Why does devaluation cause inflation

Devaluation of a currency - causes, function & goals


Everything about the devaluation of a currency

Definition: Reducing the value of a currency through active measures or market economy events

Creation of currency values: Supply & demand determine the value of a currency

Causes of automatic devaluation: Financial crises, inflation & interest rate developments

Active devaluation methods: Quantitative easing & rate adjustments

Possible advantages and disadvantages: Economic recovery or paralysis from over-indebtedness


Basically, in its function, the forex market is a market like any other: supply and demand determine what happens and the price of the currencies traded. In this sense, currencies are always expressed in another currency, trading takes place in currency pairs.

Few prices are as serious as those of foreign exchange. The world markets rule in a complicated exchange rate system on shifts and economic changes in public finances. In many cases, the Appreciation or depreciation of a domestic currency aseconomic policy instrument used, in other words, it is currency manipulation. The change in the value of the currency has different effects on all markets on earth.

Definition: what is currency devaluation?

The devaluation of a currency is understood as the process that a foreign currency - the currency of a country - loses value. This means that the purchasing power of this currency is diminishing. This can take place domestically or without major consequencesclear effects show in the current account.

Meanwhile, the devaluation has a strong effect on all goods and services that are sold or bought abroad: While itmore expensive domestically becomes, To buy products from abroad, is it cheaper for foreigners, in this countryshopping.

What are foreign currencies?

The term motto comes from French, the exact origin is not clearly clarified. The term has existed in the financial sector since in the middle of the 19th century and is interpreted differently. Today it is used to denote a monetary currency that does not correspond to the currency that is currently valid where the term is used. A currency has accordingly in the exchange rate system from country to country as oneslightly different definition, since the respective national currency is not included everywhere. As a rule, these are foreign currencies.

In addition, the term is not used uniformly and is accordingly defined differently. In the economic parlance of credit institutions, foreign exchange (exclusively in the plural) is explicitly understood to mean bank balances that areat foreign banks are located.

Foreign currencies are all non-domestic currencies or foreign currencies. They can be traded as a financial product on the international stock exchanges and financial markets.

How the foreign exchange market works: How do exchange rates arise?

However, a currency must first have a value. How do these different "ranks" of different currencies arise in an exchange rate system, when it comes to the value of the individual means of payment? This depends as with any product in the open market of the supply and the demand from.

If the demand for one euro on the foreign exchange market is greater than the supply, the euro exchange rate rises. The consequence is one Currency appreciation. If the demand for the euro is lower than the supply - if there is an oversupply of the currency - the rate falls. This corresponds to the Devaluation of the domestic currency.

There are also other mechanisms that can lead to an appreciation or depreciation. Accordingly, as mentioned at the beginning, a government can decide to lower the currency value or even to increase it. This economic or monetary policy approach is examined in more detail in the next section.

Causes of currency devaluation

A currency devaluation can different reasons to have. Why is there a currency devaluation?

  • The domestic inflation rate has risen: Causes such as an increasing amount of money or a greater speed of circulation of money lead to a decrease in value.
  • The interest rate abroad is higher: If the key interest rate in a country is low, residents and foreigners can borrow money more easily. As a result, the value of the currency decreases.
  • The central bank intervenes in the foreign exchange market: The central bank (also called central bank) constantly exerts influence on the currency and financial markets through currency manipulation. These activities affect interest rates and the value of a currency.
  • Another currency is being revalued: A devaluation can also take place when a reference currency becomes more valuable. This is not a pure devaluation but leads to similar effects.
  • Quantitative Easing: A non-controversial means of the central bank is to pump cheap money into the market in order to influence the value of the money. For this purpose z. B. Purchased government bonds and made money available.
  • Economic policy: If a country is in a recession, the targeted devaluation of the currency can lead to exports, tourism and investments in that country being supported. Foreigners can then spend more money and buy more products. This means that more money flows into the state coffers. For residents, this has a negative impact mainly when they want to buy foreign products. Exporters, on the other hand, benefit from it.

Currency devaluations in history

There is one in the story Devaluation of a currency for reasons of economic policy No rarity. Nations repeatedly tried to keep their currencies at a comparable level through currency manipulation. This is due to the fact that an appreciation or depreciation does not always have to be in the interests of the respective country. While countries with strong exports like Germany are at risk of appreciation, countries with weaker exports such as the USA are at risk of depreciation.

The J-curve effect

The J-curve effect is an economic theoretical hypothesis which shows the effect of a devaluation of the domestic currency on the foreign trade balance over time. In the short term, the effect on the current account is negative. If more time passes, a real devaluation of the currency leads to an improved current account.

How can a currency be devalued?

Basically there is two typeshow a currency can be actively devalued. These depend on how the quantity quotation between two currencies to be compared is structured. Is theFixed exchange rate and is determined exclusively by the central bank, one is enough easy customization of this course through this instance. In the case of fixed rates, one speaks of parities.

Parities

Parities are the fixed relationship between two currencies or one currency and a reference value such as gold.

Meanwhile, lies aflexible exchange rate before, in which the volume quotation changes independently, then the central bank has to interfere in this process. This is where measures such as quantitative easing come into play.

How can the supply and demand of a currency be changed?

The methods used to achieve changes in exchange rates are indeed versatile. To change the supply and demand of a currency, for example a large amount of money be put into circulation. Alternatively, money can be taken from the market by selling government bonds, etc. This causes more or less money to be available in the market.

What is the base rate?

The base rate in this context is a significant asset of central banks. It is a unilaterally set interest rate that can be used to control monetary policy in a centralized manner. The key interest rate determines the terms and conditions Credit institutions do business with the central bank. Even slight changes can have major effects.

Accordingly, banks that receive cheap money from the central bank are willing to pass it on to their customers at lower interest rates. That leads to one lower currency value and a boost to the local economy. On the other hand, poorer conditions lead to higher interest rates, a more valuable currency and possibly less investment.

Inflation vs. deflation

As briefly mentioned above, inflation and its opposite, deflation, aretypical processes in an economywhere products are either steadily more expensive (inflation) or steadily cheaper (deflation). This increase in price or discount affects all market participants. While inflation in the EU was 3.7% in 2008, it was 1.9% ten years later. This percentage varies from year to year and rises and falls continuously.

There has been an increasing in the EU since 2013 Deflation problem. Bulgaria, Greece, Slovakia, Spain and Cyprus fell below the zero line of price development in 2013/14 and developed negative inflation. The European Central Bank is trying accordingly to reduce the rate of inflation, i.e. the rate of rise in prices annually approx. 2% to keep.

Note

The central bank cannot lower the key interest rate indefinitely - only until zero is reached. Further lowering then leads to negative interest rates, as a result of which banks pay money for you to deposit it at the central bank. This can lead to a downward spiral in the economy.

What is quantitative easing?

The aforementioned quantitative easing is one of the means available to the central banks. It includes the Buying government bonds to increase the amount of money in circulation. In detail, this means that a central bank buys assets and thus achieves two things:

On the one hand the bonds rise in price and on the other handmoney flows into the banking system. Interest rates are falling and making loans and advances cheaper. This boosts consumption and investment on a broad scale provide jobs. At the same time, economic growth is protected.

Overall, quantitative easing ensuresadditional liquidity in the market. To do this, however, the process has to be carried out slowly and with tact. Otherwise, if the money supply grows too quickly, the central bank runs the risk of an excessive rise in inflation. Accordingly, the method is continuously criticized.

Differentiation: What is the appreciation of a currency?

In contrast to devaluation, an appreciation of a currency means the exact opposite. The value of the currency rises and leads to more purchasing power for residents. A domestic importer can in principle benefit from this. As mentioned before, however, this also leads to worse conditions for foreigners who want to shop in the country of the revalued currency. Apart from exports, tourism is also suffering from the appreciation of money.

The pros & cons of a Revalvation

In economic jargon, the appreciation of a currency is called Revalvation denotes, in comparison to the devaluation, the devaluation the currency. The term is particularly widespread in this form in English-speaking countries. The advantages and disadvantages of these positive exchange rate changes are different and should be clearly summarized in the following table.

advantagesdisadvantage
Imports are becoming cheaper and more goods can be imported from abroad. Domestic importers benefit from this.Exports are becoming more expensive, fewer imported goods are being imported from abroad. Importers and exporters alike are among the victims.
Domestic tourists can afford more abroad, so they may spend more money accordingly. The beneficiaries are domestic tourists.Foreign tourists are more reserved when it comes to spending money or spend their vacation completely elsewhere. The domestic tourism industry is experiencing a decline in sales.
Goods like gasoline are getting cheaper. That makes the consumer happy.The benefits can be deceiving. A revalvation can be followed by stagnation of the economy and thus a devaluation.

Goals & consequences of a currency devaluation

So far, it seems that currency devaluation is basically a good thing. A battered economycan recover their current account, thecompetitiveness and theExports are increasing and everyone is doing better overall. In fact, however not all consequences are positive. This can be clearly illustrated using the example of the Greek economy during the economic crisis.

Many economists saw salvation in the heyday of the Greek financial crisis Return to the drachma and thus to the possibility of cheaper one's own currency. This would primarily help tourism and foreign investors to get Greece back on its feet. The result: a gigantic economic program in the form of a weak currency.

The problem arises on the other hand: The Greek economy offers little-demanded industrial products on the world market and thus has astructural export problem. Accordingly, a devaluation could not have an effective effect there, as more exporters are missing who will benefit from them. At the same time, through the devaluation, wealthy people lose the incentive to To save money. Investments are then made in gold, real estate or foreign exchange. As a result, the country lacks money and the economy is slowing down.

One of the biggest problems caused by a devaluation when leaving the euro was thatenormous debt mountain of Greecethat would have continued to accumulate. A debt reduction would hardly have been possible in the foreseeable future with a heavily devalued drachma and would have paralyzed the Greek economy for decades.

Objective: Why is a currency devalued?

Nonetheless, central banks' efforts to depreciate currencies continue. This is specifically due to the objective that To reduce deflation in an economy. Efforts are being made to keep inflation at around 2% per year.

The European Central Bank will achieve this through rate adjustments and quantitative easing in the EU in 2019more or less successful. However, the key rate is with0 % reached the minimum. Other countries such as the USA and Sweden show that a negative key interest rate is not unlikely in the European Union in the future.

Conclusion on the devaluation of a currency

Overall, it can be seen that the devaluation of a currency can have different reasons, goals and consequences. It cannot be said unequivocally whether the devaluation of a state's money is an effective means or a dangerous balancing act.

On the one hand, the change in the volume quotation has advantages for the domestic and foreign economy, including an increase in exports and an increase in competitiveness and the balance of payments. On the other hand, there are also disadvantages for at home and abroad in economic activity. Using the example of the Greek crisis in particular, it is possible to gauge the dangers that arise from a careless devaluation of the national currency as an economic policy tool.

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