How Does Currency Devaluation Work?

How Does Currency Devaluation Work?

Currency devaluation is a situation where the value of a particular currency has been devalued either by automatic market forces or by intentionally devaluing its currency.
Currency devaluation is lowering the value of a currency. The value of a devalued currency is low particularly to the other nations, because foreigners can now buy more goods in the same amount of money.

There are two ways in which a currency can be devalued.

1. Floating Exchange Rate System
Under the Floating Exchange System, the market forces devalues or revalues a currency, depending on the currency's demand and supply. If a currency's demand increases with respect to its supply, its value will increase and if a currency's demand falls with respect to its supply, it's value will fall.

2. Fixed Exchange Rate System
Under Fixed Exchange Rate System, a currency is devalued intentionally by the policy makers under the influence of the market pressures.

An economy can devalue its currency by printing more currency notes or by devaluing the currency under the Fixed Exchange Rate system. An economy can change its money supply by printing more notes and creating electronic bank credit and then it is added to the economy. Also the demand for a currency can increase significantly, if foreign countries demand their currencies for their local transactions. Similarly if a currency's demand falls down, then it's currency faces devaluation. In times, when a currency's demand has lowered, a country devalues its own currency to attract other countries demand. As the currency is devalued, a foreign country will be able to buy more number of goods with the same amount of money. Therefore, tourists and importers will be willing to deal with countries which have devalued its currencies to gain profit margin.

Example: A lot of countries in the south like China, Sri Lanka and Thailand have devalued their currency in the past to increase their exports and to increase tourism. Devaluing their currency made their exports cheap for the importers and also the tourism would increase as it will now be more affordable for travelers.

Implications of Devaluation

1. Exports Favored
In devaluation, Domestic currency becomes cheaper than the other countries. This enables the foreigners to spend less money and get the same goods or get more goods at the same price.

2. Discourage Imports
In devaluation, imports become expensive as a domestic country will end up paying more money for the same quantity. This will discourage the importer to import more goods. Its effect can be bad and good both depending on the country's trade deficit and its self-sufficiency.

3. Aggregate demand is boosted
As imports are discouraged, people will start to buy more of the domestic goods. This will in turn increase the aggregate demand of the domestic goods in an economy.

4. Inflation
As the demand for domestic goods starts increasing, the demand for the domestic goods might outgrow the supply of the domestic goods, which will lead to inflation.

5. Domino Effect
If one nation has devalued its currency, other neighboring nations can take it as a threat; as foreigners will be more attracted to an economy which has devalued its currency. Looking at this scenario the other countries can also devalue its currency.

Advantages of Currency Devaluation

1. Increasing Exports
Devalued currency makes an economy's exports more favorable. This is because their currency has become cheaper than other countries, increasing the demand from the importers.

2. Domestic Prices Remain the Same
This is one major advantage that a country can attain increasing foreign exchange reserves without affecting the domestic value of their currency, per se. The major impact of this will be felt by those who deal with imports and exports for business and arbitragers who try to profit from small variations in different currencies. Though, devaluation in the long run does have ill-economic effects; like inflation.

3. Growth Because of Increased Money Supply
Devaluation will lead to an increased money supply in an economy, which in turn will increase aggregate consumption, demand, saving and investment. All these increments will lead to some amount of growth in an economy.

4. Balance Trade Deficits
Devaluation can be a way in which a country can discourage imports (if a country's imports are more than their exports) and balance the trade deficits by making imports more expensive.

5. Fight Unemployment
Reduced imports leads to increase in the demand for domestic goods. This increases the domestic supply of goods in an economy and which in turn increases economic activities that require more manpower; leading to increasing employment rates and reducing unemployment rates.

Disadvantages of Currency Devaluation

1. Imports Become Expensive
If a major part of an economy is dependent on imports then, devaluation can lead to major economic losses.

2. Inflation
Increased money supply, increased domestic demand can increase the prices of the domestic goods, leading to inflation.

3. Hyper-stagflation
This occurs in a situation where a currency is devalued and it results into inflation accompanied with a high unemployment rate. This is a bad situation, as the rising prices leads to further unemployment and the current wages are not sufficient to keep the employed in par with the current prices.

4. Creditworthiness Maybe Threatened
Devaluation of a currency is a sign of economic weakness, which can hamper the creditworthiness of an economy in the global market; Making it very unreliable.

5. Capital Flight
Devaluation of a currency makes the investors very skeptical about the economy's future prospects. Therefore, they would look at withdrawing their investments from Foreign Institutional Investments and Foreign Direct Investments, leading to a situation of capital flight.

Dollar Devaluation
The U.S Dollar is said to have devalued over the period from 2002 to 2009. In 2002, the U.S dollar was valued against Euro as 1 Euro=$0.86. In 2009, this ratio become 1 Euro=$1.41. A resulting effect is said to be that the number of Americans traveling to Europe have reduced and the number of European travelers traveling to America have increased during this period. Also the number of American goods bought by the Europeans have increased and the number of European goods bought by the Americans have reduced considerably.

Devaluation of a currency is definitely not a good economic indicator. A country chooses to devalue its currency only when it does not find any other option to revive and stimulate the economy again. History says that devaluation of a currency can lead massive economic set back. The policy makers need to be very cautious and sensitive while dealing with economic problems under such circumstances.