Definition of Devaluation:

A devaluation is when a country makes a conscious decision to lower its exchange rate in a fixed
or semi fixed exchange rate. Therefore, techically a devaluation is only possible if a country is a
member of some fixed exchange rate policy.

 For example in the late 1980s, the UK joined the Exchange Rate Mechanism ERM.
Initially the value of the Pound was set between say 3DM and 3.2DM. However, if the
government thought that was too high, they could make the decision to devalue and
change the target exchange rate to 2.7DM and 2.9DM.

Definition of depreciation: When there is a fall in the value of a currency in a floating exchange
rate. This is not due to a government’s decision but due to supply and demand side factors.
Although if the government sold alot of Pounds they could help the depreciation.

For example, the dollar has depreciated in value against the Euro during the last 12 months. This
is due to market forces, there is no fixed exchange rate target for Euro to Dollar.

The problem is that in everday use, people take about a devaluation in the dollar, when actually
they technically speaking mean a depreciation in the dollar.

Advantages of Devaluation

1. Exports become cheaper, more competitive to foreign buyers. Therefore, this provides a
boost for domestic demand.
2. Higher level of exports should lead to an improvement in the current account deficit. This
was important in the case of the UK who had a large current account deficit of over 3%
of GDP in 2008
3. Higher exports and aggregate demand can lead to higher rates of economic growth.

Disadvantages of Devaluation

1. Is likely to cause inflation because:

 Imports more expensive

 AD increases causing demand pull inflation
 Firms / exporters have less incentive to cut costs because they can rely on the devaluation
to improve competitiveness

2. Reduces the purchasing power of citizens abroad. e.g. more expensive to holiday in Europe.

3. A large and rapid devaluation may scare off international investors. It makes investors less
willing to hold government debt because it is effectively reducing the value of their holdings.

Note It depends on:

 State of business cycle – In a recession a devaluation can help boost growth without
causing inflation. In a boom a devaluation is more likely to cause inflation
 Elasticity of demand. A devaluation may take a while to improve current account because
demand is inelastic in the short term.