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ECS3703 FINAL EXAM SOLUTIONS FOR SEMESTER 1 YEAR 2024
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,This means that if the balance of payments has a deficit in an account, it must have a surplusin another account. Not always, the exchange rate adjusts to the current account deficit since
this depends on many factors that can compensate for the fluctuation in the value of a
currency. It is worth noting that a strategic currency devaluation does not always work, and
moreover may lead to a 'currency war' between nations. Competitive devaluation is a specific
scenario in which one nation matches an abrupt national currency devaluation with another
currency devaluation. In other words, one nation is matched by a currency devaluation of
another. This occurs more frequently when both currencies have managed exchange-rate
regimes rather than market-determined floating exchange rates. Even if a currency war does
not break out, a country should be wary about the negatives of currency devaluation. Currency
devaluation may lower productivity, since imports of capital equipment and machinery may
become too expensive. Devaluation also significantly reduces the overseas purchasing power
of a nation’s citizens.
Below, three top reasons why a country would pursue a policy of devaluation:
1. To Boost Exports
On a world market, goods from one country must compete with those from all other countries.
Car makers in America must compete with car makers in Europe and Japan. If the value of the
euro decreases against the dollar, the price of the cars sold by European manufacturers in
America, in dollars, will be effectively less expensive than they were before. On the other
hand, a more valuable currency make exports relatively more expensive for purchase in
foreign markets.
In other words, exporters become more competitive in a global market. Exports are
encouraged while imports are discouraged. There should be some caution, however, for two
reasons. First, as the demand for a country's exported goods increases worldwide, the price
will begin to rise, normalizing the initial effect of the devaluation. The second is that as other
countries see this effect at work, they will be incentivized to devalue their own currencies in
kind in a so-called "race to the bottom." This can lead to tit for tat currency wars and lead to
unchecked inflation.
2. To Shrink Trade Deficits
Exports will increase and imports will decrease due to exports becoming cheaper and imports
more expensive. This favors an improved balance of payments as exports increase and
imports decrease, shrinking trade deficits. Persistent deficits are not uncommon today, with
the United States and many other nations running persistent imbalances year after year.
Economic theory, however, states that ongoing deficits are unsustainable in the long run and
can lead to dangerous levels of debt which can cripple an economy. Devaluing the home
currency can help correct balance of payments and reduce these deficits.
There is a potential downside to this rationale, however. 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.
3. To Reduce Sovereign Debt Burdens
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.
Take for example a government who has to pay $1 million each month in interest payments on
its outstanding debts. But if that same $1 million of notional payments becomes less valuable,
it will be easier to cover that interest. In our example, if the domestic currency is devalued to
half of its initial value, the $1 million debt payment will only be worth $500,000 now.
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.
The Bottom Line
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 2011, 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.
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