Devaluation and the J-curve

Devaluation refers to a deliberate, policy-induced, reduction in the value of one currency against other currencies.

A devaluation can be engineered by a country's central bank by selling holdings of its own currency in exchange for other currencies (whose value will be pushed up in relative terms). Devaluation contrasts with 'depreciation' which occurs when a currency falls in value as a result of 'normal' currency trading in the foreign exchange market.

One problem associated with pegging the value of a currency in 'fixed' exchange rate regimes was that currencies could become over-valued, with the result that they would be periodically devalued in an attempt to move to a lower equilibrium rate.

Examples

There are numerous example of currencies being deliberately devalued after being pegged to gold, or to another currency, including the UK's devaluations of 1949 and 1967, India's in 1966 and 1977, and China's in 2015. Devaluations are often the result of pressure from global financial institutions, including the IMF and World Bank, who often set devaluation as one of the conditions of granting loans, and as part of structural adjustment policies (SAPs).

Pound is devalued in 1967

For example, the UK government under prime minister Harold Wilson devalued the pound by 14% in 1967 as an attempt to deal with a mounting trade deficit.

China devalues in 2015

Cause of trade deficits

Several economic events can cause a trade deficit to arise, or cause an existing deficit to increase, including:

  1. Excessive growth in the domestic economy - growth larger than the long term trend rate.
  2. Domestic inflation relative to the rest of the world, which encourages cheaper imports and discourages exports,
  3. An over-valued currency.
  4. Long-term de-industrialisation, which erodes the manufacturing base of an economy.
  5. Unfair competition, which can destroy domestic firms.
  6. Trade barriers, which make exports difficult.

Devaluation of a currency is one of several policies designed to remedy a trade deficit, and stimulate economic growth. The aim of devaluation is to reduce import spending and increase export revenue.

How does devaluation work?

Devaluation works through a process called 'expenditure switching' which means that a fall in a currency value will cause domestic consumers to switch to their own country's goods and services, and overseas consumers to switch towards the cheaper exports of the devaluing country.

Is it effective?

For devaluation to work the response of consumers at home and abroad must be relatively elastic. More specifically, it will only work if the Marshall-Lerner condition is met [which is, that the sum of PEDs for exports and imports is greater than 1.]

This is unlikely in the short-run as demand tends to be inelastic. There are several reasons for this.

  1. Firstly, some consumers may have bought goods on a contract basis (such as a 'futures' contract) and any change in current prices takes a while to impact demand.
  2. Secondly, some consumers prefer to 'wait and see' what the impact of any currency devaluation will be before committing to altering their demand.
  3. Thirdly, 'price' is only one determinant of demand - while a currency devaluation reduced price, price may not feature strongly in determining demand.
  4. Finally, some consumers may simply be ignorant of the devaluation, and its impact on price.
Video on devaluation

However, in the longer run demand tends to adjust more to price, and the Marshall-Lerner condition may be satisfied.

This explains the ‘J-curve’ path following a devaluation, indicating the Marshall-Lerner condition is not met in the short-run, and devaluation causes any trade deficit to worsen.

The 'J' curve

Although not conclusive, a good deal of research has been undertaken, which supports the general conclusion that, at least in the long-run, the Marshall-Learner conditions is satisfied (see research on exchange rates in India).

Other criticisms of devaluation

  1. Other countries may see a devaluation as an artificial attempt to gain a competitive advantage, and devalue their own currency as a form of retaliation.
  2. While devaluation could stimulate export-led growth there is a danger of inflation - firstly because import prices will rise, and secondly as a result of economic growth.
  3. Devaluation could result in speculation against the currency that devalues if speculators feel that the new rate is not sufficiently low enough to have the desired policy effect.

Trade deficits

More on aggregate demand and the AD curve.

Trade balance
Globalisation

How can fiscal policy influence aggregate demand?

Globalisation
Trade deals

Is monetary policy more effective at controlling inflation?

Trade deals

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