Effects of a Devaluation - Revision notes

Economic Effect of a Devaluation of the Currency

A devaluation occurs in a fixed exchange rate. A depreciation occurs in a floating exchange rate system. Both mean a fall in the value of the currency.

Economic Revision Notes on Devaluation

1. A devaluation of the exchange rate will make exports more competitive and appear cheaper to foreigners. This will increase demand for exports

2. A devaluation means imports will become more expensive. This will reduce demand for imports.

3. Higher economic growth. Part of AD is X-M Therefore higher exports and lower imports will increase AD. Higher AD is likely to cause higher Real GDP and inflation.

4. Inflation is likely to occur because:

i) Imports are more expensive causing cost push inflation.
ii) AD is increasing causing demand pull inflation
iii) With exports becoming cheaper manufacturers may have less incentive to cut costs and become more efficient. Therefore over time costs may increase.

Evaluation:

The effect on inflation will depend on other factors such as:

iv) Spare capacity in the economy. E.g. in a recession, a devaluation is unlikely to cause inflation
v) Do firms pass increased import costs onto consumers? Firms may reduce their profit margins, at least in the short run.
vi) Import prices are not the only determinant of inflation. Other factors affecting inflation such as wage increases may be important

5. There is likely to be an improvement in the current account balance of payments.
This is because exports are increasing and imports are falling

Evaluation of a Devaluation

The effect of a devaluation depends on elasticity of demand for exports and imports.

If demand is price inelastic, the a fall in the price of exports will lead to only a small rise in quantity. Therefore, the value of exports may actually fall.

An improvement in the current account on the Balance of Payments depends upon the Marshall Lerner condition and the elasticity of demand for exports and imports

If PEDx + PEDm > 1 then a devaluation will improve the current account
The impact of a devaluation may take time to have effect. In the short term, demand may be inelastic, but over time demand may become more price elastic and have a bigger effect.

Essays and Revision Notes on Exchange Rates

Exchange Rate Essays

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