What is Devaluation?

Devaluation is an official decrease in the par value of a currency. Most countries that are members of the International Monetary Fund have registered the par value of their currencies with the IMF. The par value is expressed in terms of gold or of the U. S. dollar, and the countries agree to maintain it within plus or minus 1%. Also, each country has agreed not to devalue its currency by more than 10% without the prior concurrence of the directors of the fund.

The U. S. dollar has a par value of 0.02857 ounces of gold; inversely, one ounce of gold is worth $35. The British pound was worth 0.11514 ounces of gold, or $4.03, in 1948. The first postwar devaluation of the British pound, in September 1949, resulted in a new value of 0.07799 ounces of gold, or $2.80. A second devaluation, in November 1967, resulted in a par value of 0.06851 ounces of gold, or $2.40.

Causes of Devaluation

The price of a currency, like the price of other things, depends primarily upon supply and demand. Supply and demand for different currencies meet on the foreign exchange markets. How do different currencies get into the foreign exchange markets?

Take the example of a manufacturer in Boston who sells a tractor for $4,800 to a tractor dealer in London. The British dealer pays for it with a check written on his own bank in London, in British pounds. At an exchange rate of £1 = $2.40, his check would be in the amount of £2,000. But the Boston manufacturer wants dollars, and so he sells the check in the foreign exchange market (that is, to a large bank, perhaps in New York or Chicago) for $4,800. On the other hand, the British dealer might have been required to make the payment in dollars. In that case, he could buy dollars from the London foreign exchange market (that is, a large London bank), obtaining $4,800 with his own £2,000 and sending the dollars to Boston. The first method increased the supply of pounds in the U. S. foreign exchange market; the second decreased the supply of dollars in London. (Tourism, private investment abroad, foreign military expenditures, and other factors also affect the supply of different currencies in different foreign exchange markets.)

If, over the years, the British keep buying far more goods from the United States than the latter buys from them, there would be a surplus of pounds available in New York and a shortage of dollars in London. When London banks start running short of dollars, they will wish to buy more from New York banks, paying for them, as usual, with British pounds, at the rate of £1 = $2.40. But the New York banks may accumulate too many British pounds and will then offer less than $2.40 per pound. When they begin to offer too much less, for example, $2.37, the Bank of England will attempt to prevent the exchange rate from falling below $2.38 per pound. The Bank of England will sell its dollar reserves on the London foreign exchange market to increase the dollar supply in England, and it will sell dollars in New York in exchange for pounds to decrease the supply of pounds in the United States. It will also sell its gold reserves for dollars and follow the same procedure. If the Bank of England runs out of both dollars and gold, it may borrow dollars from the IMF or from the United States or some other country. However, if the Bank of England can borrow no more dollars and so cannot support the price of the pound, the price will begin to go down below $2.38. At that point Britain may decide to devalue its currency.

Effects of Devaluation

The usual cause of a devaluation is that a country continually imports more goods and services than it exports (for some countries, such as the United States, other factors such as heavy foreign military expenditures cause the balance of payments deficit). A major reason for imports exceeding exports may be that the prices of a country's goods are too high in terms of other currencies. For example, if a British motorcycle sells for £ 100 at an exchange rate of $2.40 per pound, it would cost a Chicago motorcycle dealer $240. If he can buy an equivalent motorcycle from Japan for $225, he probably would do so. However, if die British devalue their currency to $2.00 per pound, the Chicago dealer can buy the £100 motorcycle for $200. So the Chicago dealer may change direction and begin buying British motorcycles, thus increasing British exports.

Devaluation has the reverse effect for the British tractor dealer who paid £2,000 for a U. S. tractor when the pound was worth $2.40. If the pound were devalued to $2.00, the $4,800 tractor would cost £2,400. But if a similar tractor were manufactured and sold in England for £2,200, the British dealer, after such a devaluation, would buy the British tractor rather than the one from Boston, thereby decreasing British imports. It is obvious, then, that a devaluation should result in decreased imports and increased exports, leading to a surplus in the balance of trade.

A government faced with continual deficits in its balance of payments could adopt fiscal and monetary measures and changes in foreign policy that might solve the problem without devaluation. Devaluation alone is only a temporary relief from a balance of payments deficit. For example, an increase in exports and a decrease in imports will tend to cause an economic boom and lead to inflation. In addition, if a country depends upon imports for a large part of its supply of food and raw materials, as Britain does, these supplies will cost more in terms of the country's currency than before devaluation. The cost of food goes up, and the cost of manufactured goods increases, again resulting in inflation. If this inflation is not controlled by the government through fiscal and monetary policies and other measures, the country will lose the benefits of its previous devaluation and will have to devalue again, leading to another round of inflation.

Diversity of Effects

Many underdeveloped countries do not benefit from a devaluation. This is because, even after the devaluation, they continue to import the same goods as previously, and they may not be able to increase their exports.

Among the developed countries, some have a great dependence on imported food and raw materials and therefore benefit less from a devaluation. If a key country such as the United States were to devalue its currency, many other countries probably would devalue their currencies by a like amount, and the United States would lose most of the potential benefits of the devaluation.

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Simone Smith profile image

Simone Smith 5 years ago from San Francisco

Blergh. Devaluation makes me nervous. But you've provided an excellent explanation here! Voted up and useful.

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