The Effects of Currency Devaluation in an Economy

Submitted By

Maarij Ahmad

Division D - D061

Semester III – Economics III

Submitted To

Dr. Parinaaz Mehta

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The Effects of Currency Devaluation in an Economy

MAARIJ AHMAD

ABSTRACT

Devaluation is the decision to reduce the value of a currency in a fixed exchange rate system.
It is done on the basis of an assumption that promoting export is an important aspect in
economic growth. Devaluation affects an economy in different aspects which are used to give
an insight over the conditions of the country. Devaluation is a tool used by the government to
help maintain exchange rates as required for keeping their economy at par with other
economies.

Keywords: Devaluation, Inflation, Capital Account, Exchange Rates, Balance of Payments

JEL Classification: E31, E44, E60, F43, G10, G15, G28, K22

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 TABLE OF CONTENTS

Sr. No. Particulars Page No.

1 Introduction 4-5
1.1. Devaluation and Depreciation 4
1.2. Advantages of Devaluation 5
1.3. Disadvantages of Devaluation 5
2 Literature Review 6-7
3 Research Methodology 7
4 Study and Findings 8-14
1.1.Effects of Devaluation 8-10
1.2.Evaluation of Devaluation 10-11
1.3.Competitive Devaluation 11-12
1.4.Devaluation of the Indian Rupee 12-13
1.5.Causes of Devaluation of Rupee 13
1.6.Policies to steam Devaluation in Rupee 14
5 Limitations and Scope 14
7 Conclusion 15
8 References 16

1. INTRODUCTION

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From 20th century till know, developing economies experienced crisis in currency at a point
leading to contemplation on if devaluation of the currency is a solution or another economic
and financial reform. There are many arguments about currency devaluation being
contractionary or expansionary, whether it has positive or negative effects on output growth,
or if it is advisable for any country with large amounts of debt in foreign currency to
undertake currency devaluation.

1.1. Devaluation and Depreciation

Devaluation is the decision to reduce the value of a currency in a fixed exchange rate system.
A devaluation is equivalent to the fall in the value of one currency. Domestic residents will
find imports and foreign travel more expensive, but domestic exports will benefit from their
exports becoming cheaper. A devaluation happens when a country makes a decision to lower
its exchange rate in a fixed or semi-fixed exchange rate system.

A depreciation is a situation when there is a fall in the value of a currency in a floating

exchange rate system. Devaluation and depreciation are often used interchangeably. Both
concepts have the same effect – a fall in the value of one currency which makes imports more
expensive, and exports competitive.

In 2008, the Pound Sterling fell in

value by 30%. The correct term is
a depreciation because the Pound
Sterling was a floating currency.

A devaluation occurs when a

country makes a decision to lower
its exchange rate in a fixed or
semi-fixed exchange rate system. Therefore, devaluation is only possible if one country is
following fixed exchange rate policy. When there is a fall in the value of one currency in a
floating exchange rate system that is not due to a decision of the government, but due to
supply and demand factors of economics.

1.2. Advantages of Devaluation

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  Exports become cheaper and more competitive for foreign buyers. This provides a
boost in domestic demand and lead to job creation in the export sector.
 A higher level of exports leads to an improvement in the current account deficit. This
is important for a country having a large current account deficit due to lack of
competitiveness.
 Higher exports and aggregate demand (AD) leads to higher rate of economic growth.
 Devaluation is a less damaging way to restore competitiveness than ‘internal
devaluation.’ Internal devaluation relies on deflationary policies to reduce prices by
reducing aggregate demand. Devaluation can restore competitiveness without
reducing aggregate demand.
 With a decision to devalue the currency, the Central Bank can cut interest rates as it
no longer needs to ‘prop up’ the currency with high interest rates.

1.3. Disadvantages of Devaluation

 Inflation - Devaluation is likely to cause inflation because:
o Imports will be more expensive (any imported good or raw material will
increase in price)
o Aggregate Demand (AD) increases – causing demand-pull inflation.
o Firms/exporters have less incentive to cut costs because they can rely on the
devaluation to improve competitiveness. Long-term devaluation may lead to
lower productivity because of the decline in incentives.
 Reduces the purchasing power of citizens abroad. e.g. it is more expensive to go on
holiday abroad.

 A large and rapid devaluation scares off international investors - It makes investors
less willing to hold government debt because of the devaluation reducing the real
value of their holdings. In some cases, rapid devaluation can also trigger capital
flight.
 If consumers have debts, e.g. mortgages in foreign currency after a devaluation, there
will be a sharp rise in the cost of their debt repayments.

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2. LITERATURE REVIEW

Devaluation is a decline in the value of a country’s currency in relation to other major

international currencies, usually brought about by the actions of monetary authority or any
significant drop in a currency's international exchange rate authority (Duncan, 2008).

 Tille (2006) believes that the impact of exchange rate shifts is highly heterogeneous
across sectors. While depreciation stimulates substantial competitiveness and welfare
gain for agents with a high exposure to foreign competition, only agents with just
domestic exposure or competition are adversely affected. He demonstrated that a
country that depreciates its currency can experience adverse terms-of-trade if its
domestically produced goods are poor substitutes for imported goods.

 Currency devaluation is the reduction of the value of a country’s currency against the
value of other currencies. Currencies are devalued by the government to reduce the cost
of exports in foreign market. Devaluation can also be referred to as a downward
adjustment of a country’s official exchange rate in relation to other countries (Krugman
& Obstfeld, 1999).

 According to Saibene & Sicouri (2012), the issue of currency devaluations can be
answered conventionally from the analysis in the Mundell-fleming model and the result
has a positive impact on the current account. Following this, in respect to GDP,
devaluation is expansionary since exports rises more than imports. To examine the level
of the reaction of the current account, the model can be extended by putting other
important features into consideration like variation in exports (imports) in response to a
variation in real exchange rate i.e. World’s prices elasticity demand for tradable goods;
and presence of supply shocks effects resulting from the presence of intermediate inputs
and raw materials; for example, oil.

 Adebayo Mohammed (2015) gave analysis on the real effects of devaluing the
currency in short and long run using panel data analysis. Seven countries were
examined, these are; Ghana, Mexico, Malaysia, Pakistan, Philippines, Singapore and

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 South Africa. These countries devalued their currencies within the same period under
consideration. The long run effects and relationships were determined by testing for co-
integration using different co-integration methods, and the short run effect was
determined using the Fully Modified OLS (FMOLS). A panel data covering the period
between 1981- 2010, was used in the analysis. The empirical results show the existence
of no significant relationship between currency devaluation and output growth in the
short run and a negative relationship between currency devaluation and economic
growth in the long run.

 This paper examined the impact of depreciation on the performance and development of
Manufacturing Small and Medium Sized Enterprises (SMEs) in Nigeria. This is against
the liberalization of trade and financial markets that led to the deregulation of the
foreign exchange market in Nigeria. The deregulation policy prompted the adoption of a
free-floating exchange rate system in place of the administratively pegged exchange rate
regime (Odusola and Akinlo, 2001).

 Lawrence Ogechukwu Obokoh (2017) was of a view that the current globalization of
trade and improvement in information technology sector enables manufacturers to
evaluate cost of products before placing the orders. This makes devaluation an
ineffective tool to correct the balance of payment problem.

3. RESEARCH METHADOLOGY

This research paper is based on the secondary data which was available on the internet,
wherein collection of the reviews, arguments and articles relating to censorship is done, i.e.
qualitative data. Time and budget constraints made the focus of the research paper on the
reviews and journals mostly with analysing of the articles for inferencing and getting the idea
of the topic. The data collected and analysed has been obtained from websites, e-books,
newspaper article, research paper etc, whose mixture of ideas made it very easy to
comprehend. This less expensive less time-consuming process helped me in extracting
information from authentic sources as mentioned in the review of literature mentioned above,
also helped me in increasing the quality of the research to a great extent.
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4. STUDY AND FINDINGS

4.1. Effects of Devaluation

 Exports cheaper - A devaluation in the exchange rate will make exports of the country
more competitive and appear cheaper to foreigners. This in return will increase demand
for exports. For example, after a devaluation India’s assets become more attractive; a
devaluation in Rupees can make Indian property appear cheaper to foreigners.

 Imports more expensive - A devaluation makes imports, such as petrol, food and raw
materials become more expensive. This in return will reduce the demand for imports. For
example, it encourages Indian tourists to take a holiday in India, rather than the US –
which now appears more expensive.

 Increased aggregate demand (AD) - A devaluation causes higher economic growth. Part
of AD is (X-M) therefore higher exports and lower imports should increase AD
(assuming demand is relatively elastic). In normal circumstances, higher AD is likely to
cause higher real GDP and inflation.

1
Pettinger, Tejvan, 2019, Economic effect of a devaluation of the currency,
https://www.economicshelp.org/macroeconomics/exchangerate/effects-devaluation/

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 2

 Inflation – Inflation is likely to occur following a devaluation because:

o Imports are more expensive – causing cost push inflation.
o AD is increasing causing demand-pull inflation
o With exports becoming cheaper, manufacturers may have less incentive to cut costs
and become more efficient. Therefore, over time, costs may increase.

 Improvement in the current account - With exports more competitive and imports more
expensive, there would be higher exports and lower imports, which will reduce the
current account deficit. In 2016, the United Kingdom had a near record current account
deficit, so a devaluation is necessary to reduce the size of the deficit.

 Wages - A devaluation in the Rupees makes India less attractive for foreign workers. For
example, with fall in the value of the Rupees, migrant workers from other countries may
prefer to work in any other country but India. Indian firms have to push up wages to keep
foreign labour. Similarly, it becomes more attractive for Indian workers to get a job in
the US because a dollar wage will go further.

 Falling real wages - In a period of stagnant wage growth, devaluation can cause a fall in
real wages. This is caused because devaluation causes inflation, but if the inflation rate is
higher than the rate at which wage increases, then real wages will fall.

2
Pettinger, Tejvan, 2019, Economic effect of a devaluation of the currency,
https://www.economicshelp.org/macroeconomics/exchangerate/effects-devaluation/

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4.2. Evaluation of Devaluation

The effect of a devaluation depends on:

 Elasticity of demand for exports and imports - If demand is price inelastic, then a fall in
the price of exports will lead to a small rise in quantity. Therefore, the value of exports
may actually fall. An improvement in the current account in the balance of payments
account depends upon the Marshall Lerner condition and the elasticity of demand for
exports and imports,
If PEDx + PEDm > 1 then a devaluation will improve the current account
In short term, demand may be inelastic, but over time demand may become more price
elastic and have a bigger effect.

3
The Effects of a Devaluation, https://www.economics.utoronto.ca/jfloyd/modules/efdv.html

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 State of the global economy - If the global economy is in a state of recession, then a
devaluation in the value of currency may be insufficient to boost export demand. If
growth is strong, then there will be a greater increase in demand. However, in a boom
period, a devaluation is likely to exacerbate inflation.

 Inflation - The effect on inflation will depend on other factors such as:
o Spare capacity in the economy. E.g. in a recession, a devaluation is unlikely to cause
inflation.
o Firms may reduce their profit margins, at least in the short run.
o Import prices are not the only determinant of inflation.
o Other factors affecting inflation such as wage increases may be important.

 Currency being devalued - If it is due to a loss of competitiveness, then a devaluation can

help in restoring competitiveness and economic growth. If the devaluation in currency is
aimed to meet a certain exchange rate targets set by the government, it may be
inappropriate for the economy.

4.3. Competitive Devaluation

 Competitive Devaluation and Currency Wars

Competitive devaluation occurs when countries reduce the value of their exchange rate to
make their exports cheaper, and gain a competitive advantage in world trade over other
countries. This encourages other countries in devaluing their currency for maintaining their
competitive advantage. If countries start making great efforts to keep devaluing their
currency against each other, it could be termed a currency war.

 Competitive Devaluation in a Recession

In a global recession, demand is low and many countries are struggling to escape recession.
Understandably, devaluation of their currency becomes an attractive option for boosting
domestic demand. It is a relatively better way to boost domestic demand. (e.g. you don’t need

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to borrow like fiscal policy). One drawback of devaluation is that it can be inflationary, but in
a recession, inflation is unlikely to be a problem. Devaluing currency involves loose
monetary policy (e.g. increasing money supply, cutting interest rates). Therefore, this
provides an additional boost to demand.

 Competitive Devaluation and Currency Manipulation

A competitive devaluation implies that a country pursues the correct monetary policy and
allows the market tools of demand and supply to allow the exchange rate to find its correct
level. However, many countries pursue currency manipulation – using exchange controls to
artificially keep the exchange rate below the market level. This can be considered unfair
trading practises. For example, in the early 2000s, China had a huge current account surplus
but still intervened to keep the value of the Yuan undervalued.

4.4. Devaluation of the Indian Rupee

The Indian Rupee has fallen in value against a lot of currencies since independence in 1947.
In recent years, the Indian Rupee has continued to depreciate in value.

Indian Rupee value against US Dollar: -

In 1990, you could buy $1 for 16

Indian Rupees. By 2013, the value
of a Rupee had fallen, so that you
would need 65 Indian Rupees to buy
$1.

In 1990 1 Indian Rupee = $0.06

In 2013 1 Indian Rupee = $0.016

4
Pettinger, Tejvan, 2017, Devaluation of the Indian Rupee,
https://www.economicshelp.org/blog/10251/currency/devaluation-indian-rupee/

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This shows there is a substantial fall in the value of the Indian Rupee against the US dollar.
When there is a devaluation in the Indian Rupee it means that Indian exports become cheaper,
but imports are more expensive for Indians to buy. In particular, a devaluation of the Rupee is
bad news for Indians who need to import raw materials, such as oil and gold.

4.5. Causes of Devaluation in Rupee

 Lack of competitiveness/inflation - The long-term decline in the value of the Rupee

reflects India’s decline in competitiveness. India has a higher inflation rate than its
international competitors. In November 2013, Indian inflation reached 11.24%.
Therefore, there is relatively less demand for the rising price of Indian goods; this
reduction in demand of goods causes a fall in the value of the Rupee.

 Current account deficit - A result of poor competitiveness and high demand for imports is
a current account deficit. This means India is purchasing more imports of goods from
other countries and services than it is exporting to other countries. A large deficit in the
current account of balance of payments tends to put a downward pressure on a currency.
This is due to more currency leaving the country to buy imports, rather than coming in to
buy exports.
In the first quarter of 2013, the Current Account Deficit was 18.1 billion. The deficit was
over 6.7% in the last quarter of 2012; the deficit has fallen to 1.2% in Q3 of 2013.
However, the Economist notes that 75% of the deficit reduction is artificially related to
reducing imports of gold through government restrictions. Therefore, there is still an
underlying trade deficit that India will need to work on through increasing exports and
competitiveness.

 Oil Prices - India is a net importer of oil. It has to buy oil in dollars. Therefore, rising oil
prices worsen India’s current account of balance of payments and also weakens the
Rupee. More Indian’s rupees have to be spent on buying oil.

4.6. Policies to stem devaluation in Rupee

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 o Supply-side policies to improve competitiveness
o Reduce dependency on foreign oil, through domestic and renewable energy.
o Monetary policy to tackle inflation and reduce domestic demand. But, will conflict
with lower economic growth and lead to higher unemployment.
o Financial controls, e.g. limiting the amount of gold imports to reduce the current
account deficit.

5. LIMITATIONS AND SCOPE

The findings of this study have to be seen in light with some limitations. The study
suffers from time and cost constraints since this study had to be completed within a span
of three months. This study is also affected by the Covid-19 pandemic which acts as a
hindrance to the data thus collected.
The study also does not include the other factors affecting the balance of payments, also
the factors needed to maintain balance of payment and balance of trade. The study also
does not include the aggregate demand and supply model for understanding balance of
payments.
Financial Markets can be explored more as many other reasons are also causing
devaluation, depreciation etcetera. Monetary Policies and Fiscal Policies can be explained
to understand the change in the economy due to change in these policies, thus causing a
need for devaluation.
Devaluation can further be understood with taking some data of past years of different
countries in a particular region relating to economy and other factors that are directly or
indirectly a cause for devaluation. Graphs and schedules of illustration are more easier to
comprehend in cases of analysis of data, and hence the past years statistics of these
countries would help understand the need for devaluation by these countries under
different circumstances.

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6. CONCLUSION

The effects of devaluation can be very complex and far-reaching. In theory, a weaker
currency means that exports from one country will be cheaper in relation to prices in
other countries, and that imports will be more expensive. These conditions provide a
boost to an economy that has experienced devaluation, but there are negative
consequences also, both internally and externally.
For large multinational corporations, devaluations often mean lost revenue and decreased
profitability in the affected country (assuming the company isn't from the country
undergoing devaluation), as companies can't raise their prices enough in competitive
markets to control the losses stemming from the lower exchange rate. Since devaluations
frequently coincide with economic turmoil such as inflation, instability in the financial
markets, and recession, spending is likely to be reduced in countries whose currencies
have been devalued, further disrupting sales. On the other hand, for companies with
export-oriented operations in countries whose currencies have been devalued, the
business may enjoy some cost advantages in its labor and materials, enhancing its
competitive position abroad.

Indian Government has tried many things to control downward spiraling rupee but those
steps are too little, too late and many are not properly directed and pointed in wrong
direction; like curbing import of gold. A government should not be telling people what to
buy and what not to buy. Demand of gold in India is culture induced. Also, demand of
gold increases when economic uncertainty increases. Trying to micromanage people’s
behavior will have undesirable impact in long term. There are not many options in short
term, but in long term government needs to bring reforms pending for many decades.

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7. REFERENCES

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Economic Development
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Devaluation and Real Devaluation” Journal of African Economies.
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