Devaluation

In modern monetary policy, a devaluation is an official lowering of the value of a country's currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect to a foreign reference currency or currency basket. In contrast, a depreciation is a decrease in a currency's value (relative to other major currency benchmarks) due to market forces under a floating exchange rate, not government or central bank policy actions.

A central bank maintains a fixed value of its currency by standing ready to buy or sell foreign currency with its own currency at a stated rate; a devaluation is a change in this stated rate that renders the foreign currency more expensive in terms of the home currency.

The opposite of devaluation, a change in the fixed rate making the foreign currency less expensive, is called a revaluation.

Related but distinct concepts include inflation, which is a market-determined decline in the value of the currency in terms of goods and services (related to its purchasing power). Altering the face value of a currency without reducing its exchange rate is a redenomination, not a devaluation or revaluation.

Historical usage

Devaluation is most often used in a situation where a currency has a defined value relative to the baseline. Historically, early currencies were typically coins struck from gold or silver by an issuing authority which certified the weight and purity of the precious metal. A government in need of money and short on precious metals might decrease the weight or purity of the coins without any announcement, or else decree that the new coins have equal value to the old, thus devaluing the currency.

Later, with the issuing of paper currency as opposed to coins, governments decreed them to be redeemable for gold or silver (a gold standard). Again, a government short on gold or silver might devalue by decreeing a reduction in the currency's redemption value, reducing the value of everyone's holdings.

In modern economies

Harold Wilson infamously declared that although the British pound would be worth a lower amount abroad it would still be worth as much at home.^[1]

China devalued its currency twice within two days by 1.9% and 1% in July 2015. India devalued its currency by 35% in 1977.^[2]

Causes

Fixed exchange rates are usually maintained by a combination of legally enforced capital controls and the central bank standing ready to purchase or sell domestic currency in exchange for foreign currency. Under fixed exchange rates, persistent capital outflows or trade deficits will involve the central bank using its foreign exchange reserves to buy domestic currency, to prop up demand for the domestic currency and thus to prop up its value. However, this activity is limited by the amount of foreign currency reserves the central bank owns; the prospect of running out of these reserves and having to abandon this process may lead a central bank to devalue its currency in order to stop the foreign currency outflows.

In an open market, the perception that a devaluation is imminent may lead speculators to sell the currency in exchange for the country's foreign reserves, increasing pressure on the issuing country to make an actual devaluation. When speculators buy out all of the foreign reserves, a balance of payments crisis occurs. Economists Paul Krugman and Maurice Obstfeld present a theoretical model in which they state that the balance of payments crisis occurs when the real exchange rate (exchange rate adjusted for relative price differences between countries) is equal to the nominal exchange rate (the stated rate).^[3] In practice, the onset of crisis has typically occurred after the real exchange rate has depreciated below the nominal rate. The reason for this is that speculators do not have perfect information; they sometimes find out that a country is low on foreign reserves well after the real exchange rate has fallen. In these circumstances, the currency value will fall very far very rapidly. This is what occurred during the 1994 economic crisis in Mexico.

Effects

After a devaluation, the new lower value of the domestic currency will make it less expensive for foreign consumers to obtain local currency with which to buy locally produced export goods, so more exports will be sold, helping domestic businesses. Further, the new exchange rate will make it more expensive for local consumers to obtain foreign currency with which to import foreign goods, hurting domestic consumers and causing less to be imported. The combined effect will be to reduce or eliminate the previous net outflow of foreign currency reserves from the central bank, so if the devaluation has been to a great enough extent the new exchange rate will be maintainable without foreign currency reserves being depleted any further.

See also

References

External links

• Economics A-Z