An overvalued exchange rate implies that a countries currency is too high for the state of the economy. An overvalued exchange rate means that the countries exports will be relatively expensive and imports cheaper. An overvalue exchange rate tends to depress domestic demand and encourage spending on imports.
An overvalued exchange rate can also be measured by looking at purchasing power parity PPP. An overvalued exchange rate will mean goods are relatively more expensive in that country. (a more sophisticated form of PPP also takes into account difference in real GDP per capita – Beefed up Big Mac Index at Economist)
An overvalued exchange rate is particularly a problem during a period of sluggish growth. If the economy is booming, an overvalued exchange rate can help reduce inflationary pressure, but in a recession an overvalued exchange rate can cause deflationary pressures.
Example Overvalued Exchange Rates
In 2011, both Switzerland and Japan have witnessed an appreciation in their currency. This appreciation occurred because investors are worried over finding secure investments in a period of economic uncertainty. However, because the global economy remains depressed (slow growth, high unemployment). This appreciation is unwelcome. It makes it more difficult to export goods and can lead to lower growth. For an economy like Japan which relies on a strong export sector, this decline in competitiveness could be very damaging for the their economy.
This is why both Switzerland and Japan have sought to intervene to try and reduce the value of their currency.
In a period of global economic stagnation, we often see countries trying to devalue their currency to boost their exports. This is known as competitive devaluation
Overvalued Exchange Rates in the Euro
Another potential problem of countries in the Eurozone is that there is a danger of running a large current account deficit due to a decline in competitiveness.
For example, countries like Portugal and Greece have a current account deficit of close to 10%. This is because they don’t have their own exchange rate to depreciate against other countries.
They have a current account deficit because they have had relatively higher inflation rates than other Eurozone economies. For example, rising labour costs not met by improved productivity.
This combination of higher prices and lower productivity makes their goods less attractive, leading to more imports and less exports. Hence the very large current account deficits
If they had their own exchange rate, we would see a devaluation in the currency making exports more competitive and imports cheaper. This would help reduce the size of the current account deficit.
For example, the UK has had a persistent current account deficit, but with an independent exchange rate, the exchange rate can depreciate to reduce the size of deficit.
Dealing with Current Account Deficit.
The problem is that in the absence of a floating exchange rate it becomes more painful to solve the current account deficit.
To regain competitiveness, Greece and Portugal will have to rely on deflationary policies. For example, higher tax and lower spending to reduce consumer spending on imports. Also by reducing inflation this makes exports more expensive.
The problem is that it requires a prolonged period of deflation to regain competitiveness. Also deflation will bring other problems such as low growth, high unemployment.