Friday, August 28, 2009

Role of Devaluation as a Method of Correcting Disequilibrium

When there is a deficit or surplus in the balance of payments of a country, it is said to be disequilibrium in the balance of payments of that country. For solving the problem of disequilibrium adjustment is brought about through price and income changes or by adopting certain policy measures like devaluation and direct control.

Devaluation

A fall in the fixed exchange rate between one currency and others. When the relative value of two currencies fixed at an officially agreed level any reduction in the value of one currency against the agreed fixed level is devaluation. In short devaluation is the official decrease in the value of the currency in terms of foreign currency.

Devaluation raises the domestic price of imports and reduces the foreign price of exports of a country. There is a difference between depreciation and devaluation of exchange rate. Depreciation is the decision of market forces, where as devaluation is the decision made by monetary authority. When the external value of currency is reduced through devaluation, exports become cheaper and imports dearer as a result exports increase and imports decline and the balance of payment deficit is eliminated.

In order to assess the true effects of devaluation, it is advisable to study price movements in exports and imports in same currency, the figures given above illustrate these effects of devaluation on exports and imports respectively. Suppose the British Pound is devalued in relation to the US dollar and the price movements before and after devaluation are taken in pound. Both the demand supply curves of exports and imports are taken as elastic. First take exports in Panel (A) of the figure. Devaluation of pound has no effect on the supply of exports in pound. Therefore the supply curve of exports Sx does not change. But to the US consumers British goods, devaluation of pound means cheaper goods than before. Consequently curve for exports Dx shifts to the right of Dx. The pre-devaluation price of OX exports is OPx after devaluation of pound the export price rises to OPx and the volume of exports increases to OX.

Now take the effect of devaluation on imports. With devaluation imports become dearer in pound and their volume is reduced than before devaluation. Therefore the supply curve of imports Sm shifts to the S´m in Panel of B of the figure. But the demand curve for imports Dm being elastic the increase in the price of imports from QPm to QP´m reduces the quantity bought from OM1 to OM.

Thus by increasing exports and decreasing imports, devaluation on terms of the currency of the devaluing country brings equilibrium in the balance of payments.

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