The Cause and Impact of Currency Devaluation

The official reduction in the value of a country’s currency within the system of fixed exchange rate is termed as devaluation. Following the devaluation a new fixed rate is established for the country taking a foreign currency as reference.

Here are the impacts that result from devaluation.

  1. Cheap exports
  • A decline in the currency value implies that the foreigners who import items from your country will be able to buy it at cheaper and more competitive rates.
  • The increase in affordability can also result in an increase in the demand of exports.
  1. Expensive imports

With depreciation in the currency of your country, imports will become more expensive and will probably suffer a setback in terms of demand.

  1. Increased AD (Assuming Demand)
  • With devaluation, there is an increase in the demand for exports and decrease in the demand for imports.
  • This leads to higher economic growth causing an increase in AD.
  • An increase in AD might result in higher Real GDP and inflation.
  1. Inflation

The factors that lead to inflation include

  • Expensive imports
  • Rise in AD
  • Cheaper exports that lead to reduced incentives for manufacturers leading to cut in costs for more efficiency. Over time this may cause an increase.
  1. Current Account Improvement

The deficit in the current account is compensated by the increase in exports and decrease in imports.

The factors on which the devaluation depends on include:

  1. Elasticity of demand for imports and exports
  • If demand is price inelastic, then there is only a small rise in quantity with a decrease in price of exports. This leads to a decline in the value of exports.
  • Devaluation may take some time to have an impact. However, in the short run, demand may become price elastic over time even if its price inelastic initially.
  1. Global Economy

Demand of export may not increase as expected if the global economy is going through recession.

  1. Inflation

The relation between inflation and devaluation is subject to many factors.

  • If there is an economic recession then devaluation will not lead to inflation.
  • In the short run, the firms may reduce their profit margins preventing inflation.

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