods markets you find a similar pattern. The UK is relatively small, accounting for only 3% of international goods trade (even including oil). Many UK firms are to a significant extent “price takers” in international markets. And you can see from Chart 7 the close correlation between the sterling price of the UK’s (non-oil) goods exports and the exchange rate. The reaction is a bit less than one-for-one but in general no less marked than that of import prices.
First, if the market has misjudged the risks – if the UK emerges from this as open an economy as it is today, or more so – one imagines the exchange rate will re-appreciate, all else equal. I’ll come back to the significance of this point later on. Second, the weaker exchange rate is acting on an economy whose trading relationships are for the time being quite unchanged. As yet Brexit has done nothing directly to affect the UK’s openness because Brexit hasn’t happened. The MPC is always keen to caution against treating a change in asset prices as some independent, “exogenous” event, without considering its underlying cause. This case is a bit special, however: in this instance the cause has yet to occur. We’ve had the reaction in asset prices well ahead of the event. In that sense it’s more independent than usual. And what’s striking about this is that economists usually view independent depreciations in the exchange rate as expansionary rather than contractionary. Yes, they dent real household incomes and therefore consumer spending. But the usual view is that this negative effect is compensated, indeed outweighed, by positive effects on other areas of spending, net exports and investment. With the additional tailwind of a strengthening world economy you might expect most forecasters to have predicted faster economic growth following sterling’s decline. Yet the opposite is true: after 2% through 2016 (in the year to Q4), the consensus forecast is that UK GDP growth will slow to 1.2% through this year.