David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

25.3 Devaluation
1
..,
Devaluation
_ _ _ _ _
Even where exchange rates are pegged at fixed values, occasional adjustments in these par values sometimes
occur.
During three decades after 1945 the major countries agreed to fix their exchange
rates, with occasional adjustments or realignments of these par values. Sterling
was devalued in 1949 and 1967, before finally floating in 1973. The general idea
was to keep exchange rates fixed for long periods if possible. We discuss exchange
rate regimes more fully in Chapter 29.
Here, we assess the effects of a devaluation. A devaluation of sterling against the
dollar is of course a revaluation of the dollar against sterling.
The par value is the
exchange rate that the
government agrees to defend.
A devaluation
(revaluation) reduces
(increases) the par value of the
pegged exchange rate.
We distinguish between effects in the short, medium and long run. Initially, we assume that the domestic
country begins from internal and external balance. This lets us highlight the effect of the devaluation itself.
Then we consider whether devaluation is an appropriate policy response to a shock that has already moved
the economy from its long-run equilibrium position.
The short run
When prices and wages adjust slowly, the immediate effect of a devaluation is to reduce the real exchange
rate, thus improving the country's competitiveness. Resources are drawn into domestic industries that
compete with imports and into export industries that compete in foreign markets.
Although devaluation tends to raise the quantity of net exports (X - Z), the initial response may be slow.
Overnight, there are contracts outstanding that were struck at the old exchange rate. It also takes time for
buyers to adjust to the new prices they face and for sellers to build up production capacity to supply more.
Hence, in the very short run, devaluation may not improve the trade balance - the value of exports minus
imports. Suppose we measure the current account in pounds. If domestic prices of export goods are
unchanged and the quantity of exports has yet to rise much, export revenues rise only a little in the short
run. Import quantities have not yet fallen much. If their foreign prices are unchanged, their price in pounds
rises by the amount of the devaluation. Hence, the value of imports in pounds may rise substantially. In
value terms, the current account initially gets worse. 2 However, in the longer run, as quantities adjust,
higher export quantities and lower import quantities improve the trade balance. 3
The medium run
Domestic output Y equals aggregate demand, which is domestic absorption ( C + I+ G) plus net exports
(X- Z). Once quantities begin to adjust, devaluation increases net export demand (X - Z). What happens
next depends crucially on aggregate supply.
An economy with Keynesian unemployment has spare resources with which to make extra goods to meet
this rise in aggregate demand. But if the economy begins at potential output, it cannot produce many more
goods. Higher aggregate demand bids up prices and wages. Competitiveness falls, undoing the gain in
2 The famous Marshall-Lerner condition says that devaluation improves the trade balance only if the sum of the price elasticities
of demand for imports and exports is more negative than -1. Recall from Chapter 4 that, when demand is elastic, the revenue
effect of changes in quantity more than offsets the effect of a change in price. In the short run, when demand is inelastic,
devaluation may worsen the current account.
3 Thus a devaluation first worsens then improves the trade balance, a response known as the !-curve. As time elapses after the
devaluation, the trade balance falls down to the bottom of the J but then rises above its initiaJ position.
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