What is devaluation? Under what conditions will devaluation improve a country's balance of payment position ?

Answer Details

Devaluation. Devaluation is a deliberate official reduction in the external value (exchange rate) of a country's currency in terms of other currencies or gold, carried out by the government or monetary authority under a fixed or managed exchange-rate system. After devaluation the country's exports become cheaper to foreigners and its imports become dearer to residents. (A fall in value caused by market forces under a floating system is called depreciation, not devaluation.)

Its aim is usually to correct a deficit in the balance of payments by encouraging exports and discouraging imports.

Conditions under which devaluation improves the balance of payments.

1. Favourable elasticities of demand (the Marshall-Lerner condition). The sum of the elasticity of demand for exports and the elasticity of demand for imports must be greater than one. If demand for exports and imports is sufficiently elastic, the fall in export prices raises export earnings and the rise in import prices cuts import spending, improving the balance.
2. Elastic domestic supply of exports. The country must be able to expand production of exportable goods to meet the extra foreign demand; if supply is fixed or inelastic, extra orders cannot be filled.
3. Availability of import substitutes. Residents must be able to switch from now-dearer imports to home-produced substitutes, otherwise import spending stays high.
4. Other countries do not retaliate. Trading partners must not devalue their own currencies or raise trade barriers in response, which would cancel the advantage.
5. Domestic prices (inflation) are controlled. If devaluation sets off internal inflation that raises export costs, the initial price advantage is quickly eroded, so inflation must be checked.

Examination reminder: the central condition is the elasticity (Marshall-Lerner) requirement; if demands are inelastic, devaluation can actually worsen the balance of payments.