Welcome to Interbank Currency Trading
Forex: Devaluation and Revaluation
Exchange rate movements have already been discussed. For this purpose they might be effectuated either by a more frequent use of the 'adjustable peg', as now allowed in the constitution of the International Monetary Fund, or by the adoption of flexible exchange rates. The weapon would work by making the products of a deficit country more price competitive or those of a surplus country less competitive.
Any program (including an incomes policy) that seeks to rectify an imbalance by changing the level of prices will be effective only if demand is 'price elastic'. In other words, if the offer of an article at a lower price did not cause an increase in demand for it more that in proportion to the fall in price, the proceeds from its export would fall rather than increase. Economists believe that the price elasticity is sufficiently great for most goods so that price reductions will increase revenues in the long run. The outcome is not quite so certain in the short run.
A much faster means of changing relative price levels is devaluation, which is likely to have a quick effect on the prices of imported goods. This will raise the cost of living and may thereby accelerate demands for higher wages. If granted, these would probably cause rises in the prices of domestically produced goods. A 'wage-price spiral' might follow. If this went too quickly it might frustrate the intended effect of the devaluation, namely that of enabling the country to offer its goods at lower prices in terms of foreign currency. This means that if the beneficial effects of devaluation are not gathered in quickly, there may be no beneficial effect at all.
The authorities of a country that has just devalued will therefore be especially active in preventing or moderating domestic price increases. They will need to use the other policy measures already discussed. Devaluation, or the downward movement of a flexible rate, is thus not a remedy that makes other forms of official policy unnecessary. Some have argued that if exchange rates were allowed to float, nothing would have to be done officially to bring the external balance into equilibrium. This is a minority view.
One further point must be made regarding the exchange rate weapon. It has been found in practice that governments resist upward valuation more than they do devaluation. Devaluations have in fact been larger and more frequent than upward valuations. This has an unfortunate consequence. It means that the aggregate amount of price decreases in the surplus countries. Therefore this system, if more strongly resorted to, would have a bias toward worldwide inflation.
