Meaning of devaluation
- Devaluation of the currency is when the government reduces the value of a currency under the Fixed-Rate System or the Bretton Woods System.
- The apex monetary authority of the country sets a lower exchange rate for the national currency in relation to a foreign reference currency or currency basket in case of devaluation.
- Historically, devaluation has been used as a tool to control the balance of payment deficits.
- India has faced the devaluation of currency in the years 1966 and 1991.
Effect of Devaluation of the Currency
- Imports become more expensive and exports become more competitive and lucrative. This in turn must have a positive impact on the trade account balance.
- A devalued currency might also encourage a greater quantity of export from that country.
- It has been a stumbling block for growth in case of developing economies.
- It can also result in an inflationary pressure on the domestic economy.
- It can result in the increase of cost of production of all those commodities that extensively depend on imported inputs.
- Domestic companies that have taken international loans will face greater servicing costs.
- Devaluation also results in reducing competition among domestic companies.
- If the country has limited labour supply, then there will be a significant rise in the wages resulting in cost push inflation in the economy.
Corrective Action to be taken To Mitigate the Effect of Devaluation
- Exports must be provided a boost through relaxation of strict rules, removal of policy barriers, and other structural changes.
- Foreign portfolio investment must be encouraged.
- Interest rates must be kept attractive to ensure that exchange rate fluctuations have a lesser impact on investment.
- As a long term measure, the country must focus on reducing import dependence to make the currency less vulnerable to external shocks.
Difference Between Devaluation and Depreciation
- Devaluation is an exercise undertaken by the government whereas, depreciation takes place under the floating exchange rate system that is market determined.
- Devaluation can trigger currency wars like in the case of China- USA.
