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Devaluation and Revaluation

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Devaluation and Revaluation

Not all countries share a single currency. In fact, there are around 180 currencies in circulation today. However, they are not all created equal. Some are stronger and have a relatively high value like the UK Pound Sterling, while some are weaker or have a relatively lower value, which is not always a bad thing. Some are used in multiple nations like the Euro in the Eurozone or the U.S. Dollar in Ecuador or El Salvador. Some have their values tied up to the U.S. dollar like Hong-Kong and Bahrain. When the currency is in a fixed exchange rate regime, its value is artificially supported by devaluation and revaluation. Eager to learn how devaluation and revaluation happens in the real world? Then keep reading!

Revaluation and Devaluation Meaning

The meaning of revaluation and devaluation of a currency is when the government issuing a currency changes its value in relation to a foreign currency that it has been fixed to.

Revaluation of a currency occurs when the value of a currency is increased relative to another currency in a fixed exchange rate regime. Devaluation of a currency occurs when the value of the currency is decreased relative to another currency in a fixed exchange rate regime. Revaluation and devaluation are terms that only apply under a fixed exchange rate regime and not under a floating exchange rate regime.

Revaluation is when a government fixes a new higher exchange rate for a currency in a fixed system.

Devaluation is when a government fixes a new lower exchange rate for a currency in a fixed system.

The exchange rate is the value of one currency when compared to another.

Fixed exchange rate regime occurs when the value of the currency in terms of another is artificially kept at the fixed level

Revaluation and devaluation of a currency are not to be confused with appreciation and depreciation of a currency.

To learn about appreciation and depreciation, check out our explanation - Appreciation and Depreciation.

To learn more about fixed exchange rate regime check out - Fixed Exchange Rate.

Devaluation and Revaluation of Currency: Fixed Exchange Rate

There are two main regimes that governments can adopt to cope with the exchange rate. One is a floating exchange rate, which is what is used in some countries like the United States, Canada, or Britain. The floating exchange rate adjusts itself with the market without direct government intervention. The other is a fixed exchange rate, where the government sets the exchange rate, or pegs it, at a certain value of a foreign currency. This scenario is where we get devaluation and revaluation of a currency from.

To find out more about the benefits and drawbacks of different exchange rate regimes click on these articles:

Fixed Exchange Rate and Floating Exchange Rate!

devaluation and revaluation surplus of Chinese yuan studysmarterFigure 1. The surplus of the Chinese Yuan - StudySmarter Originals

devaluation and revaluation shortage of Chinese yuan studysmarterFigure 2. The shortage of the Chinese Yuan - StudySmarter Originals

In Figures 1 and 2, the Chinese Yuan is fixed to the U.S. Dollar. By doing this, the Chinese government is intervening in the exchange market and preventing it from reaching its market equilibrium (E). It can help to think of a fixed exchange rate as a price floor or price ceiling.

In Figure 1, there is a surplus of Yuan in the market and the Chinese government will want to prevent the price of Yuan from falling. To do this, they can buy up Yuan and sell U.S. dollars.

In Figure 2, there is a shortage of Yuan which would push the price up. To prevent this price increase, the Chinese government would sell Yuan and buy U.S. dollars.

To read more about price floors and price ceilings, check out our explanations:- Price Ceilings- Price Floors

Although having a fixed exchange rate sounds rather set and unchanging, this is not necessarily the case. A fixed exchange regime sets a target rate at which the currency will be pegged. This benefits the country whose exchange rate is fixed because it stabilizes the price of its goods to the other countries and can make them appear more or less expensive. However, sometimes adjustments need to be made. The target exchange rate can be changed to best meet the needs of the nation's economy.

The Chinese Yuan (CNY) has been fixed, or pegged, to the US dollar to a certain extent since 1994. This has kept the Yuan low in comparison to the US dollar, which makes Chinese goods appear cheaper. Currently, it is at about 6.50 CNY to one USD. This has allowed China to maintain a trade surplus with the United States and grow its GDP by about 10% annually. Although the average trend since 1994 is a revaluation of the Yuan, there have been periods between 2014 and 2020 that saw an overall devaluation in the Yuan.

devaluation and revaluation Chinese yuan to usd studysmarterFigure 3. Chinese Yuan to U.S. Dollar Exchange Rate 1990-2022. Source: Wikimedia Commons

Devaluation of currency examples

A country may choose to devalue its currency for several reasons. If it wants its goods to appear more competitive to the international market, or it wants to avoid a trade deficit.

A devaluation is when the value of a currency, that has been pegged to a foreign currency under a fixed exchange rate, is reduced.

Pros of currency devaluation

When a country's currency is weaker, its goods appear cheaper to foreign currency holders. This will increase domestic exports because the country will appear more competitive in terms of price in comparison to those with stronger currencies. This increase in exports presents an improvement in the balance of payments on the nation's current account. This is a benefit because it may be an indicator of a trade surplus and an injection into the nation's economy spurring economic growth.

The balance of payments

The balance of payments is a way for a nation to keep track of its incomes and expenditures. It is divided into the current account on one side and financial accounts on the other. The current account consists of its trade in goods and services (exports - imports), its investment incomes, and its transfer payments. This side is where we see the effects of devaluation. The financial account (also known as the capital account) consists of Foreign Direct Investment (FDI) and Portfolio Investments such as bonds and savings.

Dive in deeper in our article on the Balance of payments accounts!

A trade surplus occurs when a nation's net exports are greater than its net imports. If a country is experiencing a large trade deficit, meaning it imports more goods than it exports, it can devalue its currency by increasing the target exchange rate.

For example, let's say currency A is pegged to currency B. The target exchange rate between currency A (cA) and currency B (cB) is 2.5cA per 1cB. To increase the exchange rate, the target rate is increased to 4cA per 1cB. Now, goods that are priced in currency A appear cheaper when the currency is converted to currency B. This is how devaluing a currency can decrease trade deficits. It can also be used to address surpluses in the foreign exchange market. If a nation wants to prevent its currency from falling in the case of a surplus, it has to buy its own currency and sell foreign currency, or it can devalue its currency to prevent having to sell foreign currency.

If a nation has a lot of government debt at a fixed interest rate, then devaluing the currency could make the repayment of the debt cheaper in the long run.

Imagine country A has to pay back interest on a debt of 100,000cA to country B. Before the devaluation, country A would have to pay back 40,000cB of interest. After devaluing their currency they would only have to pay back 25,000cB of interest in real terms. Of course, this only works if the payments are fixed in country A's currency. If they were not, then it would have the opposite effect and make the debt more expensive.

Cons of currency devaluation

Devaluation is not without its risks. It can cause foreign imports to appear more expensive on domestic markets, and decrease purchasing power in foreign markets. This can encourage domestic consumption but that is not always possible if some goods simply are not available domestically. Then we see both cost-push and demand-pull inflation. To control inflation, the government might increase interest rates to decrease the supply of currency.

Cost-push inflation: An increase in the overall price of goods in the economy due to an increase in input costs for firms.

Demand-pull inflation: An increase in the price of goods in the economy because of an increase in the aggregate demand.

You are invited to learn more in our articles - Costs of Inflation.

Devaluation can also demotivate domestic producers to improve efficiency since they know they can rely on devaluation to keep them competitive in their markets. This would make them less cost-effective in the future and could set them back on technological advancements.

Revaluation of currency example

A currency revaluation, although less common than devaluation, can be a response to a couple of things. One is the interest rate, another is when changes in the foreign market affect how competitive a nation is in international trade, or a change in leadership can cause political shifts that affect a market and its perceived stability.

A revaluation is when the value of a currency, that has been pegged to a foreign currency under a fixed exchange rate, is increased.

Pros of currency revaluation

The benefit of revaluing a currency is that it makes foreign goods less expensive on the domestic market. This allows domestic consumers to purchase off the foreign market, diversify their consumption and hold more foreign assets. It also encourages domestic producers' cost efficiency in order to remain competitive in foreign markets.

In 2011 the Swiss franc was first pegged to the Euro at 1.20 Euros to 1 Swiss franc. This was done to help Swiss exporters turn a profit in Europe. In January 2015, the Swiss National Bank abruptly removed the Swiss franc’s peg to the Euro and the U.S. dollar, citing a lack of sustainability in the Eurozone. This caused a nearly 30% revaluation in the Swiss franc overnight. This made swiss export profits fall but the Swiss National Bank claimed that the market will eventually return to 1.10 Euros to 1 Swiss franc rate.

devaluation revaluation swiss franc StudySmarterSwiss Franc, Source: Wikimedia Commons

Cons of currency revaluation

Revaluing a currency could hurt a country's exports because its goods become relatively more expensive to foreign markets. This appears as a deterioration in the balance of payments in a nation's current account.

Devaluation and Revaluation as Tools of Monetary Policy

Adjustments of the exchange rate, like its devaluation and revaluation, are usually performed by a nation's monetary authority like its central bank which is controlled by its government.

Devaluation can be used as a tool for monetary policy as a way to control aggregate demand. Aggregate demand for domestically produced goods increases when the currency is devalued because of the increase in exports and decrease in imports. This increase in aggregate demand for domestically produced goods will help reduce the chance of a recession and will help reduce any recessionary gap that the nation's economy may be experiencing.

The opposite occurs when a currency experiences revaluation. Aggregate demand will fall due to the increase in imports and the fall in exports which will encourage any inflationary gap to shrink.

To learn more about monetary policy, read our explanation - Monetary Policy

Impacts of Currency Devaluation and Revaluation on International Trade

Devaluation and revaluation both impact international trade because of how they affect the relative prices of goods. When a weak currency is fixed to a stronger currency it has more stability and it is more competitive in terms of price because its goods appear cheaper in foreign markets making it more appealing. Most consumers will look for the best price to purchase their goods so if they can import goods from another country to increase their own profits they will.

China is a great example of the success achieved via the pegged exchange rate. For years they were able to remain competitive in the international market allowing their tremendous economic and developmental growth over the last three decades.

Devaluation and Revaluation - Key takeaways

  • A devaluation is when the value of a currency, that has been pegged to a foreign currency under a fixed exchange rate, is reduced. Revaluation of a currency is when the value of a currency increases in relation to its target exchange rate.
  • The exchange rate is the value of one currency when compared to another, and when it is fixed or pegged it means that the exchange rate of one nation is dependent on another.
  • A devaluation of the currency will increase exports and decrease foreign imports because it will make domestic goods appear cheaper in foreign markets while foreign goods will be more expensive in the domestic market.
  • A revaluation of the currency will drive exports down because it will make domestic goods appear more expensive to foreign markets. Domestic markets will increase their imports consumption because foreign goods appear cheaper than domestic ones.
  • Both devaluation and revaluation can be implemented by central banks as monetary policy as a way to control aggregate demand to influence recessionary and inflationary gaps.

Frequently Asked Questions about Devaluation and Revaluation

Devaluation is when the value of a currency, that has been pegged to a foreign currency under a fixed exchange rate, is reduced. Revaluation of a currency is when the value of a currency increases in relation to its target exchange rate.  

The effect of devaluation is an increase in exports, a decrease in imports, it can make government debts less expensive in the long run, and it encourages a reduction in the recessionary gap. The effect of revaluation is to increase imports and decrease exports, which helps close the inflationary gap by reducing aggregate demand. 

Devaluation is a decrease in the value of a currency in relation to its target exchange rate while revaluation is an increase. Devaluation is weakening the currency where as revaluing strengthens it. 

When a currency is revalued, its value increases in comparison to the value of the currency it is fixed to under a fixed exchange rate.

The disadvantages of devaluation are that it can cause inflation and can decrease a currency's purchasing power in foreign markets.

Final Devaluation and Revaluation Quiz

Question

What is a devaluation of a currency?

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Answer

A devaluation is when the value of a currency, that has been pegged to a foreign currency under a fixed exchange rate, is reduced.

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What is a revaluation of a currency?

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A revaluation is when the value of a currency, that has been pegged to a foreign currency under a fixed exchange rate, is increased.

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What are 3 benefits of devaluating a currency?

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Answer

It increases domestic exports. It decreases foreign imports. It helps increase aggregate demand, which helps prevent recession.

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What is a con of devaluating currency?

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Answer

It can cause inflation.

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What are the benefits of revaluation?

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It makes foreign goods appear cheaper and allows domestic consumers to purchase off the foreign market, diversify their consumption and hold more foreign assets.

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What is a con of revaluation?

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It can hurt a nation's export market because domestic goods appear less competitive. 

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Why might a devaluation in currency cause a decrease in production efficiency?

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It might demotivate domestic producers to improve efficiency if they know they can rely on devaluation to keep them competitive in the market.

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What is the exchange rate?

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The value of one currency compared to another.

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What is the difference between a floating and a fixed exchange rate?

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A floating exchange rate adjusts with the demand and supply in the foreign exchange market, whereas a fixed exchange rate bases its value off of the target value in terms of another currency. 

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What happens to demand for domestic goods when the currency is devalued?

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Aggregate demand for domestically produced goods increases.

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What will happen to aggregate demand when the currency experiences revaluation?

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Aggregate demand will fall due to the increase in imports and the fall in exports.

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What was the effect of China's fixed exchange rate on its economic growth?

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China saw a huge benefit from having its exchange rate fixed because it allowed its prices to remain competitive with the foreign market.

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Did China fix Yuan below or above the US dollar? Why?

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Below, because China always wanted its prices lower than the competitor's prices.

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Did the Swiss franc see a depreciation or an appreciation after it was no longer pegged to the euro?

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It saw an appreciation because the value of the Swiss franc increased by about 30%

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What benefit did Swiss exporters gain when the franc was pegged to the euro?

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Swiss exporters were able to be more competitive in the European market because their goods seemed relatively less expensive when the fixed exchange rate limited how valuable the Swiss franc could be.

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If a video game is heavily featured in the hottest new movie in the cinema. Everyone rushes to buy the video game, so the price rises. What is this an example of?

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Demand-pull inflation.

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Due to climate change, the purest freshwater spring is drying up. Because of the reduced supply, the price of each bottle has doubled. What is this an example of?

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Cost-push inflation.

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If there is a surplus in a currency and the government wants to prevent it from falling, what can it do?

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It can buy its own currency.

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Say India's Rupee is pegged to the GBP. India wants its goods to appear cheaper in the UK market. What measures should the Indian government take to make this happen?

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They should lower their currency peg to make the Rupee devaluate.

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Country A has debt it must pay back to country B at a fixed interest rate. Would revaluing the currency help or harm Country A? Why?

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It would harm them because it would make the debt more expensive.

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How can changing the value of a currency be a tool of monetary policy?

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Devaluation can be used to affect aggregate demand.

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How can the central bank combat an inflationary gap? Why does it work?

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By revaluing the currency imports will increase, which reduces aggregate demand.

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When the exchange rate goes from 1USD:1.3CAD, to 1USD:1.45CAD, has it revalued or devalued?

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Neither, because the US and Canada have a floating exchange rate.

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A fixed exchange rate cannot move at all.

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False, adjustments can be made to benefit the market.

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If South Africa wants its Rand(ZAR) to appear more competitive with India's Rupee(INR), and the exchange rate is 1 ZAR:4.8INR, what should it do?

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It should devaluate it's Rand.

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An increase in exports due to the devaluation of currency presents an ____________ in the balance of payments on the nation's current account.

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Answer

improvement.

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If you feed your friend dinner more often than your friend feeds you dinner, what type of trade situation are you running?

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You are running a trade surplus. 

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If the government wants to use monetary policy to combat demand-pull inflation, what might it do?

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They could increase interest rates.

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The foreign exchange market controls the exchange rate for each country.

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False, each country controls its own currency to an extent.

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When a weak currency is fixed to a stronger currency it is ___________ and it is more ___________ in terms of price.

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more stable, competitive

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What is an alternative to devaluing their currency for countries with a pegged exchange rate?

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They could buy more of their own currency.

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What can a nation do if there is a surplus of its currency?

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It can buy its own currency.

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If your sibling does your chores for you way more often than you do theirs, what type of trade are you running?

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You are running a trade deficit.

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How does devaluation have a positive impact on a nation's current account?

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It increases exports and has more money flowing into the nation's economy.

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