A devaluation (depreciation) occurs when the exchange rate falls in value. This causes exports to be cheaper and imports to be more expensive. In theory, it can help increase economic growth, though it may cause inflation.
In theory, a devaluation will cause the following to happen:
- The price of UK exports will be lower in foreign currencies. This will increase the competitiveness of UK exports and should cause an increase in demand for UK exports.
- The price of imported goods into the UK will increase. This will reduce our spending on imports and instead we will be more likely to buy domestic goods.
- The increase in (X-M) should cause an increase in Aggregate Demand (AD), economic growth and cause a reduction in unemployment.
- The increased competitiveness should cause an improvement in the current account on the balance of payments.
Evaluation
The impact of a devaluation depends on economic circumstances.
- If a country is suffering from being uncompetitive with high unemployment and low inflation – a devaluation may help considerably.
- However, in a severely depressed global economy (e.g. 2008-13), a devaluation may be insufficient to restore economic growth.
- The fall in the value of the Pound (2016) is partly due to concerns over Brexit (British exit from EU). This is causing uncertainty and will likely to reduce investment from export firms. In this situation, the devaluation will probably do little to boost economic growth. However, with inflation near zero, the usual inflationary pressure of devaluation will not be a problem.
UK Devaluation between 2008 and 2013
Between 2008 and 2013, the Pound experienced a 25-30% devaluation in Sterling, but the UK had only a weak recovery, some cost push inflation and a surprisingly large current account deficit. It seems the depreciation in the pound did little to help the UK economy. This was due to several factors
- Demand for exports and imports relatively inelastic. UK continued to import more expensive German cars, but export demand also inelastic.
- Weak Eurozone growth. 2008-13 was a period of low EU growth, therefore more competitive UK exports were insufficient to boost export demand.
- Fiscal austerity and fall in bank lending were major factors depressing the economy. Therefore, the devaluation was insufficient to compensate for the fall in other components of AD.
Pound Sterling Index
Impact of devaluation on economic growth
1. Economic growth. In terms of economic growth, the five years after 2007/08 devaluation were relatively low. The devaluation was insufficient to stop the deepest recession for a long time, and the recovery was weak – compared to other recoveries. (see: Comparison of different recessions)
2. Current account deficit. The current account deficit actually got bigger from 2010.
In 2008, the current account deficit was less than 2% of GDP. At the end of 2013, this current account deficit fell to more than 5% of GDP – a very high deficit (more at current account balance of payments) This seems to contradict economic theory – as you would expect a devaluation to improve the current account – not worsen it.
How do we explain the relative failure of devaluation to rebalance the economy in UK 2007-13?
1. Inelastic demand for exports and imports Evidence suggests that demand for UK exports is relatively inelastic. UK exports have become less price competitive as we’ve moved away from low-cost manufacturers to a variety of services and high-tech manufacturing; these goods tend to have relatively few close substitutes. Therefore, even if the price falls, the increase in demand is relatively low. Similarly, demand for imports is relatively inelastic meaning we continue to pay the higher price. (The Marshall-Lerner condition states a devaluation will worsen the current account if PEDx + PEDm >1)
