Advantages and Disadvantages of Devaluation

Readers question: what are Advantages and Disadvantages of Devaluation?

Devaluation is the decision to reduce the value of a currency in a fixed exchange rate. The £ Sterling has been depreciating in value since the middle of last summer and provides a practical example.

Advantages of Devaluation

1. Exports become cheaper, more competitive to foreign buyers. Therefore, this provides a boost for domestic demand.
2. Higher level of exports should lead to an improvement in the current account deficit. This was important in the case of the UK who had a large current account deficit of over 3% of GDP in 2008
3. Higher exports and aggregate demand can lead to higher rates of economic growth.

Disadvantages of Devaluation

1. Is likely to cause inflation because:

• Imports more expensive
• AD increases causing demand pull inflation
• Firms / exporters have less incentive to cut costs because they can rely on the devaluation to improve competitiveness

2. Reduces the purchasing power of citizens abroad. e.g. more expensive to holiday in Europe.

3. A large and rapid devaluation may scare off international investors. It makes investors less willing to hold government debt because it is effectively reducing the value of their holdings.

Note It depends on:

• State of business cycle – In a recession a devaluation can help boost growth without causing inflation. In a boom a devaluation is more likely to cause inflation
• Elasticity of demand. A devaluation may take a while to improve current account because demand is inelastic in the short term.

See also:

• Effects of falling value of dollar
• understanding exchange rates