Why Greece will Devalue after leaving the Euro

Readers Question. You said that if Greece leaves the Euro, the Drachma will depreciate. Why will this happen?

If Greece did leave the Euro, then the currency which replaced the Euro, would definitely fall in value.

Greeks would soon see the price of imports increase. The foreign price of Greek exports would fall.

If Greece left the Euro, the Greek Drachma would fall, for quite a few reasons.

  1. Loss of Confidence. Because the Greek government is on the verge of default, investors would fear losing money held in Drachma’s, therefore there would be a rush by savers to buy Euro investments and save in Euros. Therefore there would be capital flight, as Greeks tried to move their savings out of Greece and put it into Euros. This increase in supply of Drachma’s would cause it to fall.
  2. Fundamental Economic Imbalance. The Greek economy has become fundamentally imbalanced. Prices and Wage costs have risen faster in Greece than elsewhere in the Eurozone. This means Greek exports have become uncompetitive. In a floating exchange rate, this uncompetitiveness would lead to a fall in the exchange rate because people choose less Greek exports.

greece

Source: Current account deficits in the Euro

This graph shows Greece has a current account deficit of 10% of GDP. In a floating exchange rate, this wouldn’t occur, the Greek currency would have fallen – restoring competitiveness.

3. Independent Monetary Policy

With an independent monetary policy, Greece would be able to eschew the focus on keeping inflation low. To offset the fiscal austerity, the Greek central bank maybe able to pursue quantitative easing. This increases likelyhood of higher inflation rate. This tends to reduce value of currency as it loses value against others.

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By on August 9th, 2011

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