Since , exchange rates for most industrialized countries have floated, or fluctuated, according to the supply of and demand for different currencies in international markets. An increase in the value of a currency is known as appreciation, and a decrease as depreciation. Some countries and some groups of countries, however, continue to use fixed exchange rates to help to achieve economic goals, such as price stability.
Under a fixed exchange rate system, only a decision by a country's government or monetary authority can alter the official value of the currency. Governments do, occasionally, take such measures, often in response to unusual market pressures.
Devaluation , the deliberate downward adjustment in the official exchange rate, reduces the currency's value; in contrast, a revaluation is an upward change in the currency's value. For example, suppose a government has set 10 units of its currency equal to one dollar. To devalue, it might announce that from now on 20 of its currency units will be equal to one dollar. This would make its currency half as expensive to Americans, and the U.
To revalue, the government might change the rate from 10 units to one dollar to five units to one dollar; this would make the currency twice as expensive to Americans, and the dollar half as costly at home. But if the actual exchange rate is 6 yuan to the dollar — meaning 1 yuan gets you only about 16 cents — then the yuan is viewed as undervalued. You don't get as much bang for your yuan as you should. A currency may be undervalued simply because there's insufficient demand for it.
If no one wants to buy the Botswana pula, then the pula is probably going to be undervalued no matter how healthy Botswana's economy is. But governments also deliberately undervalue their currencies — for example, by manipulating the money supply or setting artificially low exchange rates. They do this because they know that you like to save money.
If the Chinese yuan is undervalued in relation to the dollar, then Chinese-made products are cheaper in the U. Devaluation also increases the debt burden of foreign-denominated loans when priced in the home currency. This is a big problem for a developing country like India or Argentina which hold lots of dollar- and euro-denominated debt. These foreign debts become more difficult to service, reducing confidence among the people in their domestic currency.
A government may be incentivized to encourage a weak currency policy if it has a lot of government-issued sovereign debt to service on a regular basis. If debt payments are fixed , a weaker currency makes these payments effectively less expensive over time. Again, this tactic should be used with caution.
As most countries around the globe have some debt outstanding in one form or another, a race to the bottom currency war could be initiated. This tactic will also fail if the country in question holds a large number of foreign bonds since it will make those interest payments relatively more costly. Currency devaluations can be used by countries to achieve economic policy. Having a weaker currency relative to the rest of the world can help boost exports, shrink trade deficits and reduce the cost of interest payments on its outstanding government debts.
There are, however, some negative effects of devaluations. They create uncertainty in global markets that can cause asset markets to fall or spur recessions.
Countries might be tempted to enter a tit for tat currency war, devaluing their own currency back and forth in a race to the bottom. This can be a very dangerous and vicious cycle leading to much more harm than good.
Devaluing a currency, however, does not always lead to its intended benefits. Brazil is a case in point. The Brazilian real has plunged substantially since , but the steep currency devaluation has been unable to offset other problems such as plunging crude oil and commodity prices, and a widening corruption scandal. As a result, the Brazilian economy has experienced sluggish growth. Monetary Policy. Your Privacy Rights. To change or withdraw your consent choices for Investopedia.
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