Explain how a depreciation of the pound may cause inflation

AQA A-Level Economics Paper 2 June 2024

Extract C (lines 4–5) states ‘Energy and food bills had risen dramatically due to shocks to the economy, such as labour shortages, a depreciation of the pound…’

With the help of a diagram, explain how a depreciation of the pound may cause inflation. (June 2024)

1. Exchange rates are the price of one currency in terms of another

1. A currency depreciation means that there is a fall in the value of a currency due to market forces.
2. As the pound becomes weaker, UK exports become cheaper and therefore more competitive, so the value of exports increase.
3. Also, imports become more expensive so the value of imports is likely to decrease.
4. As a result, net exports (X-M) is likely to decrease.
5. As this is a component of aggregate demand (AD), AD decreases
6. This means that there is less pressure on firms to produce goods and services.
7. This causes a fall in demand-pull inflationary pressure.

1. Additionally, a weaker pound means that imports are more expensive.
2. This causes firms to pay more for the raw materials that they import.
3. Also, as it becomes more expensive to import oil, energy prices are likely to increase.
4. As costs of production increase, short-run aggregate supply is likely to decrease.
5. This would cause an increase in cost-push inflationary pressure.

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