Economic effect of a devaluation of the currency
A devaluation means there is a fall in the value of a currency. The main effects are:
✓ Exports are cheaper to foreign customers
✓ Imports more expensive.
✓ In the short-term, a devaluation tends to cause inflation, higher growth and increased
demand for exports.
✓ A devaluation in the Rupee means PKR1 is worth less compared to other foreign
currencies.
✓ For example
June 2021: PKR 155= $1
June 2022: PKR 205=$1
o A devaluation occurs when a country makes a conscious decision to lower its exchange rate in
a fixed or semi-fixed exchange rate.
o A depreciation is when there is a fall in the value of a currency in a floating exchange rate.
Effects of a devaluation
1. Exports cheaper. A devaluation of the exchange rate will make exports more competitive and
appear cheaper to foreigners. This will increase demand for exports. Also, after a devaluation, PK
assets become more attractive; for example, a devaluation in the PKR Pound can make Pakistan
property appear cheaper to foreigners.
2. Imports more expensive. A devaluation means imports, such as petrol, food and raw materials
will become more expensive. This will reduce the demand for imports. It may also encourage
Pakistani tourists to take a holiday in the PK, rather than the US – which now appears more
expensive.
3. Increased aggregate demand (AD). A devaluation could cause 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.
4. Inflation is likely to occur following a devaluation because:
4. Inflation is likely to occur following a devaluation because:
▪ Imports are more expensive – causing cost push inflation.
▪ AD is increasing causing demand-pull inflation
▪ With exports becoming cheaper, manufacturers may have less incentive to cut costs and
become more efficient. Therefore, over time, costs may increase.
5. Improvement in the current account. With exports more competitive and imports more
expensive, we should see higher exports and lower imports, which will reduce the current account
deficit. In 2022, the PK had a near record current account deficit, so a devaluation is necessary to
reduce the size of the deficit.
6. Wages. A devaluation in the PKR makes the Pakistan less attractive for foreign workers. For
example, with fall in the value of the PKR, migrant workers from Europe may prefer to work in
Germany than the Pakistan. Pakistani firms may have to push up wages to keep foreign labour.
Similarly, it becomes more attractive for Pakistani workers to get a job in the US because a dollar
wage will go further. (FT – migrants become pickier about Pakistani jobs)
7. Falling real wages. In a period of stagnant wage growth, devaluation can cause a fall in real
wages. This is because devaluation causes inflation, but if the inflation rate is higher than wage
increases, then real wages will fall.
Evaluation of a devaluation
The effect of a devaluation depends on:
1. Elasticity of demand for exports and imports. If demand is price inelastic, then a fall in the
price of exports will lead to only a small rise in quantity. Therefore, the value of exports may
actually fall. An improvement in the current account on the balance of payments 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
The impact of a devaluation may take time to influence the economy. In the short term, demand
may be inelastic, but over time demand may become more price elastic and have a bigger effect.
2. State of the global economy. If the global economy is in recession, then a devaluation may be
insufficient to boost export demand. If growth is strong, then there will be a greater increase in
demand. However, in a boom, a devaluation is likely to exacerbate inflation.
3. Inflation. The effect on inflation will depend on other factors such as:
Spare capacity in the economy. E.g. in a recession, a devaluation is unlikely to cause inflation.
Do firms pass increased import costs onto consumers? Firms may reduce their profit margins, at
least in the short run.
Import prices are not the only determinant of inflation. Other factors affecting inflation such as
wage increases may be important.
4. It depends on why the currency is being devalued. If it is due to a loss of competitiveness,
then a devaluation can help to restore competitiveness and economic growth. If the devaluation is
aiming to meet a certain exchange rate target, it may be inappropriate for the economy.
Winners and losers from Devaluation
