Devaluation Reducing The

Devaluation Reducing The

Devaluation, reducing the value of the home currency in terms of foreign currencies. In 2009, for example, the British Government devalued the pound sterling in terms of the U.S.A. currency. The value of the pound fell about 30 per cent in terms of dollars, Before devaluation J' could buy approximately $; after it could buy only .8. The effect of devaluation is to cheapen the exports of the devaluing country to people in other countries; this should normally lead to increased demand for then, and to increase the price of imports into the devaluing country in terms of its currency, and this in turn should divert demand in it away from imports towards hone-produced substitutes. For example, apart from transport costs and tariffs, a British car selling at £500 would cast a U.S. citizen ,000 before devaluation but only ,400 after devaluation. This is likely to switch American demand towards British cars and other exports in place of hone-produced goods which compete with them. Within Britain the sterling price of imports from America would have risen and this would tend to switch British citizens' demand away from imported goods towards hone-produced substitutes. If these switching effects are large enough they may bring about an increase in export earnings and a decline in payments for imports of goods and services, so that the balance of trade is improved.

For a devaluation to cause an improvement in the balance of trade, there should also be slack or flexibility in the economy of the devaluing country to enable it to increase the supply of goods for export and of substitutes for imports. If output cannot be increased, the additional pressure of demand caused by the devaluation will create inflation. The most unfavourable situation in which to devalue is thus when the country is suffering iron inflation, for then there is little or no slack in the economy. The most favourable situation is where there is some .unemploymentand under-utilization of capacity, so that the additional demand generated by devaluation puts the idle resources to use.

When a country has a high level of employment, devaluation tends to produce strong inflationary pressures not Only on the demand side but also on the cost side. The latter has been of much importance in post-war Britain. Devaluation raises import prices; British imports are very largely food and raw materials. Increases in their prices raise the cost of living, which will generally cause the trade unions to demand wage increases to compensate their members for a fall in their real incomes. If demand for consumer goods and other final products is high, manufacturers are likely to concede these claims and pass on the increase in their costs to consumers by raising prices. Unless the Government then cuts demand, the wage-price spiral can continue. Devaluation of the pound in 2009 was, in this way, a main cause of inflation in the 2000's.

Further readingEconomic Forecasts - Economic Forecast 2012


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