While devaluation is a well-known monetary policy instrument, many are little aware its most apparent effects. Discover the main reasons why a country or currency area might to resort to devaluation, as well as its major consequences.
Devaluation is described as a deliberate reduction in the value of one currency relative to others. It is a tool used by the monetary authority or central bank of a particular country or currency area.
While the devaluation of a currency offers certain advantages for the country involved, such as more price-competitive exports, it is not without risk.
But what are the main risks involved? And what is the difference between currency devaluation and currency depreciation?
Are devaluation and depreciation the same thing?
Contrary to devaluation, depreciation is not intentional. Rather, depreciation refers to a decline in a currency’s value due to adverse economic developments. It results from phenomena that are quite simply beyond the control of the state or monetary authority concerned.
On the other hand, devaluation is a monetary policy tool deliberately used in fixed or semi-fixed exchange rate systems. Under such regimes, the exchange rate is pegged to a reference or pivot of some kind, usually made up of a currency, a basket of currencies or a commodity, such as gold for example.
In floating (or flexible) exchange rate regimes, the value of a currency fluctuates freely in accordance with supply and demand on the foreign exchange market, and intervention is limited.
What are the major advantages of devaluation?
There are many reasons for currency devaluation. As an instrument, its main objective is to reduce a trade deficit through the promotion of exports. Another advantage is that it sometimes leads to higher wages.
Main advantages of devaluation:
- More competitive exports
A weaker currency leads to a drop in the price of exported products. The quantity of products sold abroad increases as these products become more affordable to a greater number of consumers overseas.
- Lower trade deficit
As exported products become cheaper, foreign demand for these products increases. The volume of imported products, which are now more expensive, falls, along with the country’s trade deficit.
- Wage increases
Since devaluation causes an increase in the price of imported products, wages are often increased in order to improve the purchasing power of consumers and limit the impact of inflation.
Did you know?In 1967, the British government decided to devalue the pound sterling, then pegged to the US dollar, in accordance with the prevailing fixed exchange rate regime of the era. The cabinet of Harold Wilson, initially reluctant to take such action, ultimately gave in to pressures caused by a burgeoning trade deficit and the United Kingdom’s poor economic performance. As a result, between 1966 and 1968, the UK’s year-on-year GDP growth went from 1.6% to 5.4% and inflation reached 4.65%.
What are the major disadvantages of devaluation?
Devaluation can present significant drawbacks, ranging from more expensive imports to higher inflation, as well as a decline in local consumer purchasing power. It can also result in less efficient and less competitive domestic industries in the medium term.
Main disadvantages of devaluation:
- More expensive imports
The price of imports increases, leading to a rise in the consumption of local products, but consumer purchasing power decreases on the whole.
- Rising inflation
The combination of pricier imports and increased foreign demand for exports leads to inflationary pressures. Overall, domestic consumption may decline.
- Less competitive local industries
Local industries are supported by the higher price of imported products. As there is less external competition, some industries are likely to become less productive and less efficient in the medium term.
Did you know?In 1998, Russia’s rising interest rates and increased capital outflow stoked fears of a devaluation of the rouble and a default on the country’s debt. In August of the same year, Russia’s stock, bond and currency markets collapsed. To limit the damage, the government undertook a series of measures, including the devaluation of the rouble. As a result, the inflation rate reached 27.6% in 1998, before rising to 85.7% in 1999.
Devaluation, unlike depreciation, is a voluntary decrease in the value of one currency relative to others. It is a well-known monetary policy tool, but the extent of its advantages and disadvantages is sometimes glossed over.
The main advantage of devaluation is to make the exports of a country or currency area more competitive, as they become cheaper to purchase as a result. This can increase external demand and reduce the trade deficit. Conversely, devaluation makes imported products more expensive and stimulates inflation. Purchasing power and domestic consumption may suffer.
It is important to note that devaluation is a technique adopted by central banks or monetary authorities in fixed or semi-fixed exchange rate regimes. In floating (or flexible) exchange rate regimes, these institutions tend to limit their interventions since the value of their currencies fluctuates on the foreign exchange market in accordance with supply and demand.