Economic effect of a devaluation of the currency

Economics

                                    

Economic effect of a devaluation of the currency

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A devaluation occurs in a fixed exchange rate. A depreciation occurs in a floating exchange rate system. Both mean a fall in the value of the currency. e.g. a devaluation in the Pound means it is worth less Euros.

Effects of a devaluation

1. Exports cheaper. A devaluation of the exchange rate will make exports more competitive and appear cheaper to foreigners. This will increase demand for exports

2. Imports more expensive. A devaluation means imports will become more expensive. This will reduce demand for imports.

3. Increased AD. A devaluation could cause higher economic growth. Part of AD is (X-M) therefore higher exports and lower imports should increase AD (assuming demand is relatively elastic). Higher AD is likely to cause higher Real GDP and inflation.

4. Inflation is likely to occur because:

Imports are more expensive causing cost push inflation.

AD is increasing causing demand pull inflation

With exports becoming cheaper manufacturers may have less incentive to cut costs and become more efficient. Therefore over time, costs may increase.

5. Improvement in the current account. With exports more competitive and imports more 

expensive, we should see higher exports and lower imports, which will reduce the current account deficit.

Evaluation of a Devaluation

The effect of a devaluation depends on:

1. Elasticity of demand for exports and imports. If demand is price inelastic, the a fall in the price of exports will lead to only a small rise in quantity. Therefore, the value of exports may actually fall. An improvement in the current account on the Balance of Payments depends upon the Marshall Lerner condition and the elasticity of demand for exports and imports

If PEDx + PEDm > 1 then a devaluation will improve the current account

The impact of a devaluation may take time to have effect. In the short term, demand may be inelastic, but over time demand may become more price elastic and have a bigger effect.

2. State of the global economy. If the global economy is in recession, then a devaluation may be insufficient to boost export demand. If growth is strong, then there will be a greater increase in demand. However, in a boom, a devaluation is likely to exacerbate inflation.

3.Inflation The effect on inflation will depend on other factors such as:

Spare capacity in the economy. E.g. in a recession, a devaluation is unlikely to cause inflation.

Do firms pass increased import costs onto consumers? Firms may reduce their profit margins, at least in the short run.

Import prices are not the only determinant of inflation. Other factors affecting inflation such as wage increases may be important.

4. It depends why the currency is being devalued. If it is due to a loss of competitiveness, then a devaluation can help to restore competitiveness and economic growth. If the devaluation is aiming to meet a certain exchange rate target, it may be inappropriate for the economy.

5 Things to Know About China’s Currency Devaluation

Economics

                     
                                                              

5 Things to Know About China’s Currency Devaluation

10 AUG 2015 11:57PMBY CARLOS TEJADA
http://blogs.wsj.com/

China on Tuesday devalued its currency in a way that left it 1.9% weaker versus the U.S. dollar. The move will likely have a ripple effect through financial markets as well as in politics, as China is the world’s largest trader and the yuan is increasingly used overseas. Here are five things you need to know about Beijing’s latest move.

                                                                                              

1 What did China do?

China tightly controls the value of its currency by setting a daily rate for the yuan versus the dollar. In China’s domestic market, traders are allowed to push the yuan 2% stronger or weaker for the day. But the People’s Bank of China often ignores those market signals when it sets the next day’s rate, sometimes setting the yuan stronger versus the dollar when the market is signaling it sees the yuan as weaker. The central bank said it will now take the previous day’s trading into account – and it attributes that move to Tuesday’s sharp drop.

2 Why did China do it?

In its statement, the PBOC said it wants to bring the yuan more in line with the market. But the move also comes as China’s important export sector has weakened – and overall economic growth looks sluggish. Over the weekend, Chinese customs officials said July exports fell 8.3% compared with a year ago. A weaker currency helps China’s exporters sell their goods abroad.

3 What does this mean for the rest of the world?

The most immediate effect is that it signals to the world that Beijing thinks the Chinese economy is sputtering. The move suggests China is looking for ways to get it going again. But it also has major implications for the U.S. and other countries that trade with China because it puts their companies at a disadvantage. In the U.S., it will likely reignite criticism that Beijing keeps the currency artificially low to help its own manufacturers – a charge that could get added impetus during the presidential election campaign.

4 What does this mean for markets?

The move puts pressure on other central banks around the world to push down their own currencies to help their own exporters and to prevent destabilizing capital flows. The move could hurt commodities markets because it signals potential weak demand from China. It could also accelerate capital outflows out of China, especially if investors expect further devaluations.

5 What’s next?

The move could add to tensions ahead of Chinese President Xi Jinping’s visit to the U.S. and his meetings with President Barack Obama, which is set for late September. It could also complicate China’s efforts to get the yuan added to a basket of currencies tracked by the International Monetary Fund – efforts aimed at giving the yuan greater acceptance abroad. Longer-term, the move raises questions about Beijing’s pledge to liberalize its economy. On one hand, making the yuan more market-driven is a step in that direction. But the move also appears to be designed to help exporters, at a time when China has been looking for other, more dependable sources of growth.