Transcript Slide 1

1
Devaluation
Devaluation
2
Meaning of Devaluation
Devaluation refers to a reduction in the external value of a
currency in terms of other country’s currency.
Under it, there is no change in the internal purchasing power of
the country.
A country with fundamental disequilibrium in its BOP may
devalue its currency in order to
INCREASE its EXPORTS &
DISCOURAGE IMPORTS
For example: With devaluation, the domestic price of imports in
the devaluing country increase and the foreign price of its
exports falls.
3
Explanation:
This can be explain with the help of the following
example:
Before the devaluation exchange rate in afghanistan was
50Afs=$1, it means 1Afs = 0.020 $ after the devaluation
the exchange rate is 55Afs=$1, means 1 Af=0.018$.
As a result US imports became expensive for Afghanistan
and exports became cheaper in US because the US traders
could buy goods worth 1Afs from Afghanistan by paying
$0.18 instead of 0.020$.
And for imports it have apposite effects .
4
Devaluation and depreciation
• If an economy is operating under a fixed exchange rate and if
it officially lowers the price of its currency in foreign market
• It is known as devaluation
• thus devaluation is the official decrease in domestic value of
the currency in relation to foreign currency
• Depreciation
• Depreciation means reduction in value of domestic currency
in relation to foreign currency due to market demand and
market supply
• If demand for foreign currency is remaining constant and if
supply of foreign currency increase, so it will depreciate the
value of foreign currency
Example:
Before the Devolution in the
currency in a country
Purchases 10 kg Rice
internally ( in country)
After the Devaluation in currency of a country
There will be the same position of
prices, because the devaluation can not
affect internal purchasing power of the
population. Its affect the Imports or
Exports prices in the rest of the world
countries.
6
Effects of devaluation
1.
Effects of Devaluation In BOP: We have already told that because of
devaluation the exports will increase and imports will decrease.
The exportable commodities of a country become cheaper abroad and
on other hand the prices of imported commodities become goes up.
Economists have explained a number of situations
a) Inelastic demand for Exports
Incase of inelastic demand for export
Devaluation instead of increasing export
earning decrease the export earnings
of devaluating country. So total value of
export after devaluation decreases
Dx
R
Sx
R1
Sx
Export X
7
Effects of Devaluation
b) less elastic demand for Exports
incase of less elastic demand for exports the result will be same as
in case of above
Total exports earning before devaluation are greater than after
devaluation .
after devaluation exchange rate tends
to decrease from R to R1
and export earnings
after devaluation decrease
R
R
Sx
R1
Sx1
Dx
xx
X
Effects of Devaluation (cont..)
c) Elastic demand for exports
• If foreign demand for exports is elastic or greater than unity,
devaluation will improve the BOP
before devaluation R is exchange rate
and X is export, after devaluation
exchange rate tends to decrease
R
Sx
, the new exchange rate is R1 ,
Sx
R1
which cause to increase the
Dx
export from X to
x
x1
Effects of Devaluation (cont..)
X1 so export earnings after devaluation
increase
Effects of Devaluation (cont..)
D) Unity elastic demand for exports
• If foreign demand for exports is unity elastic, devaluation is
ineffective
before devaluation R is
exchange rate
and X is export, after devaluation
Sx
R
exchange rate tends to decrease
Sx
R1
, the new exchange rate is R1 ,
Dx
which is ineffective in improving
the BOP because
x
x1
Effects of Devaluation (cont..)
•
2)
Reduction in exchange rate is equal to increase to export
Effects of devaluation on imports
In the effect of devaluation on imports we should consider
different import elasticities,
a) inelastic demand for import
Devaluation increases the import prices, which decrease the
demand for imported goods
but when demand for imported goods became inelastic
it can not decrease its imports even when they have become
costlier
Effects of Devaluation (cont..)
• There will be loss instead of gain.
because if we look at the fig total value of import
increase form OREM to OR1E1M
DM
R1
R
E1
E
import M
S1m
Sm
Effects of Devaluation (cont..)
b) Less elastic demand for imported goods
when demand for imported goods are relatively inelastic
devaluation in that case is ineffective ,because due to
devaluation increases in exchange
is greater than decrease
R
in import
Look at the picture due to
Sm
R1
devaluation exchange rate
R
Sm1
increases from R to R1
Dm
m1 m
M
Effects of Devaluation (cont..)
but there is a small reduction in import i.e. import decreases
from m to m1
C) More elastic demand for imports
incase of more elastic demand
for imports Devaluation of
currency is effective
Because reduction in import is
Greater than increase in
R1
exchange rate
R
And this thing is visible from the fig
Dm
m1
m
Effects of Devaluation (cont..)
• D) Unity elastic demand for imports
If elasticity of demand for imported goods is equal to unity the
total value of imports before and after devaluation remains
the same and there is no effect of devaluation on BOP
because total value of imports
before and after devaluation of
R1
Import are equal
R
m
m1
m
Effects of Devaluation (cont..)
3

a.
b.
c.
Terms of Trade( TOT) Effect of Devaluation:
TOT means the ratio of exports prices and imports prices.
The effect of devaluation on terms of trade depends on demand
and supply elasticities for exports and imports. The following
relationships explain the effects of devaluation on ToT.
If demand elasticisties for imports and exports > supply
elasticities for imports and exports devaluation improve the ToT.
If demand elasticisties for imports and exports < supply
elasticities for imports and exports devaluation worsens the ToT.
If demand elasticisties for imports and exports = supply
elasticities for imports and exports devaluation no effect on the
ToT.
Effects of Devaluation
3. Income effects Devaluation:
It is difficult to measure the exact effect of devaluation on the
national income, but normally it has been seen that it leads to
rise the real volume of exports and decline the real volume of
imports, as a result the national income of devaluating country
will increase
The additional income so generated will further increase income.
This will leads to an increase in domestic consumption and saving
18
Effects of a Currency Devaluation
Exchange
rate, E
DD
2
E1
1
E0
AA2
AA
1
Y1
Y2
Output, Y
19
Explanation of Graph
• Due to devaluation exchange rate rises from E0 to
E1 .
• Due to devaluation exports increases so supply of
money increases , money supply curve shift to the
right
• the AA curve to the right. So, devaluation raises GDP
and reduces unemployment
20
Effects of Devaluation
4) Effect of devaluation on supply
in case of devaluation the exports increase and imports
decrease , but exports increase if supply of resources and raw
material could be increase easily,
it may be true in case of depression when a country is
possessing unused resources. But if a country is already
having full employment the supply will not increase
this is the reason that so many developing countries do not
have “Export Surplus”
in such circumstances the devaluation will hardly lead to
increase the exports
Effects of Devaluation (cont..)
5)
Effect of devaluation on debt burden
Owing to devaluation, debt burden of a country will increase
because of devaluation, the expenditures pertaining with the
imports of military hardware's, invisible items, education,
embassies, health care and shipping will increase
Conditions for the success of Devaluation
Devaluation is an important measure to remove the
disequilibrium in the balance of payment. But it success
depends on some essential conditions. They are as follows,
1. More than unity Elasticity of Demand for exports :
It is essential for the success of devaluation that the elasticity
of demand for exports should be grater than unity, if elasticity
of demand for exports is less than unity the effect of
devaluation on BOP is not favorable
2. Sufficient supply of Exports:
The second condition is that the supply of exports should be
adequate to meet the increase demand for exports after
devaluation.
23
Condition for the success of Devaluation
3. Stable Internal Price Level:
The effects of devaluation will be positive if the price level
remain constant in the country after devaluation. When
there is devaluation, exports increase and imports dearer, as
a result shortage of consumer goods appear in the country
which rises the prices.
4. Non Competitive Devaluation:
Devaluation will be successful if other countries do not
devalue their currencies. If the other countries devalue their
currencies the effect of devaluation for the first devalue
country will be neutralized.
24
Condition for the success of Devaluation
5. Counter devaluation measure:
When a country devalue it currency and other countries
adopt measure to counter the effects of devaluation on
them, devaluation will not help the devalue country.
Because if other countries raises tariffs duties on imports
from the devaluing country the export of devaluing
country will become dearer and the beneficial effect of
devaluation will be offset
25
Condition for the success of Devaluation
In other hand the non devalue countries give exports subsidies
to their industries, their exports to devaluing country will
become cheaper and the later will not be able to reduce its
imports.
6) Spirit of sacrifice by people:
For successful devaluation spirit of sacrifice in devaluating
country is important ,workers should avoid disputes and
strikes in order to increase the productivity
people should limit their expenditure on imported goods,
restricts unnecessary foreign trips, measures should be taken
to encourage exports and discourage imports