If, for as long as it lasts, financing the deficit 5  The word “relatively” is important here – what matters is the behaviour of domestic demand compared with that in other countries. If demand weakens in other countries the home country’s exchange rate will still appreciate even if nothing happens to domestic savings rates. [More here on global imbalances] 6 For a thorough treatment of the relationship between imbalances and the exchange rate – and specifically the chain of causation running from the former to the latter – see Obstfeld and Rogoff (2000), Obstfeld and Rogoff (2007). 5  All speeches are available online at www.bankofengland.co.uk/speeches  5  relies on “the kindness of strangers” (as the Governor once described it) perhaps the foreign exchange market thinks those strangers will be less generous to a UK outside the EU. International capital markets might require a higher premium for sterling finance. If so, this would slow the growth of domestic demand 7  that much earlier, accelerate a rebalancing of the economy and depress the fair value of the exchange rate . While possible in principle, I’m not convinced this is the main explanation for sterling’s reaction to the referendum result. The currency has remained weak even in the face of robust consumption growth since that date.
We know too that 11  export prices rose strongly last year, much faster than those of domestic-facing firms . At a rough guess, and relative to that in the non-traded sector, this will have pushed up the rate of return in the 12  traded sector by 2-3 percentage points .   Second – and this is in sharp contrast to the early 1990s – there is only limited spare capacity in the economy, including in its more tradable sectors (Chart 10 again). One would certainly expect net export volumes to improve this year. But one would also expect a greater share of the response to the depreciation, compared with the early 1990s, to come via stronger investment, less of it from  11  While export prices rose 12% in the year to 2016Q4, gross output prices across the economy as a whole, excluding the government sector, rose by around 4½% (by gross I mean including the cost of imports). With exports worth around one quarter of gross output, this would imply output-price inflation in the rest of the economy of less than 2%. 12 Higher prices boost profits, and disproportionately so, given the operational gearing. On the other hand exporting firms will also be paying more for their imports, on which they rely more than others. To work out the overall impact on profits you need to net out the extra cost of imports.