Readers Question: Q. Wouldn’t a floating exchange rate correct the deficits via the automatic stabilizer? High demands for foreign goods causes a huge supply of the US dollar and subsequently the value of the dollar should fall. A depreciated currency would mean less goods are imported since it would be more expensive, therefore, correcting the deficit.
The current account deficit causes an outflow of dollars. Without any other capital flows, this increase in supply would cause a depreciation until the deficit is solved. However, what happens, is that the US is able to attract inflow of capital flows which act as credit on the Capital account (sometimes known as Financial account) For example, Chinese bank buy US securities and Japanese firms invest in US factories. Therefore, the inflow on the capital account (and therefore demand for dollars) prevents the value of the dollar falling.
Readers Question: On a side note, is the term “devalue” correct in a floating exchange rate system? I have been told the terms “revalue” and “devalue” only comes in a pegged exchange rate. For a floating system, “appereciate” and depreciate would be used instead.
You are quite correct. The technical term is depreciate rather than devalue. A devaluation should only refer to a pegged exchange rate. However, in everyday use, people often fail to distinguish as they have the same effect – a lower value of the dollar.
I blogged about this previously, Definition of Devalue and Depreciation