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In macroeconomics and modern monetary policy, a devaluation is an official lowering of the value of a country's currency within a fixed exchange-rate system, in which a monetary authority formally sets a lower exchange rate of the national currency in relation to a foreign reference currency or currency basket. The opposite of devaluation, a change in the exchange rate making the domestic currency more expensive, is called a revaluation. A monetary authority (eg., a central bank) maintains a fixed value of its currency by being ready to buy or sell foreign currency with the domestic currency at a stated rate; a devaluation is an indication that the monetary authority will buy and sell foreign currency at a lower rate.

However, under a floating exchange rate system (in which exchange rates are determined by market forces acting on the foreign exchange market, and not by government or central bank policy actions), a decrease in a currency's value relative to other major currency benchmarks is instead called depreciation; likewise, an increase in the currency’s value is called appreciation.

Related but distinct concepts include inflation, which is a market-determined decline in the value of the currency in terms of goods and services (related to its purchasing power). Altering the face value of a currency without reducing its exchange rate is a redenomination, not a devaluation or revaluation.

Historical usage

Devaluation is most often used in a situation where a currency has a defined value relative to the baseline. Historically, early currencies were typically coins struck from gold or silver by an issuing authority which certified the weight and purity of the precious metal. A government in need of money and short on precious metals might decrease the weight or purity of the coins without any announcement, or else decree that the new coins have equal value to the old, thus devaluing the currency. Later, with the issuing of paper currency as opposed to coins, governments decreed them to be redeemable for gold or silver (a gold standard). Again, a government short on gold or silver might devalue by decreeing a reduction in the currency's redemption value, reducing the value of everyone's holdings.

Causes

Fixed exchange rates are usually maintained by a combination of legally enforced capital controls and the central bank standing ready to purchase or sell domestic currency in exchange for foreign currency.[citation needed] Under fixed exchange rates, persistent capital outflows or trade deficits will involve the central bank using its foreign exchange reserves to buy domestic currency, to prop up demand for the domestic currency and thus to prop up its value. However, this activity is limited by the amount of foreign currency reserves the central bank owns; the prospect of running out of these reserves and having to abandon this process may lead a central bank to devalue its currency in order to stop the foreign currency outflows.

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).[1] 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.

Economic implications

There are significant economic consequences for the country that devalues its currency to address its economic problems. A devaluation in the exchange rate lowers the value of the domestic currency in relation to all other countries, most significantly with its major trading partners. It can assist the domestic economy by making exports less expensive, enabling exporters to more easily compete in the foreign markets. It also makes imports more expensive, providing a disincentive for domestic consumers to purchase imported goods, leading to lower levels of imports (which can benefit domestic producers),[2] but which reduces the real income of consumers.

However, under a floating exchange rate system (in which exchange rates are determined by market forces acting on the foreign exchange market, and not by government or central bank policy actions), a decrease in a currency's value relative to other major currency benchmarks is instead called depreciation; likewise, an increase in the currency’s value is called appreciation.

Related but distinct concepts include inflation, which is a market-determined decline in the value of the currency in terms of goods and services (related to its purchasing power). Altering the face value of a currency without reducing its exchange rate is a redenomination, not a devaluation or revaluation.

Devaluation is most often used in a situation where a currency has a defined value relative to the baseline. Historically, early currencies were typically coins struck from gold or silver by an issuing authority which certified the weight and purity of the precious metal. A government in need of money and short on precious metals might decrease the weight or purity of the coins without any announcement, or else decree that the new coins have equal value to the old, thus devaluing the currency. Later, with the issuing of paper currency as opposed to coins, governments decreed them to be redeemable for gold or silver (a gold standard). Again, a government short on gold or silver might devalue by decreeing a reduction in the currency's redemption value, reducing the value of everyone's holdings.

Causes

Fixed exchange rates are usually maintained by a combination of legally enforced capital controls and the central bank standing ready to purchase or sell domestic currency in exchange for foreign currency.[citation needed] Under fixed exchange rates, persistent capital outflows or trade deficits will involve the central bank using its foreign exchange reserves to buy domestic currency, to prop up demand for the domestic currency and thus to prop up its value. However, this activity is limited by the amount of foreign currency reserves the central bank owns; the prospect of running out of these reserves and having to abandon this process may lead a central bank to devalue its currency in order to stop the foreign currency outflows.

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).[1] 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.

Economic implications

There are significant economic consequences for the country that devalues its currency to address its economic problems. A devaluation in the exchange rate lowers the value of the domestic currency in relation to all other countries, most significantly with its major trading partners. It can assist the domestic economy by making exports less expensive, enabling exporters to more easily compete in the forei

Fixed exchange rates are usually maintained by a combination of legally enforced capital controls and the central bank standing ready to purchase or sell domestic currency in exchange for foreign currency.[citation needed] Under fixed exchange rates, persistent capital outflows or trade deficits will involve the central bank using its foreign exchange reserves to buy domestic currency, to prop up demand for the domestic currency and thus to prop up its value. However, this activity is limited by the amount of foreign currency reserves the central bank owns; the prospect of running out of these reserves and having to abandon this process may lead a central bank to devalue its currency in order to stop the foreign currency outflows.

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 ac

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).[1] 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.

There are significant economic consequences for the country that devalues its currency to address its economic problems. A devaluation in the exchange rate lowers the value of the domestic currency in relation to all other countries, most significantly with its major trading partners. It can assist the domestic economy by making exports less expensive, enabling exporters to more easily compete in the foreign markets. It also makes imports more expensive, providing a disincentive for domestic consumers to purchase imported goods, leading to lower levels of imports (which can benefit domestic producers),[2] but which reduces the real income of consumers.[3] Devaluation tends to improve a country’s balance of trade (exports minus imports) by improving the competitiveness of domestic goods in foreign markets while making foreign goods less competitive in the domestic market by becoming more expensive. The combined effect will be to reduce or eliminate the previous net outflow of foreign currency reserves from the central bank, so if the devaluation has been to a great enough extent the new exchange rate will be maintainable without foreign currency reserves being depleted any further. However, the devaluation increases the prices of imported goods in the domestic economy, thereby fueling inflation.[2] This in turn increases the costs in the domestic economy, including demands for wage increases, all of which eventually flow into exported goods. These dilute the initial economic boost from the devaluation itself. Also, to combat inflation, the central bank would increase interest rates, hitting economic growth.[2] A devaluation could also result in an outflow of capital and economic instability.[2] In addition, a domestic devaluation merely shifts the economic problem to the country's major trading partners, which may take counter-measures to offset the impact on their economy of a loss of trade income arising from the initial devaluation.

Devaluations in modern economies

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