Terms Beginning With 'd'

Devaluation

  • January 11, 2020
  • Team Kalkine

What is Meant by Devaluation?

Devaluation refers to the act of deliberately decreasing the value of the domestic currency with respect to the currency of a trading partner. It is different from depreciation in the sense that it is done on purpose by the domestic monetary authority. The opposite of devaluation is revaluation, where the value of the domestic currency is deliberately increased.

Countries having a fixed exchange rate system, or a semi-fixed exchange rate system can use devaluation. The decision to devalue or revalue the currency is taken by the central bank of a country or the monetary policy authority.

How do Countries Devalue their Domestic Currency?

Consider the following example showing the determination of the exchange rate of Dollar in terms of Euro. In other words, the exchange rate here represents the Dollar-Euro exchange rate. The supply of Euro refers to the quantity of Euro available as foreign exchange, while the demand for the Euro reflects its demand in the domestic country.

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Considering the above diagram, the supply of Euro in the economy is increasing, while the demand for Euro remains the same. As more and more units of Euro are accumulated as foreign exchange, Euro depreciates while Dollar appreciates.

Now consider the following example when the domestic demand for Euro rises. Here the increased demand for Euro leads to Dollar depreciating with Euro appreciating. Thus, the Dollar-Euro exchange rate rises.

Therefore, it is possible to change the value of the domestic currency with respect to foreign currency by changing the supply of foreign exchange reserves of the latter. This method is used by central banks of various countries to devalue or revalue their domestic currency.

If the current exchange rate is maintained at 2:1, then the home country can just announce that the value of the domestic currency will be devalued to 10:1. This further decreases the value of the domestic currency.

Why do Countries Decide to Devalue their Currency?

Devaluing domestic currency decreases its value with respect to a foreign currency. This means that if previously, 20 Dollars could be bought in exchange for 1 unit of the domestic currency, after devaluation, one unit of domestic currency would be equal to less than 20 Dollars.

Devaluation is a quick and risky way for countries to come out of debt. It is also done to boost exports, as the domestic goods become relatively cheaper as compared to the goods of the trading partner. Further, it makes imports more expensive, as the foreign currency seems to have gained value with respect to domestic currency. This urges domestic consumers to prefer domestic goods instead of imports.

As imports fall and exports rise, the current account strengthens and deficits in the Balance of Payments can be recovered. Moreover, devaluation allows countries to make the domestic products competitive with respect to foreign produce. It offers an edge over internal devaluation which relies on implementing a deflationary policy.

These advantages offered by devaluation can be misused by countries as they try to reduce the debt burden on them.

As countries usually borrow from each other, the amount of interest that they must repay to the lenders depends not only on the interest rate but also on the foreign exchange rate. As the domestic currency becomes cheaper, the foreign country can repay a larger amount of debt with the same amount of foreign currency.

For instance, as the USD becomes cheaper, the European nation can repay a larger amount of debt with the same amount of foreign currency.

What are the Challenges Faced by the Economies which Devalue their Currency?

  • Inflation: The biggest issue that arises because of devaluation is inflation. As the aggregate demand increases in the economy because goods become cheaper, demand-pull inflation takes its course. This may also lead to lack of productivity in firms as they enjoy price competitiveness due to devalued currency.
  • Travel: Foreign travel is hampered as it becomes relatively more expensive to go on a foreign tour. This may affect the tourism industry in the home country along with the foreign country.
  • Real Income: Inflation and devaluation both reduce the purchasing power of domestic consumers.
  • Investment: Foreign investors would be wary of depositing funds in the home country as they would not enjoy the same amount of returns as before.

How should Devaluation be Implemented?

Under tight circumstances when a boost to aggregate output is much needed, then devaluation can be implemented. However, an economy that sees prolonged devaluation can be an underperforming economy.

Devaluation is used as a regulation tool; however, if it is misused by one country, other countries might be tempted to retaliate. This could lead to a trade war, which would further be a threat to global economic growth. International asset market would take a hit, and it may lead to a global recession.

The Year 2019 observed escalation of a trade war between the US and China. To Read More on the US-China Trade War, Click Here!

The devaluation could prove to be more harmful than beneficial as it can cripple the domestic markets. Thus, implementing it for a short period of time could be a good solution; however, in the long run, other alternatives should be adopted.

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