The Reasons and Consequences of the Devaluation of a Currency - Research Paper Example

Introduction Devaluation is the decrease in the value of a country’s currency proportional to gold or the currencies of other nations. Currency depreciation is defined as the value depreciation of currency relative to gold; which means that the smaller amount of gold that can be purchased with a certain amount of currency from one point of time to another. For instance if 100 units of currency can be used to buy one gram of gold this year where as 120 units of currency can buy the same unit of gold the next year then this only means that the currency has depreciated. The causes of a currency collapse may be due to inflation. Inflation actually decreases the value of money. If there is uncontrolled inflation, then a currency will deprecate in value. Inflation is caused due to excess printing of money. This means that when the supply of money is more than the development of real output then inflation results. Even though printing of money does not directly cause inflation but it induces devaluation of money. In case when there is a large amount of national debt then the government will print more money to clear the debt and this will induce inflation. Devaluation of a country’s currency may also occur when there is deficit in the current account of that country. Current account deficit occurs when imports of goods and services are more than exports. Such current account deficits can be cleared when there is enough capital inflow. But once currency flow stops or slows down then the deficit arising out of current account cannot be met finally leading to depreciation in the exchange rate. Even when there is fall in the confidence of the economy or the financial sector of a country currency outflow will follow. People never like to face the loss of their currency. This results in the outflow of capital ending in the depreciation of the exchange rate. The fall in confidence may be trigged due to political or economic factors of a country. Lesser rates results in repulsive savings of a country and hence, there will be a reserved depreciation. Lower rates normally do not result in collapse of a currency, but, they make the currency less tempting. Finally an economy which depends on the exports of raw materials will encounter depreciation in its exchange rate when the price of this raw material decreases. This in turn will lead to export revenue decrease leading to devaluation of currency. Body I How is Currency valued by Exchange Rate? The determiners of prices in any market are seldom clear. Innumerable hypotheses try to clarify differences in exchange rates, but none of them can be taken as law. The foreign exchange market, which has 193 active countries and US$ 1.9 trillion in everyday income, is far too intricate to be depicted efficiently by a set of theories or rules (US Federal Reserve, 2005). Fixed and Floating Exchange Rate Regimes Under the Bretton Woods arrangement which existed between 1944 and1973 the US used gold to support its dollar. Other countires who took part in this regime valued their exchange rates in terms of the US dollar. But during the 1970s, the scheme faded away, and US left the gold criterion, disclosing the dollar and the exchange rates of all active countries, to market drives. Without a real commodity connected to every dollar, currency continued to be valuable only as people conceived it to be valuable. Since then, some participating countries have preferred to let market drives prescribe the value of their currency by floating exchange rate regimes while other countries choose the fixed exchange rate systems. Fixed Exchange Rate Regimes A country which does not want its currency to follow a fluctuating rate regime will have it fixed or “pegged” to a foreign currency or a ‘basket’ of many foreign currencies or commodity regularly gold. Under the pegged regime the value of the currency involves constant management through monetary and trade policies. The central bank of the country following pegged regime does it with two primary tools. Currency Intervention: Under this system a country is free to buy or sell its own currency and the purchase of its currency is conducted with the foreign reserves which are held by the central bank. Thus adequate foreign reserves have to be maintained. Capital Control: Under this system the government policies limit the amount of capital which flows in and out of the country. In most cases the government restricts the out flow of currency and encourages inflow of currencies. Floating Exchange Rate Regimes Short-Term Determinants Interest Rate Arbitrage: The relative interest rates between different countries influence the Exchange rates. In situations when the central bank of a country increases its interest rates then the capitalists can earn higher returns in that country there by augmenting the demand for that currency. The opposite occurs when the interest rate is lowered. Speculation: It is the speculators who are responsible for roughly 70-80% of currency trading (http://www.bized.ac.uk/current/mind/2003_4/171103.htm, accessed May 2010). Speculators try to venture exchange rate progress with the usage of historical data, the present macroeconomic environ and forecasting of future events. Consequently, exchange rates, like stock prices, include anticipations for the future. Political imbalance or some unexpected incident: Political imbalance which is a natural event or any other unexpected incident may affect the exchange rates. Actually events like terrorist attacks will affect all the financial markets like debt, currency and equity etc. Medium-Term Determinants Monetary Growth: When two countries are compared then the country which has the higher monetary development will face a depreciating currency rate provided all other factors being same. Under the laws of supply an increasing supply of money will reduce the price of such a currency with the assumption that demand remains stable (Rudiger, 1988). Real Income Growth: When there is a fast rate of development in the income of a country then the demand for imports for that country also increases. When the imports increase then automatically the demand for that currency also increases. Trade Balance: When there is a trade imbalance then the floating exchange rate regime produces a natural means to ease the improvement of a trade imbalance. Long-Term Determinants Interest Rate Parity: Interest rate parity is actually a relationship and not a theory. It depicts the relationship between spot exchange rates, short-term interest rates and forward exchange rates. Purchasing Power Parity: This theory proposes that alterations in nominal exchange rates should anticipate proportional variation in price levels provided the real rate of exchange will be constant. In the long term, the theory submits, goods invested for internationally traded commodities should be equal to the prices of these goods throughout different currencies (Rudiger, 1988). History furnishes us with proof of the drives of purchasing power parity (Mussa, 1990). References Bized, “The Balance of Payments, Exchange Rates, Elasticity and Inflation,” Bized Web site, http://www.bized.ac.uk/current/mind/2003_4/171103.htm, accessed May 2010. Mussa, Michael. 1990. “Exchange Rates in Theory and in Reality.” Princeton, NJ: Princeton University Press. p.14 Rudiger, Dornbusch. 1988. “Exchange Rates and Inflation”. USA, Halliday Lithograph. pp.153 - 154 U.S. Federal Reserve, “Federal Reserve Statistical Release – Foreign Exchange Rates,” U.S. Federal Reserve Web site, http://www.federalreserve.gov/releases/H10/Hist/, accessed November 2005. Read More