Q&A: The falling pound

The most dramatic market reaction to the election of Tony Blair to a second term in office has been the fall in the value of the pound. BBC News Online examines the causes and consequences of the sudden drop in sterling.

What has happened to the value of the pound?

The pound has fallen sharply this week on the foreign exchange markets. It reached a 15-year low against the dollar of $1.38 after it became clear that Labour would win a landslide General Election victory.

It has also fallen - but less strongly - against the euro, the single currency used by 12 European countries.

Continuing uncertainties about economic growth in the eurozone countries have kept the euro weak, and limited the extent of the drop.

Why has it dropped so sharply?

The main reason is that the markets now believe it is more likely that the UK will eventually join the single currency, following the overwhelming Labour victory.

If Labour wants to join the euro, it is widely believed that it will want to join at a lower exchange rate, and will have to take action to weaken the pound.

Most analysts - and many business leaders - believe that sterling is currently "over-valued", and locking in the current exchange rate forever with Britain's main trading partners would be disastrous for manufacturing exporters.

And under the official rules for membership in the single currency, the UK would need a period of two years of a lower, stable exchange rates in relation to the euro before it could join.

Why is the pound also falling against the dollar?

Under a single currency, the value of the pound would be fixed against the 12 other currencies in the eurozone.

Sterling would no longer exist as an international currency, and the UK would be subject to the fluctuations of the euro on currency markets.

In the past two years, the euro has fallen by 30% against the dollar - but it is now expected to recover some of those losses.

That means that if Britain was in the eurozone, the UK would also need a lower exchange rate against the dollar in order to avoid making its US exports uncompetitive.

What rate would be good for manufacturing industry?

At the moment, UK manufacturing exports are suffering from the high value of the pound, with many arguing that the UK manufacturing sector is already in recession.

The benchmark for UK exports traditionally was the pound's rate to the Deutschmark - now part of the euro.

Business leaders are widely believed to want an exchange rate of around 2.75 Deutschmarks to the pound, a fall of some 20% from the current value of sterling in relation to the euro and thus the Deutschmark.

But so far, the Bank of England has argued that it cannot target exchange rates as that would undermine its focus on inflation.

What risks are there from a fall in the pound?

There are risks as well as benefits for the UK economy from a fall in the value of the pound.

The UK is a very open economy, with 30% of its GDP generated through trade.

As the value of sterling falls, the cost of imported goods rises - which could cause inflation.

That in turn could make the Bank of England reluctant to cut interest rates further.

Lower interest rates would encourage sterling to fall further, but could boost inflation and borrowing.

At the moment, interest rates in the UK are higher than those in Europe or the United States, tempting some international investors to hold on to their sterling deposits.