Devaluation - Devaluation in Modern Economies

Devaluation in Modern Economies

Present day currencies are usually fiat currencies with insignificant inherent value. Some countries hold floating exchange rates while others maintain fixed exchange rate policies against the United States dollar or other major currencies. These fixed rates are usually maintained by a combination of legally enforced capital controls or through government trading of foreign currency reserves to manipulate the money supply. Under fixed exchange rates, persistent capital outflows or trade deficits may lead countries to lower or abandon their fixed rate policy, resulting in a devaluation (as persistent surpluses and capital inflows may lead them towards revaluation).

In an open market, the perception that a devaluation is imminent may lead speculators to sell the currency in exchange for the country's foreign reserves, increasing pressure on the issuing country to make an actual devaluation. When speculators buy out all of the foreign reserves, a balance of payments crisis occurs. Economists Paul Krugman and Maurice Obstfeld present a theoretical model in which they state that the balance of payments crisis occurs when the real exchange rate (exchange rate adjusted for relative price differences between countries) is equal to the nominal exchange rate (the stated rate). In practice, the onset of crisis has typically occurred after the real exchange rate has depreciated below the nominal rate. The reason for this is that speculators do not have perfect information; they sometimes find out that a country is low on foreign reserves well after the real exchange rate has fallen. In these circumstances, the currency value will fall very far very rapidly. This is what occurred during the 1994 economic crisis in Mexico.

Generally, a steady process of inflation is not considered a devaluation, although if a currency has a high level of inflation, its value will naturally fall against gold or foreign currencies. Especially where a country deliberately prints money (often a cause of hyperinflation) to cover a persistent budget deficit without borrowing, this may be considered a devaluation.

In some cases, a country may revalue its currency higher (the opposite of devaluation) in response to positive economic conditions, to lower inflation, or to please investors and trading partners. This would imply that existing currency increased in value, as opposed to the case with redenomination where a country issues a new currency to replace an old currency that had declined excessively in value (such as Turkey and Romania in 2005, Argentina in 2002, Russia in 1998, Germany in 1923, or Bizone/Trizone in 1948).