Devaluation

Devaluation occurs when a government or its central bank reduces the official price at which its currency can be bought on the foreign exchange (Forex) market. For example, suppose that the current $/£ exchange rate was 2:1, meaning that two USD had to be given up for each 1GBP or, equivalently, that 1GBP was worth 2 USD. If the GBP were devalued, this would mean that fewer USD had to be exchanged for each GBP, meaning that GBP had become cheaper in dollar terms.

Devaluation occurs under a fixed exchange rate regime. Under such a regime the government is committed to a particular exchange rate and manages its foreign exchange reserves (holdings of foreign currencies and gold) to ensure that this rate is maintained. Because a country's holdings of foreign exchange reserves are closely related to its balance of payments, the extent to which a government is able to maintain a fixed exchange rate is also affected by the balance of payments. For example, a country that has a deficit on its external account would face a positive net supply of its currency as domestic residents seek to pay for their net imports. This, in turn, would place downward pressure on the exchange rate and the government would intervene to defend it by buying its domestic currency on the Forex markets. This mechanism works in the opposite direction in the case of a revaluation.

[Page 508]The operation of this balance of payments mechanism can impose severe macroeconomic costs on the country effecting devaluation. Often, devaluation occurs because of persistent trade deficits caused by a country experiencing higher rates of inflation (or lower levels of productivity growth) compared to its trading partners. To overcome this problem, one solution is to impose contractionary fiscal and monetary policies to reduce inflation in an effort to restore international competitiveness. Such policies can result in significant reductions in the standard of living for domestic residents in the following ways: Reduction in government expenditure on education, health, social, and welfare programs. In certain cases, the International Monetary Fund (IMF) requires the imposition of such policies as a pre-condition for international borrowing. In more serious cases, and to avoid a conflict between external policy objectives (deficit on external account) and internal policy objectives (low levels of unemployment), countries can devalue their currency. The advantage of devaluation in this case is that by making the currency less expensive, deflationary pressures are subdued.

Historically, countries that have devalued their currencies have suffered relatively lower rates of growth in productivity and this, in turn, has resulted in significant deficits on the external account. A classic example of this situation was Britain in 1967. It is often the case that heavy international speculation precedes devaluation. This is because speculators hope to benefit from purchasing a currency at a lower price and selling it after revaluation. In the preceding example, the Bank of England spent £200 million on November 19, 1967, trying to defend sterling against speculative attack. Similarly, in a more recent British example—the decision to take sterling out of the European Exchange Rate Mechanism in 1992—the chancellor of the exchequer authorized the Bank of England to spend billions of pounds trying to defend sterling from speculative attack.

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