Currency Depreciation and Its Impacts

Topics: Bretton Woods system, Currency, Foreign exchange market Pages: 5 (1945 words) Published: June 20, 2013
Devaluation means decreasing the value of nation's currency relative to gold or the currencies of other nations. Devaluation occurs in terms of all other currencies, but it is best illustrated in the case of only one other currency. Devaluation and Depreciation are sometimes used interchangeably, but they always refer to values in terms of other currencies and the value of currency is determined by the interplay of money supply and money demand. In common modern usage, it specifically implies an official lowering of the value of a country's currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect to a foreign currency. In contrast, (currency) depreciation is most often used for the unofficial decrease in the exchange rate in a floating exchange rate system. Historically, early currencies were typically coins stamped from gold or silver by an issuing authority which certified the weight and purity of the precious metal. A government in need of money and short on precious metal might abruptly lower the weight or purity of the coins without announcing this, or else decree that the new coins had equal value to the old, thus devaluing the currency. Present day currencies are usually fiat currencies with insignificant inherent value. As some countries hold floating exchange rates, others maintain fixed exchange rate policy against the United States dollar or other major currencies. These fixed rates are usually maintained by a combination of legally enforced capital controls or through government trading of foreign currency reserves to manipulate the money supply. Under fixed exchange rates, persistent capital outflows or trade deficits may lead countries to lower or abandon their fixed rate policy, resulting in devaluation (as persistent surpluses and capital inflows may lead them towards revaluation). Devaluation is usually undertaken as a means of correcting a deficit in the balance of payments. Some analyst are of the view that weakening the value of currency could actually be good for the economy—since a weaker currency will boost manufacturing production, which in turn will lift employment and all this will set in motion economic growth and keep the economy going. But the dangers of a falling rupee too quickly, would be that the foreigners will stop investing in the country, which would make it impossible to finance the current account (trade) deficit. It will then be forced to push interest rates up to defend the rupee (crashing rupee stock and bond markets is supposed to make the rupee more valuable), and that could create recession. In an open market, the perception that a devaluation is imminent, may lead speculators to sell the currency in exchange for the country's foreign reserves, increasing pressure on the issuing country to make an actual devaluation. When speculators buy out all of the foreign reserves, a balance of payments crisis occurs. Economists Paul Krugman and Maurice Obstfeld state that the balance of payments crisis occurs when the real exchange rate (exchange rate adjusted for relative price differences between countries) is equal to the nominal exchange rate (the stated rate). In practice, the onset of crisis has typically occurred after the real exchange rate has depreciated below the nominal rate. The reason for this is that speculators do not have perfect information; they sometimes find out that a country foreign reserve are at lower level after the real exchange rate has fallen. In these circumstances, the currency value will fall rapidly. This is what occurred during the 1994 economic crisis in Mexico. Devaluation of a currency was a matter of prestige in the past. However with the lapse of time it has been learnt that such an operation is sometime necessary to save the country from economic hardships. Devaluation is not an enduring way to improve the economy, unless the Government revises its...
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