Devaluation

I INTRODUCTION

Devaluation, in economics, official act reducing the exchange rate at which one currency is exchanged for another in international currency markets. A government may choose to devalue its currency when a chronic imbalance exists in its balance of trade or overall balance of payments, which weakens the international acceptance of the currency as legal tender.

The lowering of a currency value by devaluation occurs when a country has been maintaining a fixed exchange rate relative to other major foreign currencies. When a flexible exchange rate is maintained—that is, currency values are not fixed but are set by market forces—a decline in a currency’s value is known as a depreciation.

II CAUSES

The free-market value of a national currency is determined by the interaction of supply and demand. If the quantity of the currency demanded is greater than the quantity supplied, a nation will experience a balance of payments surplus. A balance of payments deficit exists when the quantity of currency supplied is greater than that in demand.

The demand for a nation’s currency depends on a number of its exports, domestic investments, and assets held in domestic currency. A nation’s currency supply on world markets depends partly on a number of imports, investments abroad, and assets held in foreign countries. Ultimately, the supply of a currency depends on national monetary policy; if a country prints too much money, causing inflation domestically, a balance of payments deficit results.

Under a system of fixed exchange rates, a country can adjust its balance of payments by trading its national currency for foreign currency or gold. If a balance of payments surplus persists, the government may decide to buy more foreign currency or gold in order to move back into equilibrium. Conversely, if a deficit exists, the government may sell some of its reserves of foreign currency or gold in order to bolster the value of its own currency. Because a nation’s reserves of other currencies and gold are limited, the government may choose to correct an imbalance by officially readjusting the value of its currency. Such a devaluation will usually be achieved through a legislative or administrative order. Under a flexible exchange-rate system, alterations in the exchange rate can be made to help a nation achieve equilibrium in its balance of payments.

III EFFECTS

Currency devaluation primarily affects a nation’s trade balance, which is the difference between the value of its exports and that of its imports. Devaluation reduces the value of a nation’s currency in terms of other currencies; thus, following a devaluation, a nation will have to exchange more of its own currency in order to obtain a given amount of foreign currency. This causes the price of imports to rise and makes domestic products more attractive to consumers at home. Because it takes less foreign currency to buy a given amount of a devalued currency, the price of the nation’s exports declines, making them more desirable to foreign consumers.

Depending on consumer and producer responsiveness to price changes (known as supply and demand elasticities), an effective devaluation should reduce a nation’s imports and raise world demand for its exports. Improvement in a country’s balance of trade will cause an increase in the new inflow of foreign currency; this, in turn, may help strengthen a country’s overall balance of payments account.

The total effect of a currency devaluation depends on the actual elasticities of the supply and demand for traded goods. The more elastic the demand for imports and exports, the greater the effect of the devaluation will be on the country’s trade deficits and, therefore, on its balance of payments; the less elastic the demand, the greater the necessary devaluation will be to eliminate a given imbalance.

Devaluation often is criticized as an inflationary monetary policy because it raises the domestic price of exports and imports. The underlying cause of inflation is not devaluation, however, but rather excess money creation. Nonetheless, devaluation is an unpopular policy, especially in small countries that are extremely dependent on imports as a source of food and other necessities.

IV HISTORICAL BACKGROUND

In 1944 the major world powers met at the Bretton Woods Conference to organize an international monetary system that would alleviate many of the foreign-exchange problems created by World War II. The International Monetary Fund, or IMF, was established at the conference primarily to promote currency stabilization, thereby facilitating the growth of world trade. The participating nations agreed to tie the values of major world currencies to the value of the United States dollar, which was determined by the amount of gold the dollar could buy. An agreement was also reached to set upper and lower limits within which exchange-rate fluctuations were permitted in response to market conditions. At the time of the conference, this limit was set by the IMF at 1 percent in either direction. If a country chose to adjust the value of its currency beyond 1 percent, the nation would have to change its currency value officially in terms of US dollars. Although the Bretton Woods agreement enabled countries to raise their currency values, in practice almost all currency changes since then have been devaluations. The British pound sterling, for example, was devalued in 1949 and again in 1967.

In the years following the Bretton Woods agreement, the US dollar emerged as the world’s leading currency. It was used as an alternative to gold when handling international payment imbalances. In a sense, the US dollar functioned as the world’s money because it served as a unit of account, a medium of exchange, and a store of value. Other nations kept large proportions of their international monetary reserves in dollars.

V DEVALUATION OF US CURRENCY

This system functioned well until the mid-1960s when the United States began to have the large balance of payments deficits. The supply of dollars exceeded the demand, and some sources urged the devaluation of the dollar. Because it was the centre of the international monetary system, however, the United States and other nations were reluctant to devalue the dollar.

Eventually, the persistent US balance of payments deficits caused a loss of confidence in the dollar, and on August 15, 1971, US President Richard M. Nixon suspended the convertibility of the dollar into gold. Representatives of the ten major world currencies met in Washington, D. C., in December of that year to revise the system agreed on at the Bretton Woods Conference. The result was the Smithsonian Agreement (1971), which broadened the band within which currencies could be freely adjusted to 2.25 per cent above and below the legal value of the currency. Following this agreement, the United States devalued the dollar by 8 percent and the value of the British pound sterling was again adjusted.

Because the price of US imports and exports was relatively inelastic, the dollar devaluation of 1971 did not have an immediate positive impact on the trade balance. The US trade balance actually declined from -$2.3 billion in 1971 to -$6.4 billion in 1972. At the same time, the government was conducting an overly expansionary monetary policy so that the US money supply increased by historic proportions. These forces again put pressure on the value of the dollar, and it had to be devalued by an additional 10 percent in February 1973. The nation reported a trade surplus in 1973, but the sharp rise in oil prices late that year had a major effect on the US trade balance throughout the remainder of the decade. Beginning in 1973 the US actively promoted a policy of flexible exchange rates under which currency values are determined by the interactions of supply and demand. This brought the end of the Bretton Woods system.

Under this system of free-floating exchange rates it is estimated that, between June 1980 and March 1985, the US dollar rose about 100 percent against the currencies often leading industrial nations. The rise in the dollar eventually contributed to an immense US trade deficit. In September 1985, representatives of Great Britain, West Germany (now part of the united Federal Republic of Germany), France, Japan, and the United States agreed to work together to bring down the value of the dollar; within a year the dollar had declined in value about 40 percent against the West German mark and over 50 percent against the Japanese yen.

The next attempt to formulate a fixed exchange rate system, the European Exchange Rate Mechanism between members of the European Community (now the European Union), collapsed under attack from financial speculators in September 1992. By leaving the system, Italy and Great Britain accepted devaluations of their currencies, which speculators had taken to be artificially overvalued; concerted intervention by central banks worldwide had failed to raise the values of the currencies. No further attempt has been made since then to institute a strict fixed exchange rate system.

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