Deliberate changes to a peg
Definition
Fixed exchange rate: an exchange rate held by the central bank at an announced official level against another currency or basket.
Devaluation: a deliberate reduction in the official value of a currency within a fixed system.
Revaluation: a deliberate increase in the official value of a currency within a fixed system.
- A devaluation is a deliberate cut in that official value, and a revaluation is a deliberate rise.
- Because the authorities choose them, these are policy decisions rather than market outcomes, so they are distinct from depreciation and appreciation.
What each one does
- Devaluation
- Exports become cheaper in foreign currency and imports dearer at home, so net exports and AD tend to rise.
- A government may devalue to correct a persistent current account deficit or to support output and jobs.
- Revaluation
- Exports become dearer and imports cheaper, so net exports and AD tend to fall.
- A government may revalue to ease imported inflation or to cool an overheating economy.
Example
- In 1967 the UK devalued the pound under the Bretton Woods fixed system from $2.80 to $2.40.
- Sterling fell by roughly 14.3%, so a £1,000 UK export cost a US buyer $2,400 instead of $2,800, making it markedly more competitive.
Note
- Devaluation and revaluation apply only to fixed or managed systems, where an official rate exists to change.
- Under a floating system the equivalent market movements are called depreciation and appreciation.
Does devaluation work?
- A devaluation improves the current account only if the Marshall-Lerner condition holds, so demand for exports and imports is elastic enough.
- Even then the J-curve implies the balance may worsen first, because trade volumes adjust slowly to the new prices.
- Dearer imports can also raise costs and import inflation, which may offset the competitiveness gain, so it depends on how the economy responds.
Exam technique
- Use devaluation and revaluation only for fixed or managed systems.
- State the direction clearly: devaluation lowers the peg, revaluation raises it.
- Trace the chain through export and import prices to the current account.
- Evaluate with the Marshall-Lerner condition and the J-curve.
Common Mistake
- Do not use devaluation and depreciation as if they mean the same thing.
- Devaluation is a deliberate policy act under a fixed system, while depreciation is a market fall under a floating one.
- Do not assume devaluation always improves the current account.
- It depends on elasticities and the J-curve lag.
Self review
- What is a devaluation, and which systems does it apply to?
- How does a revaluation differ from a devaluation?
- What is the floating-system equivalent of a devaluation?
- Why might a devaluation fail to improve the current account?
- What does the J-curve show?
