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Currency Devaluation and Revaluation
At the Bretton Woods Conference in July 1944, international
leaders sought to insure a stable post-war international
economic environment by creating a fixed exchange rate system.
The United States played a leading role in the new arrangement,
with the value of other currencies fixed in relation to
the dollar and the value of the dollar fixed in terms of
gold—$35 an ounce. Following the Bretton Woods agreement,
the United States authorities took actions to hold down
the growth of foreign central bank dollar reserves to reduce
the pressure for conversion of official dollar holdings
into gold.
During the mid- to late-1960s, the United States experienced
a period of rising inflation. Because currencies could not
fluctuate to reflect the shift in relative macroeconomic
conditions between the United States and other nations,
the system of fixed exchange rates came under pressure.
In 1973, the United States officially ended its adherence
to the gold standard. Many other industrialized nations
also switched from a system of fixed exchange rates to a
system of floating rates. Since 1973, exchange rates for
most industrialized countries have floated, or fluctuated,
according to the supply of and demand for different currencies
in international markets. An increase in the value of a
currency is known as appreciation, and a decrease as depreciation.
Some countries and some groups of countries, however, continue
to use fixed exchange rates to help to achieve economic
goals, such as price stability.
Under a fixed exchange rate system, only a decision by
a country's government or monetary authority can alter the
official value of the currency. Governments do, occasionally,
take such measures, often in response to unusual market
pressures. Devaluation, the deliberate
downward adjustment in the official exchange rate, reduces
the currency's value; in contrast, a revaluation
is an upward change in the currency's value.
For example, suppose a government has set 10 units of its
currency equal to one dollar. To devalue, it might announce
that from now on 20 of its currency units will be equal
to one dollar. This would make its currency half as expensive
to Americans, and the U.S. dollar twice as expensive in
the devaluing country. To revalue, the government might
change the rate from 10 units to one dollar to five units
to one dollar; this would make the currency twice as expensive
to Americans, and the dollar half as costly at home.
Under What Circumstances Might a Country Devalue?
When a government devalues its currency, it is often
because the interaction of market forces and policy decisions
has made the currency's fixed exchange rate untenable. In
order to sustain a fixed exchange rate, a country must have
sufficient foreign exchange reserves, often dollars, and
be willing to spend them, to purchase all offers of its
currency at the established exchange rate. When a country
is unable or unwilling to do so, then it must devalue its
currency to a level that it is able and willing to support
with its foreign exchange reserves.
A key effect of devaluation is that it makes the domestic
currency cheaper relative to other currencies. There are
two implications of a devaluation. First, devaluation makes
the country's exports relatively less expensive for foreigners.
Second, the devaluation makes foreign products relatively
more expensive for domestic consumers, thus discouraging
imports. This may help to increase the country's exports
and decrease imports, and may therefore help to reduce the
current account deficit.
There are other policy issues that might lead a country
to change its fixed exchange rate. For example, rather than
implementing unpopular fiscal spending policies, a government
might try to use devaluation to boost aggregate demand in
the economy in an effort to fight unemployment. Revaluation,
which makes a currency more expensive, might be undertaken
in an effort to reduce a current account surplus, where
exports exceed imports, or to attempt to contain inflationary
pressures.
Effects of Devaluation
A significant danger is that by increasing the price
of imports and stimulating greater demand for domestic products,
devaluation can aggravate inflation. If this happens, the
government may have to raise interest rates to control inflation,
but at the cost of slower economic growth.
Another risk of devaluation is psychological. To the extent
that devaluation is viewed as a sign of economic weakness,
the creditworthiness of the nation may be jeopardized. Thus,
devaluation may dampen investor confidence in the country's
economy and hurt the country's ability to secure foreign
investment.
Another possible consequence is a round of successive devaluations.
For instance, trading partners may become concerned that
a devaluation might negatively affect their own export industries.
Neighboring countries might devalue their own currencies
to offset the effects of their trading partner's devaluation.
Such "beggar thy neighbor" policies tend to exacerbate
economic difficulties by creating instability in broader
financial markets.
Since the 1930s, various international organizations such
as the International Monetary Fund (IMF) have been established
to help nations coordinate their trade and foreign exchange
policies and thereby avoid successive rounds of devaluation
and retaliation. The 1976 revision of Article IV of the
IMF charter encourages policymakers to avoid "manipulating
exchange rates...to gain an unfair competitive advantage
over other members." With this revision, the IMF also
set forth each member nation's right to freely choose an
exchange rate system.
September 2011
[You must be registered and logged in to see this link.]
- Under a fixed exchange rate system, devaluation
and revaluation are official changes in the value of a
country's currency relative to other currencies. Under
a floating exchange rate system, market forces generate
changes in the value of the currency, known as currency
depreciation or appreciation.
- In a fixed exchange rate system, both devaluation
and revaluation can be conducted by policymakers, usually
motivated by market pressures.
- The charter of the International Monetary Fund
(IMF) directs policymakers to avoid "manipulating
exchange rates...to gain an unfair competitive advantage
over other members."
At the Bretton Woods Conference in July 1944, international
leaders sought to insure a stable post-war international
economic environment by creating a fixed exchange rate system.
The United States played a leading role in the new arrangement,
with the value of other currencies fixed in relation to
the dollar and the value of the dollar fixed in terms of
gold—$35 an ounce. Following the Bretton Woods agreement,
the United States authorities took actions to hold down
the growth of foreign central bank dollar reserves to reduce
the pressure for conversion of official dollar holdings
into gold.
During the mid- to late-1960s, the United States experienced
a period of rising inflation. Because currencies could not
fluctuate to reflect the shift in relative macroeconomic
conditions between the United States and other nations,
the system of fixed exchange rates came under pressure.
In 1973, the United States officially ended its adherence
to the gold standard. Many other industrialized nations
also switched from a system of fixed exchange rates to a
system of floating rates. Since 1973, exchange rates for
most industrialized countries have floated, or fluctuated,
according to the supply of and demand for different currencies
in international markets. An increase in the value of a
currency is known as appreciation, and a decrease as depreciation.
Some countries and some groups of countries, however, continue
to use fixed exchange rates to help to achieve economic
goals, such as price stability.
Under a fixed exchange rate system, only a decision by
a country's government or monetary authority can alter the
official value of the currency. Governments do, occasionally,
take such measures, often in response to unusual market
pressures. Devaluation, the deliberate
downward adjustment in the official exchange rate, reduces
the currency's value; in contrast, a revaluation
is an upward change in the currency's value.
For example, suppose a government has set 10 units of its
currency equal to one dollar. To devalue, it might announce
that from now on 20 of its currency units will be equal
to one dollar. This would make its currency half as expensive
to Americans, and the U.S. dollar twice as expensive in
the devaluing country. To revalue, the government might
change the rate from 10 units to one dollar to five units
to one dollar; this would make the currency twice as expensive
to Americans, and the dollar half as costly at home.
Under What Circumstances Might a Country Devalue?
When a government devalues its currency, it is often
because the interaction of market forces and policy decisions
has made the currency's fixed exchange rate untenable. In
order to sustain a fixed exchange rate, a country must have
sufficient foreign exchange reserves, often dollars, and
be willing to spend them, to purchase all offers of its
currency at the established exchange rate. When a country
is unable or unwilling to do so, then it must devalue its
currency to a level that it is able and willing to support
with its foreign exchange reserves.
A key effect of devaluation is that it makes the domestic
currency cheaper relative to other currencies. There are
two implications of a devaluation. First, devaluation makes
the country's exports relatively less expensive for foreigners.
Second, the devaluation makes foreign products relatively
more expensive for domestic consumers, thus discouraging
imports. This may help to increase the country's exports
and decrease imports, and may therefore help to reduce the
current account deficit.
There are other policy issues that might lead a country
to change its fixed exchange rate. For example, rather than
implementing unpopular fiscal spending policies, a government
might try to use devaluation to boost aggregate demand in
the economy in an effort to fight unemployment. Revaluation,
which makes a currency more expensive, might be undertaken
in an effort to reduce a current account surplus, where
exports exceed imports, or to attempt to contain inflationary
pressures.
Effects of Devaluation
A significant danger is that by increasing the price
of imports and stimulating greater demand for domestic products,
devaluation can aggravate inflation. If this happens, the
government may have to raise interest rates to control inflation,
but at the cost of slower economic growth.
Another risk of devaluation is psychological. To the extent
that devaluation is viewed as a sign of economic weakness,
the creditworthiness of the nation may be jeopardized. Thus,
devaluation may dampen investor confidence in the country's
economy and hurt the country's ability to secure foreign
investment.
Another possible consequence is a round of successive devaluations.
For instance, trading partners may become concerned that
a devaluation might negatively affect their own export industries.
Neighboring countries might devalue their own currencies
to offset the effects of their trading partner's devaluation.
Such "beggar thy neighbor" policies tend to exacerbate
economic difficulties by creating instability in broader
financial markets.
Since the 1930s, various international organizations such
as the International Monetary Fund (IMF) have been established
to help nations coordinate their trade and foreign exchange
policies and thereby avoid successive rounds of devaluation
and retaliation. The 1976 revision of Article IV of the
IMF charter encourages policymakers to avoid "manipulating
exchange rates...to gain an unfair competitive advantage
over other members." With this revision, the IMF also
set forth each member nation's right to freely choose an
exchange rate system.
September 2011
[You must be registered and logged in to see this link.]
