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Prepared by Ben Hunt. A more detailed version of this paper is forthcoming as an IMF Working Paper.
The appreciation of the U.K. real effective exchange rate reflects the absolute levels of trade from emerging Asia. Although as a percent of GDP, imports from emerging Asia are larger in the United Kingdom than in either the United States or the Euro area, the levels of imports from emerging Asia are significantly larger in the United Sates and the Euro area. Consequently, to ensure that current accounts are sustainable in the long run, emerging Asian currencies must appreciate more relative to the dollar and the Euro than the pound. The pound, although it also depreciates relative to emerging Asian currencies, appreciates sufficiently against the Euro and the dollar to more than offset the effect in the real effective exchange rate.
To construct these charts, the impact of a smaller exchange rate appreciation than seen historically was scaled up and added to the simulation combining all the other factors. This was necessary since it was not possible to solve the model with an exchange rate appreciation shock as large as occurred historically.