Trade Gap and QE

Two bits of news today relating to the macroeconomy; first the Bank of England is extending Quantitative Easing (QE), its programme of pumping more money into the economy, by £50bn. Second, the UK's trade deficit has fallen to its lowest level since 2003.

On the first, QE is an attempt by the Bank of England to stimulate the economy. This works in the way we discussed in lectures last week, as the Bank prints new money and uses it to buy government bonds and other types of assets from banks. This turns assets the banks have into liquid form, ready to be used to provide cheaper credit to the wider economy via loans. In doing this now for a number of years, the Bank has amassed a balance sheet on a monumental scale - the assets its procured are equivalent to over 20% of UK GDP (national output).

We're going to discuss much more about monetary policy later in term, but QE is not part of conventional monetary policy; the Bank of England in normal times would make use of the interest rate to influence the economy, yet currently interest rates are as low as they can practically go (we can't have negative nominal interest rates as that would imply banks deducting money from savings accounts and paying borrowers to borrow). So in an attempt to still influence the economy, it has embarked on QE.

Turning to the trade deficit, this is the balance of goods and services, or our exports of goods and services minus our imports of them. For many years now the UK has run a substantial trade deficit, importing more than it exports. Theoretically, this ought to lead to a depreciation in the pound since there's less demand for pounds, and we supply them to buy imports in foreign currency. However, that analysis doesn't include demands and supplies of pounds from the financial sector and so despite this trade deficit, the pound hasn't depreciated. In fact, it only had one, substantial depreciation in the entire period, which was at the time of the financial crisis, in 2007-08, when the pound lost 25% of its value against its major trading partners.

Such a dramatic devaluation would be expected to have impacted trade since it makes imports for us more expensive, and exports less expensive, yet for a long time there was no pick up in UK trade - the deficit remained large. This could have been because of a lack of overseas (eurozone) demand for our goods, it could have been because our exports are produced with many imported inputs, or that the price elasticity of our imports is low, or for a whole host of other reasons.

Either way, it appears that at long last, the effect of that devaluation may be filtering through. That or we're just spending less as well as those elsewhere spending less.