Q. Consider the following statements:

The effect of the devaluation of a currency is that it necessarily

  1. Improves the competitiveness of the domestic exports in the foreign markets
  2. Increase the foreign value of the domestic currency
  3. Improves the trade balance

Which of the above statements is/are

  • 1 only
  • 1 and 2
  • 3 only
  • 2 and 3

Answer: a) 1 only

Notes:
  • Devaluation of a currency means a reduction in the value of a currency vis-a-vis major internationally traded currencies.
  • Devaluation occurs when a country intentionally reduces the value of its currency relative to one or more foreign countries. Thus, Devaluation of a currency decreases the foreign value of domestic currency.  
  • When the country follows a fixed exchange rate regime the government constantly has to revalue and devalue the currency to maintain the pegged exchange rate.
  • When there is upwards market pressure on the currency to appreciate, the central bank will artificially devalue the currency by buying up foreign reserves. 
  • Devaluation occurs when a government wishes to increase its balance of trade by decreasing the relative value of its currency.
  • The government does this by adjusting the fixed or semi-fixed exchange rate of its currency versus that of another country.
  • Exports become cheaper and more competitive to foreign buyers. Higher exports relative to imports can increase aggregate demand as increased consumer spending on domestic goods and services. Hence, it improves the competitiveness of the domestic exports in the foreign markets.
    • With exports more competitive and imports more expensive, we may see higher exports and lower imports, which will reduce the current account deficit.
  • Devaluation of currency increases the volume of exports and reduces the volume of imports, both of which have a favourable effect on the balance of trade, that is, they will lower the trade deficit or increase the trade surplus. 
  • Although devaluation is done to improve the trade balance, the difference between the value of imports and exports as well as the preference of people in both countries will determine the improvement or deterioration of the trade balance, and we cannot conclude that devaluation will necessarily improve trade balance.
  • Devaluation also increases the debt burden of foreign-denominated loans when priced in the home currency. Thus, devaluation may not improve the trade balance in the long run.