Currency Devaluation and Revaluation

BIBLIOGRAPHY

In economics, the terms currency devaluation and currency revaluation refer to large changes in the value of a country’s currency relative to other currencies under a fixed exchange rate regime. These changes are made by the country’s government or monetary authority. If a country has a floating exchange rate regime, or if the changes in the exchange rate under a fixed exchange rate regime are small (within the boundaries allowed by the government), the changes in the exchange rate induced by market fluctuations are referred to as currency depreciation and appreciation.

When a government conducts a devaluation, or devalues its currency, it changes the fixed exchange rate in a way that makes its currency worth less. When a government conducts a revaluation, or revalues its currency, it changes the fixed exchange rate in a way that makes its currency worth more. Since the exchange rates are usually bilateral, an increase in the value of one currency corresponds to a decline in the value of another currency. The convention is to use the term that describes the origin of the policy change. For example, during the period when the Bretton Woods system of currencies was in use (from 1944 to 1973, when many currencies were fixed to the U.S. dollar and the U.S. dollar was fixed to gold), there were cases of devaluations and revaluations. Figure 1 shows how, in November 1967, the British pound was devalued with respect to the U.S. dollar from 2.8 dollars per pound to 2.4 dollars per pound. The pound thus became less valuable with respect to the U.S. dollar, while the dollar became more valuable with respect to the pound. Such an episode is referred to as pound devaluation, rather than a dollar revaluation, because it was originated by the British government.

Before World War II (1939-1945), many countries were fixing their currency to gold. In order to improve the competitiveness of their exporters, the countries engaged in competitive “beggar-thy-neighbor” devaluations, meaning that one country would devalue its currency (with respect to gold and therefore with respect to all other currencies that were pegged to gold) and another would devalue in response. Such competitive devaluations were harmful for the international financial system overall. One reason behind the establishment of the Bretton Woods system and the International Monetary Fund (IMF) in July 1944 was to avoid such competitive depreciations in the future. The charter of the IMF directs policymakers to avoid “manipulating the exchange rates … to gain an unfair competitive advantage over other members.”

Governments usually fix the exchange rates to allow for stable conditions in foreign trade or to fight high levels of inflation driven by high inflationary expectations. In the fixed exchange rate regime, the exchange rate is not determined by the markets. It can therefore deviate from the equilibrium exchange rate, creating disequilibrium in international prices. Thus, countries that fix their currency frequently find themselves in a situation in which their currency is either overvalued (is worth more than in equilibrium) or undervalued (is worth less than in equilibrium). In the case of overvalued currency, the government has to keep selling foreign exchange reserves in exchange

for domestic currency in order to maintain the value of domestic currency above equilibrium. When the reserves run out (or, as Paul Krugman showed in his 1979 article “A Model of Balance-of-Payments Crises,” even before the reserves run out), the country has to either devalue the currency or let it float and depreciate while adjusting to its equilibrium exchange rate. Most countries with fixed exchange rate regimes either devalued their currency or switched to a floating exchange rate regime within less than five years after the initiation of the peg (Rose 2006).

The situation is different when the currency is undervalued. In order to keep the value of domestic currency below equilibrium, the government has to keep selling domestic currency in exchange for foreign currency. In this case, the government accumulates foreign exchange reserves and can always print more domestic currency. Thus, there is no well-defined limit on such foreign exchange interventions. Because the cases of undervalued currency are less common, they are less studied in economic literature than cases of overvalued currency.

The most discussed case of undervalued currency is the Chinese renminbi. China was fixing its exchange rate to be equal to 8.3 yuan (a unit of renminbi) per one U.S. dollar between January 1994 and July 2005, when China revalued the renminbi to 8.11 yuan per one U.S. dollar. After July 2005, the renminbi experienced a small controlled appreciation of about 3 percent per year. At the end of 2006, many economists believed that the renminbi remained undervalued, which explains an increasing amount of export from China (because, for the rest of the world, the goods produced in China seem inexpensive). However, since the equilibrium value of the currency is not observed in the fixed exchange rate regime, there was a disagreement as to how much revaluation would be needed to restore the equilibrium. At one extreme, Barry Eichengreen suggested that China allow its currency to float freely and adjust to its equilibrium level. At the other extreme, Michael Dooley and Peter Garber argued that there was no need for renminbi readjustment at all. There was a whole range of opinions in the middle as well, such as suggesting that China revalue its currency by 10 percent right away and let it float some time later, or that China allow a controlled appreciation of the currency.

As outlined by Andrew Rose in a 2006 discussion paper, most economies that are now open to international capital flows let their currencies float freely, meaning that devaluations and revaluations are slowly becoming a phenomenon of the past.

SEE ALSO Central Banks; Currency; Currency Appreciation and Depreciation; Exchange Rates; International Monetary Fund; Money

BIBLIOGRAPHY

Dooley, Michael, and Peter Garber. 2005. Is It 1958 or 1968? Three Notes on the Longevity of the Revived Bretton Woods System. Brookings Papers on Economics Activity 1: 147–187.

Eichengreen, Barry. 2005. Chinese Currency Controversies. CEPR Discussion Paper 4375. London: Centre for Economic Policy Research.

Krugman, Paul R. 1979. A Model of Balance-of-Payments Crises. Journal of Money, Credit, and Banking. 11 (3): 311–325.

Rose, Andrew K. 2006. A Stable International Monetary System Emerges: Bretton Woods, Reversed. CEPR Discussion Paper 5854. London: Centre for Economic Policy Research.

Galina Hale