Intentional Depreciation Of The Currency - Devaluation

Devaluation and inflation, do they mean the same thing? The answer is no. However, despite the different meaning, these two words are quite closely related.

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Devaluation - definition

Devaluation is nothing more than an administrative or statutory reduction in the price of a country's currency, which is denominated in another country's currency or in gold. Countries that use the so-called adjustment policy, i.e. a fixed exchange rate system, devaluations are carried out by the Central Bank or by law. Interestingly, the fact that devaluation can only be done by statute or administrative decision means that the phenomenon of devaluation is intentional. And the result is inflation.

In the case of countries with a floating exchange rate, any reduction in the currency can be called depreciation. On the other hand, the opposite of depreciation is appreciation and it means strengthening of a given currency. More importantly, devaluation should not be confused with redenomination. Redenomination is responsible for changing the current currency to a new one without affecting its value.

Main reasons for the use of the devaluation mechanism by states

• The desire to increase the value of the country's exports. As a result of monetary or fiscal policy, the country's authorities may lead to currency devaluation, which leads to an increase in the price attractiveness of exported products. Which in turn leads directly to an increase in demand for exported goods from the country where the devaluation occurred.
• Normalization of the country's balance of payments In a situation where a country buys more than it sells, ie has a negative balance of payments, devaluation can help to normalize the situation. This is because the country can export its products more attractively and the value of imports usually decreases.
• Weakening of speculative demand for foreign currencies.

Currency devaluation and inflation

Devaluation is a reduction in the value of a currency against gold or foreign currency, and inflation is an increase in prices. Both of these issues are related. when devaluation is introduced, inflation is usually the result. Unfortunately, such a procedure adversely affects the state's economy.

The effect of devaluation on inflation is very similar to that of depreciation:

• There are such foreign goods and services (e.g. capital goods, raw materials needed for production) that will be imported despite devaluation. Their prices on the domestic market expressed in PLN after devaluation will be higher. Inflation will spread throughout the economy.
• The increase in the prices of foreign goods and services causes a tendency to replace some imports with domestic production, which usually becomes profitable only when the selling price is higher than the price of imported goods expressed in zlotys before devaluation.
• Demand for export is growing, which causes the need to shift the means of production from production intended for the domestic market. Thus, the prices of factors of production related to production for export must be higher than before the devaluation.

Devaluation and the trade balance

In a situation where the price elasticity of demand for exports from a given country and demand for imports decreases, there is an opportunity to restore equilibrium. The condition is the existence of a balance of payments deficit at the starting point.

According to the Marshall-Lerner condition, trade balance equilibrium can be achieved only when the sum of the absolute volumes of the price elasticity of export demand and import demand is greater than one. When the sum of these elasticities equals one, the devaluation does not affect the balance of trade. On the other hand, if it is less than one, the currency devaluation will cause the trade balance to deteriorate.

Source: Samuelson P. A., Nordhaus W. D., Economy