How does the exchange rate mechanism affect aggregate demand in the UK?

The exchange rate is defined as the value of one currency against another. Aggregate demand (AD) comprises of consumption, government spending, investment and exports minus imports. 

A fall in the value of a currency will make exports cheaper and imports more expensive. This will cause the volume of exports to rise, which would positivley impact aggregate demand and cause subsequent economic growth. As well as this, AD would shift from imports to domestically produced goods and services, leading to a further rise in imports. 

However, If demand for imports is price inelastic then demand would not fall by as much as the price rise. This would mean the value of imports would rise which would actualy cause a larger withdrawl from the circular flow of income causing AD to fall.

TH
Answered by Tom H. Economics tutor

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