Currency Devaluation And Its Effect Economics Essay

INTRODUCTION

Background of the Study

According to many economists, weakening of the currency could actually strengthen economy, since a weaker currency will increase the production, which in turn will uplift employment and raising the economic growth. It is held that increases in demand for goods and services gives rise to economic growth by triggering the production of goods and services. Increases or decreases in demand for goods and services are behind rises and declines in the economy’s production of goods. Hence in order to keep the economy going economic policies must pay close attention to overall demand. Now, part of the demand for domestic products emanates from overseas. The accommodation of this demand is labeled exports. Likewise, local residents exercise demand for goods and services produced overseas, which is labeled imports. Note that while an increase in exports gives rise to overall demand for domestic output, an increase in imports weakens demand. Hence exports, according to this way of thinking, are a factor that contributes to economic growth while imports are a factor that detracts from the growth of the economy.

Because overseas demand for a country’s goods and services is an important ingredient in setting the pace of economic growth, it makes sense to make locally produced goods and services attractive to foreigners. One of the ways to make domestically produced goods more in demand by foreigners is by making the prices of these goods more attractive.

Traditionally there are three main approaches to devaluation or currency depreciation: the elasticities approach, the absorption approach and the monetary approach. According to the elasticities framework, devaluation improves a country’s balance of trade when the Marshall-Lerner condition is satisfied, i.e., when the sum of the import demand elasticities of the two trading partners exceeds unity. In the absorption methodology, however, the elasticities do not matter, and the trade balance improves only if the nation’s GDP increases faster than domestic spending. In the monetary approach, by contrast, only money demand and supply matter, and devaluation always improve the trade balance. According to the monetary approach to the exchange rate, a devaluation or depreciation decreases the real supply of money, resulting in an excess demand for money. This leads to hoarding and an increase in the trade balance

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Currency Devaluation and its effect:

Devaluation and revaluation are official changes in the value of a country’s currency relative to other currencies under the phenomenon of fixed exchange rate. Whereas in floating exchange rate system, currency appreciation or depreciation result as changes in market forces.

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 indefensible. 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.

When a central bank announces a loosening in its monetary stance, this leads to a quick response by the participants in the foreign exchange market through selling the domestic currency in favor of other currencies, thereby leading to domestic currency depreciation. In response to this, various producers now find it more attractive to boost their exports.

There are two implications of 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, which discourages the imports. It decreases the trade deficit and may increase trade competitiveness of the economy. A government might use devaluation to boost aggregate demand in the economy in an effort to fight unemployment.

Depending on consumer and producer responsiveness to price changes (known as supply and demand elasticities), an effective devaluation should reduce a nation’s imports and raise world demand for its exports. Improvement in a country’s balance of trade will cause an increase in the new inflow of foreign currency; this, in turn, may help strengthen a country’s overall balance of payments account. The total effect of a currency devaluation depends on the actual elasticities of the supply and demand for traded goods. The more elastic the demand for imports and exports, the greater the effect of the devaluation will be on the country’s trade deficits and, therefore, on its balance of payments; the less elastic the demand, the greater the necessary devaluation will be to eliminate a given imbalance.

Devaluation often is criticized as an inflationary monetary policy because it raises the domestic price of imports. The underlying cause of inflation is not devaluation, however, but rather excess money creation. Nonetheless, devaluation is an unpopular policy, especially in small countries that are extremely dependent on imports as a source of food and other necessities.

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 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. Devaluation give rise to inflationary pressure because of which, imported good become more expensive both to the direct consumer and to domestic producer using them for further processing.

‘J-curve’ Phenomenon:

Exchange rates have different effects in long run and short run of the economy. One reason for the difference is that quantities traded are often slow to adjust to exchange rate movements. Many economists believe that the trade balance in domestic currency terms should drop first in response to a depreciation (or devaluation) of the domestic currency since initially export and import quantities will change little but the price of imports will increase. Over time, however, more will be exported and less imported due to the cheaper value of domestic currency, so the trade balance rises, resulting in what is known as a trade ‘J-curve’ when the path of the trade balance is plotted over time.

Value Determination:

The value of anything is determined by what you can get in exchange for it. Or, on the other hand, what you have to give up obtaining and keeping it. So in effect, the value of anything is its opportunity cost. This holds true for money itself. It is worth what you can get for it… and, what you’re willing to give up, in order to get it. Thus, money itself is a commodity and can be used as barter in exchange for other commodities.

Purchasing Power Parity (PPP) is the relationship between the currencies of two or more countries and the commodities that can be purchased. Parity suggests that, products that are substitutes for each other in international trade should have similar prices in all countries when measured against the same currency.

The basic idea that supports PPP is that (Ceteris Paribus) any deviation from parity would leave room for arbitrage. An entrepreneur could continuously buy an item in one country, and then sell the same item in another country, making a fortune on the price differential. Because of this profit potential, eventually everyone would get in on this action, until the price differential was eliminated and there were no more profits to be had. This results in the Law of One Price.

Any deviations from this parity value should be due to changes in the ratio of imports/exports and/or capital inflows/outflows. These ratios represent changes in demand for the country’s currency and will cause the exchange rate to fluctuate above or below parity value.

Devaluation and Economic Well-Being

Currency depreciation affects the social welfare as well, which depends upon real GDP and the rate of unemployment. If there is unemployment along with a high trade deficit, then currency depreciation unambiguously raises welfare, even though the price level rises and inflationary pressures escalate. This is because in this case outputs as well as employment go up, while the trade deficit disappears.

On the other hand, if the nation is already at full employment, devaluation simply raises the price level, lowers aggregate spending, improves the trade balance, but has no impact on overall welfare. However, the weakest sections of society, the retirees, the minimum-wage earners, the older workers, etc., suffer, because their nominal incomes remain fixed while prices go up.

Objectives of the Study:

It is aimed to achieve the following objectives:

To find the need for Devaluation of the currency.

To find the effect of Devaluation of the currency on the domestic exports.

To find the effect of Devaluation of the currency on the domestic imports.

To find the changes in the trade balance, when Devaluation is observed.

To find the impact on the balance of payments, when Devaluation is observed.

Organization of the Study:

To achieve the above-mentioned objectives the study is organized as under. The second chapter consists of the literature, on the effect of devaluation of the local currency, on the domestic exports, domestic imports, trade balance and the balance of payments. While in the third chapter an econometric model is developed, which explains the channel thorough which relationship between devaluation of the local currency and the international trade, in which domestic exports, domestic imports, trade balance and balance payments are included, has been described. Chapter four takes care of the issue of variable construction and also describing the data sources. Chapter five is the one, which is exhibiting the empirical results, based on the methodology, developed in chapter three. The chapter six provides conclusions and policy implications.