Devaluation Essay

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Devaluation  occurs  when a government  or its central bank reduces  the official price at which its currency can be bought on the foreign exchange (Forex) market.  For example, suppose  that  the  current  $/£ exchange  rate  was 2:1, meaning  that  two USD had to be given up for each 1GBP or, equivalently, that 1GBP was worth 2 USD. If the GBP were devalued, this would mean that fewer USD had to be exchanged for each GBP, meaning that GBP had become cheaper in dollar terms.

Devaluation  occurs  under  a fixed exchange  rate regime. Under such a regime the government is committed  to a particular  exchange  rate  and  manages its foreign exchange  reserves (holdings of foreign currencies  and gold) to ensure  that  this rate is maintained.  Because a country’s holdings of foreign exchange reserves are closely related to its balance of payments, the extent  to which a government  is able to maintain  a fixed exchange rate is also affected by the balance of payments. For example, a country that has a deficit on its external account would face a positive net supply of its currency as domestic residents seek to pay for their net imports. This, in turn, would place downward  pressure  on the exchange rate and the government  would intervene to defend it by buying its domestic currency on the Forex markets. This mechanism  works in the  opposite  direction  in the case of a revaluation.

The operation  of this balance of payments mechanism can impose severe macroeconomic costs on the country effecting devaluation. Often, devaluation occurs  because  of  persistent   trade  deficits  caused by a country  experiencing  higher  rates  of inflation (or  lower  levels of productivity  growth)  compared to  its trading  partners.  To  overcome  this  problem, one solution  is to impose  contractionary fiscal and monetary  policies to reduce inflation in an effort to restore  international competitiveness.  Such policies can result in significant reductions  in the standard of living for domestic  residents  in the following ways: Reduction in government  expenditure  on education, health, social, and welfare programs. In certain cases, the International Monetary Fund (IMF) requires the imposition  of such  policies  as a pre-condition for international borrowing. In more serious cases, and to  avoid  a conflict  between  external  policy objectives (deficit on external account) and internal policy objectives (low levels of unemployment), countries can devalue their currency. The advantage of devaluation in this case is that by making the currency less expensive, deflationary pressures are subdued.

Historically, countries that have devalued their currencies have suffered relatively lower rates of growth in productivity and this, in turn, has resulted in significant deficits on the external account. A classic example of this situation  was Britain in 1967. It is often the case that heavy international speculation precedes  devaluation.  This  is  because  speculators hope to benefit from purchasing a currency at a lower price and selling it after revaluation. In the preceding example, the Bank of England spent £200 million on November 19, 1967, trying to defend sterling against speculative attack.  Similarly, in a more  recent  British example—the decision to take sterling out of the European  Exchange Rate Mechanism  in 1992—the chancellor  of the exchequer  authorized  the Bank of England to spend billions of pounds trying to defend sterling from speculative attack.

Devaluation can be beneficial for a number of reasons,  especially in the  short  term.  For example, it makes exports relatively cheaper with consequent benefits for the trade balance. In the short  run, it is possible  that  a devaluation  will worsen  the  external account. This is because contracts  agreed before devaluation have to be honored after devaluation, but using a cheaper  currency.  Only in the longer term, when  contracts  are renegotiated  and  when  the  full impact  of the devaluation  on exports  has occurred, will  the   external   account   improve.   Additionally, there  are two other  factors that  can undermine the long-run  benefits from devaluation. The first is that if a country  continues  to have relatively high rates of inflation  (or  relatively low rates  of productivity growth)  after devaluation,  any costs advantage  will quickly be eroded and eventually reversed; this may require another devaluation. Second, and particularly in times of a global recession (for example, during the 1930s), devaluation by one country can trigger a series of competitive devaluations by other countries.

Devaluation can also generate disadvantages. Devaluation increases the costs of imported  goods and can result  in imported  inflation. This imported  inflation can generate  a wage-price spiral as workers demand higher  wages to compensate  for the  higher  costs of imported  products.  These disadvantages  are exacerbated the more dependent  a country  is on imported foodstuffs and energy. A further problem is that devaluation can reduce efforts to improve competitiveness. This is because in the short term devaluation removes the need to lower costs to increase exports; in the long run, if the “breathing space” offered by devaluation is not used to improve productivity, the country will end up with the same problems it had prior to devaluation.

Bibliography: 

  1. Mohsen Bahmani-Oskooee, Scott W. Hegerty, and  Ali M. Kutan,  “Do Nominal  Devaluations Lead to Real Devaluations? Evidence from 89 Countries,” International   Review  of  Economics  &  Finance  (v.17/4, 2008);
  2. Arran Hamilton, “Beyond the Sterling Devaluation: The Gold Crisis of March 1968,” Contemporary European History (v.17, 2008);
  3. G. Lipsey and K. A. Chrystal, Positive Economics, 8th ed. (Oxford  University  Press, 1995);
  4. James R. Owen, Currency Devaluation and Emerging Economy Export Demand (Ashgate, 2005);
  5. Mriduchhanda Paul and Sajal Lahiri “The Effect of Temporary Devaluation on Foreign Investment: A Trade-theoretic Analysis and an Application to Mexico,” Journal of International  Trade & Economic Development (v.17/2, 2008).

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