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