Devaluation of Currency
What is devaluation of a currency?
It refers to decline in value of a currency with respect to other currencies, which is most of the times brought by central bank. It should not be confused with term depreciation of currency which is a decline in currency value due to market forces without interference of government.
When does this happen and how?
This happens mostly in developing countries which don’t allow currency prices to be determined by market forces. What happens is that they want to avoid financial crisis, for which they adopt policies to maintain a stable exchange rate to minimize exchange rate risk and save their gold (foreign currency) reserves. Restrictions placed are either trade barriers or financial. Financial restrictions are on flow of assets or money across border which is associated with policy of fixed exchange rate or managed exchange rate. The nation will be forced to devalue its currency if its market is too weak to justify the exchange rate. Example a country has depleted foreign reserves and is not credit worthy to borrow from IMF then it has to pay for its imports by devaluation. When currency is overvalued or a country wants to reduce trade deficit then devaluation is used as a policy tool.
Advantages of Devaluation
One of the major advantages of devaluation is increased exports and reduced imports which in turn result in economic growth of the country. Let me explain now how this happens. As central bank announces loosening of monetary policy, participants in foreign exchange market start selling domestic currency leading to depreciation. As a result producers who want to export their products start producing more and start approaching commercial banks which due to loosening of monetary policy are happy to extend credit at lower interest rate. The fall in exchange rate leads to increased competitiveness at international level. Due to fall in value of currency imports become expensive and thus are reduced while exports are
It refers to decline in value of a currency with respect to other currencies, which is most of the times brought by central bank. It should not be confused with term depreciation of currency which is a decline in currency value due to market forces without interference of government.
When does this happen and how?
This happens mostly in developing countries which don’t allow currency prices to be determined by market forces. What happens is that they want to avoid financial crisis, for which they adopt policies to maintain a stable exchange rate to minimize exchange rate risk and save their gold (foreign currency) reserves. Restrictions placed are either trade barriers or financial. Financial restrictions are on flow of assets or money across border which is associated with policy of fixed exchange rate or managed exchange rate. The nation will be forced to devalue its currency if its market is too weak to justify the exchange rate. Example a country has depleted foreign reserves and is not credit worthy to borrow from IMF then it has to pay for its imports by devaluation. When currency is overvalued or a country wants to reduce trade deficit then devaluation is used as a policy tool.
Advantages of Devaluation
One of the major advantages of devaluation is increased exports and reduced imports which in turn result in economic growth of the country. Let me explain now how this happens. As central bank announces loosening of monetary policy, participants in foreign exchange market start selling domestic currency leading to depreciation. As a result producers who want to export their products start producing more and start approaching commercial banks which due to loosening of monetary policy are happy to extend credit at lower interest rate. The fall in exchange rate leads to increased competitiveness at international level. Due to fall in value of currency imports become expensive and thus are reduced while exports are