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

25.3 Devaluation
Table 25.1
The 1967 sterling devaluation
1967
Current account (£bn) -0.3
-
Public sector deficit (% of GDP) 5.3
Nominal exchange rate: $/£ 2.8
Real exchange rate (1 975 = l 00) 109
Source: ONS, Economic Trends.
1968 1969 1970
-0.2 0.5 0.8
3.4 -1 .2 0
2.4 2.4 2.4
l 02 102 103
--
The public sector deficit as a percentage of GDP shows fiscal policy. In 1967 UK unemployment was low.
The economy had few spare resources with which to produce extra goods for export or for import
substitution. In 1969 fiscal policy was tightened substantially, reducing domestic absorption and allowing
an improvement in net exports. The government (including the nationalized industries) actually ran a
budget surplus in 1969.
The final row of Table 25. l shows the real exchange rate, the relative price of UK goods to foreign goods
when measured in a common currency. Note two things. First, instead of using the 15 per cent devaluation
to cut export prices in foreign markets, UK exporters responded in part by raising prices and profit margins.
Only half the competitive advantage was passed on to foreign purchasers as lower foreign prices for UK
goods. Second, even by 1970, competitiveness was falling again. Domestic wages rose as workers asked for
wage increases to meet higher import prices. By 1970, the real exchange rate had begun to rise.
Devaluation and adjustment
To sum up, once quantities begin adjusting, devaluation leads to a temporary but not a permanent rise in
competitiveness relative to the path that would have occurred without the devaluation. In the long run,
real variables are determined by real forces. Changes in one nominal variable eventually induce offsetting
changes in other nominal variables to restore real variables to their equilibrium values.
But devaluation may be the simplest way to change competitiveness quickly. It is a useful policy when the
alternative adjustment mechanism is a domestic slump and a protracted period of lower inflation until
competitiveness is increased.
Suppose there is a permanent fall in export demand. At the original exchange rate, this generates a slump
that induces a period of lower inflation, which reduces wages and prices enough to boost competitiveness
and restore current account balance. But this takes several years. Devaluation accomplishes an overnight
improvement in competitiveness. It speeds up adjustment.
Devaluation may therefore be an appropriate response to a real shock that requires a change in the
equilibrium real exchange rate. Conversely, where no real change is required, devaluation eventually
generates rises in prices and nominal wages. Chapter 22 discussed inflation expectations and credibility.
Economies can get locked into self-fulfilling prophecies of high inflation. In such circumstances,
maintaining a constant real exchange rate requires a steady reduction in the nominal exchange rate. One
way to accomplish this is by regular devaluations.
Devaluation has a bad name because it is often associated with periods of high inflation and weak
government. This is correct. However, even well-designed macroeconomic policy might choose occasionally
to realign the nominal exchange rate. The appropriate circumstance would be a large and sustained shock
to the trade balance.
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