Devaluation
What is Devaluation?
Devaluation is a deliberate official cut in a currency's fixed exchange rate, decided by the government or central bank rather than by market trading.
Under a fixed exchange rate the central bank commits to buying and selling its currency at a stated rate, so the rate moves only when the authorities announce a new one, and announcing a weaker one is a devaluation. The usual motive is a stubborn trade deficit or a drain on the foreign reserves the country can no longer afford to spend defending the old rate. A cheaper currency makes exports cheaper to foreign buyers and imports dearer at home, but whether the trade balance actually improves depends on the Marshall-Lerner condition, and the improvement typically arrives late because trade volumes adjust slowly. Devaluation also raises the domestic-currency cost of imported inputs, so it tends to push up inflation.
Devaluation: a worked example
Country A pegs its currency at 0.50 dollars per unit, then announces a new peg of 0.40 dollars per unit. The change is (0.40 − 0.50) / 0.50 × 100, which is −20 percent, so the currency has been devalued by 20 percent. An export priced at 60 units at home used to cost foreign buyers 60 × 0.50 = $30 and now costs 60 × 0.40 = $24, a saving of $6 for them. An imported machine priced at $90 abroad used to cost 90 / 0.50 = 180 units at home and now costs 90 / 0.40 = 225 units, a rise of 25 percent. Notice the asymmetry: a 20 percent devaluation raises import costs by 25 percent, because 1 / 0.8 = 1.25.
The mistake students make with devaluation
The common error is treating devaluation and depreciation as the same word. Depreciation is a fall in a floating currency's value produced by supply and demand in the foreign exchange market, while devaluation is an announcement by authorities who were holding a fixed rate. Only a country running a peg can devalue at all. The second error is assuming a devaluation automatically fixes a trade deficit: it does so only if export and import demand are jointly elastic enough, and even then the effect is delayed.
Devaluation questions
What is the difference between devaluation and depreciation?
Devaluation is a policy decision to lower a fixed exchange rate, while depreciation is a market-driven fall in a floating currency's value. A country with a peg devalues by announcing a new, weaker official rate. A country with a floating rate cannot devalue, because no authority is setting the rate that would be changed.
Why would a government devalue its currency?
Governments usually devalue to make exports cheaper abroad and to stop burning the foreign reserves needed to defend an overvalued peg. A weaker rate can lift export volumes and shrink a trade deficit. The costs are dearer imports, higher inflation, and lost credibility, which makes any future peg harder to defend.
Does devaluation always improve the trade balance?
No, a devaluation improves the trade balance only if the combined price elasticities of demand for exports and imports are greater than one, which is the Marshall-Lerner condition. If buyers barely change the quantities they trade, the country simply pays more for much the same imports and the balance worsens. Even when the condition holds, volumes adjust slowly, which produces the J-curve pattern of a worse balance before a better one.
Formula / Example
Related terms
Common comparisons
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