The Reltaionship Between Devaluation and Inflation

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A devaluation leads to a decline in the value of a currency making exports more competitive and imports more expensive. Inflation occurs when there is an increase in the general price level. A devaluation could cause inflation for 3 reasons.

Firstly, there is likely to be an increase in AD. AD = C+I+G+X-M, Therefore if exports are cheaper will be more exports sold , imports will fall. If the economy is close to full capacity then higher AD will cause inflation.

Diagram: Demand Pull inflation

However, increased AD may not cause inflation it depends on various factors:

a) If the economy is in recession and there is spare capacity there will not be inflation b) IF other components of AD are not increasing (e.g. consumer spending is low) then there is unlikely to be demand pull inflation. (X-M is not the biggest component of AD) c) Also if exports are cheaper then the effect on AD depends upon the elasticity of demand. IF demand is inelastic there will only be a small increase in Quantity and there could be a fall in the value of exports (Marshall Lerner condition states devaluation only increases AD if PEDx + PEDm >1) Secondly, if there is a devaluation then there will be an increase in the price of imported goods. Imports are quite a significant part of the RPI, therefore there will be cost push inflation. However it is possible that retailers may not pass the price increases onto consumers but have lower profit margins.

Thirdly, if there is a devaluation exports become less competitive without firms having to make much effort, therefore there is less incentive for them to cut costs and therefore in the long run costs will increase and therefore inflation will increase. However this may not occur if firms are well run

The UK devalued its currency quite significantly in 1992 when it left the ERM however it didn't cause inflation. This was because the economy was in a recession and there was a lot of spare capacity. This shows there are...
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