Devaluation and Revaluation

Devaluation and Revaluation of Currency: Fixed Exchange Rate

There are two main regimes that governments can adopt to cope with the exchange rate. One is a floating exchange rate, which is what is used in some countries like the United States, Canada, or Britain. The floating exchange rate adjusts itself with the market without direct government intervention. The other is a fixed exchange rate, where the government sets the exchange rate, or pegs it, at a certain value of a foreign currency. This scenario is where we get devaluation and revaluation of a currency from.

In Figures 1 and 2, the Chinese Yuan is fixed to the U.S. Dollar. By doing this, the Chinese government is intervening in the exchange market and preventing it from reaching its market equilibrium (E). It can help to think of a fixed exchange rate as a price floor or price ceiling.

In Figure 1, there is a surplus of Yuan in the market and the Chinese government will want to prevent the price of Yuan from falling. To do this, they can buy up Yuan and sell U.S. dollars.

In Figure 2, there is a shortage of Yuan which would push the price up. To prevent this price increase, the Chinese government would sell Yuan and buy U.S. dollars.

Although having a fixed exchange rate sounds rather set and unchanging, this is not necessarily the case. A fixed exchange regime sets a target rate at which the currency will be pegged. This benefits the country whose exchange rate is fixed because it stabilizes the price of its goods to the other countries and can make them appear more or less expensive. However, sometimes adjustments need to be made. The target exchange rate can be changed to best meet the needs of the nation's economy.

Devaluation of currency examples

A country may choose to devalue its currency for several reasons. If it wants its goods to appear more competitive to the international market, or it wants to avoid a trade deficit.

Pros of currency devaluation

When a country's currency is weaker, its goods appear cheaper to foreign currency holders. This will increase domestic exports because the country will appear more competitive in terms of price in comparison to those with stronger currencies. This increase in exports presents an improvement in the balance of payments on the nation's current account. This is a benefit because it may be an indicator of a trade surplus and an injection into the nation's economy spurring economic growth.

A trade surplus occurs when a nation's net exports are greater than its net imports. If a country is experiencing a large trade deficit, meaning it imports more goods than it exports, it can devalue its currency by increasing the target exchange rate.

If a nation has a lot of government debt at a fixed interest rate, then devaluing the currency could make the repayment of the debt cheaper in the long run.

Cons of currency devaluation

Devaluation is not without its risks. It can cause foreign imports to appear more expensive on domestic markets, and decrease purchasing power in foreign markets. This can encourage domestic consumption but that is not always possible if some goods simply are not available domestically. Then we see both cost-push and demand-pull inflation. To control inflation, the government might increase interest rates to decrease the supply of currency.

Devaluation can also demotivate domestic producers to improve efficiency since they know they can rely on devaluation to keep them competitive in their markets. This would make them less cost-effective in the future and could set them back on technological advancements.

Revaluation of currency example

A currency revaluation, although less common than devaluation, can be a response to a couple of things. One is the interest rate, another is when changes in the foreign market affect how competitive a nation is in international trade, or a change in leadership can cause political shifts that affect a market and its perceived stability.

Pros of currency revaluation

The benefit of revaluing a currency is that it makes foreign goods less expensive on the domestic market. This allows domestic consumers to purchase off the foreign market, diversify their consumption and hold more foreign assets. It also encourages domestic producers' cost efficiency in order to remain competitive in foreign markets.

Cons of currency revaluation

Revaluing a currency could hurt a country's exports because its goods become relatively more expensive to foreign markets. This appears as a deterioration in the balance of payments in a nation's current account.

Devaluation and Revaluation as Tools of Monetary Policy

Adjustments of the exchange rate, like its devaluation and revaluation, are usually performed by a nation's monetary authority like its central bank which is controlled by its government.

Devaluation can be used as a tool for monetary policy as a way to control aggregate demand. Aggregate demand for domestically produced goods increases when the currency is devalued because of the increase in exports and decrease in imports. This increase in aggregate demand for domestically produced goods will help reduce the chance of a recession and will help reduce any recessionary gap that the nation's economy may be experiencing.

The opposite occurs when a currency experiences revaluation. Aggregate demand will fall due to the increase in imports and the fall in exports which will encourage any inflationary gap to shrink.

Impacts of Currency Devaluation and Revaluation on International Trade

Devaluation and revaluation both impact international trade because of how they affect the relative prices of goods. When a weak currency is fixed to a stronger currency it has more stability and it is more competitive in terms of price because its goods appear cheaper in foreign markets making it more appealing. Most consumers will look for the best price to purchase their goods so if they can import goods from another country to increase their own profits they will.