No country in the world wants its national currency to lose value against foreign countries. However, some situations may make devaluation necessary for the economic recovery of the country. If the total imports in a country’s economy are higher than the exports, it means that there is a foreign trade deficit.
In such a case, the purchasing power of the country is weakened and exports are increased and imports are decreased. With the decrease in the value of the country’s currency against other currencies, the purchasing power decreases and the price of imported goods increases. The price of the products that the country will export to foreign countries will decrease. Thus, an increase in export revenues and a decrease in import expenditures are aimed to bring the budget into balance.
What is Devaluation? What is the Definition of Devaluation?
It is an action that occurs in the economy of a country and gives a deficit in payments on the fixed exchange rate system. In short, it can be defined as the depreciation of a country that is subject to devaluation over the official currency of other countries.
What Happens If There Is a Devaluation?
The act of devaluation arises from the political conflicts experienced within the country, the import level of that country is higher than the export rate, and the depreciation of domestic capital against foreign currencies. Due to all these and similar generalizations, the foreign trade deficit grows. Devaluation is also known as the depreciation of a country’s currency against foreign governments.
When the country devalues its own currency, it devalues it at the rate it lowers. The devalued national currency changes the course of the state’s macro-economy. Internal and external purchasing power is reflected in exchange rates.
As a result of this situation, the effects of devaluation will also increase. First of all, imports are handled at an expensive price, while exports are handled at a more affordable price. On the other hand, inflation values increase and the current account deficit decreases further. The country’s economy slows down and interest rates are therefore reflected in even higher rates.
How does Devaluate Happen?
In countries that implement a fixed exchange rate regime, the governments of the countries determines the value of the national currency. When the country’s government decides to reduce the official value of the national currency against foreign currencies for various reasons such as high current account deficit and the like, the central bank of that country usually lowers the official value of the national currency against the US dollar or EURO by a certain percentage and fixes it there. Until the next devaluation, all official transactions are based on the new parity announced by the central bank of the state.
Why is Devaluation Done?
In countries where the current account deficit is generally high, when sufficient foreign currency inflows cannot be provided to finance the current account deficit through exports, foreign investment and capital inflows. There is upward pressure on exchange rates.
With devaluation, it is aimed that imports become more expensive and foreign exchange outflows fall, exports become attractive and foreign exchange inflows increase, thereby reducing the foreign trade deficit and attracting foreign investors to the country by the cheaper asset prices in foreign currency. The increase in exports and the devaluation of the national currency against the currency of foreign countries increase the competitiveness of exported goods.
Reducing the foreign trade deficit reduces the demand for more expensive imported products, as the purchasing power of the national currency against foreign currencies decreases in devaluation. Thus, an increase in exports and a decrease in imports cause a decrease in the foreign trade deficit.
As a result of reducing the demand for foreign currency, decreasing imports and increasing exports; as well as cheaper asset prices encouraging foreign capital inflows, the demand for foreign currency due to financing the current account deficit decreases. Demand-driven price rise can be relatively balanced by reducing inflation. And the pressure on the exchange rate caused by the current account deficit that cannot be financed.
Devaluation in Past History
The act of devaluation takes a long way from the past to the present. The model it represented on the Ancient Greek and Roman Empire in history was known as the decrease in the amount of metal used instead of money. The amount of coins multiplied by the gold or silver amounts was considered as an indication of the decrease in the value of money. The increase in the amount of paper money in the nineteenth century caused a devaluation on inflation.
Today, the term devaluation is expressed as a deficit in the balance of payments that a government lives in at a fixed rate. In other words, devaluation means the depreciation of the currency level of any state by other countries. In response to such an event, a country with a deficit in payments tries to reduce its purchasing power through foreign states.
With the decisions taken by the government, the price range of imported goods becomes more expensive. And this situation remains in a low range for domestic goods. Every government ties to put in a way all economic functions. Such as the stable progress of the exchange rates or the desire to apply the fixed exchange rate system.
What are the Advantages of Devaluation?
It is possible to explain the advantages of devaluations in a few enties.
- When devalued, exports become cheaper and more competitive for foreign buyers. It thus provides a boost to domestic demand and can lead to job creation in the export sector.
- A higher level of exports should lead to an improvement in the current account deficit. This is important if the country has a large current account deficit due to its lack of competitiveness.
- High exports and current demand can lead to higher economic growth rates.
- Devaluation is a way to regain competitiveness. Internal devaluation relies on deflationary policies to lower prices by reducing aggregate demand. Devaluation can restore competitiveness without reducing aggregate demand.
In addition, with the decision to devalue the currency of the countries; the central bank can lower the interest rates as it no longer needs to support the currency with high interest rates.
What are the Disadvantages of Devaluation?
Devaluation is likely to cause inflation because:
- Imports will be more expensive (the price of any imported goods or raw materials will increase)
- Aggregate Demand increases and causes demand inflation.
- Firms/exporters have less incentive to cut costs as they can rely on devaluation to increase their competitiveness. The concern is that long-term devaluation could lead to lower productivity due to a drop in incentives.
In addition to these, it reduces the purchasing power of citizens abroad. For example, going on vacation abroad is more expensive. For these reasons, governments have heavy responsibilities when there is devaluation in economy.