Posted in Finance, Accounting and Economics Terms, Total Reads: 344
Devaluation of currency is defined as the decrease in currency value with respect to gold or another foreign currency. It can be explained as the deliberate downward adjustment of the currency rate. The result of devaluation can be observed by the shift of demand of foreign goods to domestic goods.
Devaluation is done by Government which follows fixed exchange rate system due to market pressures. Under a floating exchange rate system, the market demand and supply decide the exchange rate and due to changes in monetary and fiscal policies, the situation in the country can be monitored.
Consider an example where the Hong Kong government (which has a fixed exchange rate pegged to US Dollar) has set its currency of 15 units equivalent to 1 USD. In order to devaluate, the Government might set its currency to 25 units equal to 1 USD. This will make the domestic currency equal to half that of US, and US dollar becomes twice as expensive as the domestic currency. Revaluation means an upward adjustment in currency i.e. 1 USD= 10 Hong Kong Dollar
Effects of Devaluation:
• Current account balance increases and in turn balance of payments shows a surplus
• Exports become cheaper because the currency value has reduced in the foreign market
• Imports become more expensive and imports decrease
• The Aggregate demand increases and might cause economic growth and reduce unemployment
• Inflation might increase because costly imports cause cost push inflation. Also, demand pull inflation might occur due to higher aggregate demand
Causes of Currency Devaluation:
When the Government is unable to defend the exchange rate it has fixed, it decreases the value. To sustain the exchange rate, there must be sufficient foreign currency reserves and the ability to spend it.