Previous Year Question
The effect of devaluation of a currency is that it necessarily:
improves the competitiveness of the domestic exports in the foreign markets.
increases the foreign value of domestic currency.
improves the trade balance.
Which of the above statements is/are correct?
1 only
1 and 2
3 only
2 and 3
Correct Answer: A
Detailed Solution
Devaluation is an official reduction in the external value of the domestic currency by the Government or monetary authority under a fixed exchange-rate system. It differs from depreciation, which results from market forces.
Statement 1 is correct.
Following devaluation, more units of domestic currency are required to purchase one unit of foreign currency. If domestic prices initially remain unchanged, the country’s exports become cheaper for foreign buyers in terms of their currencies.
For example, if an Indian product costs ₹1,000:
At ₹50 per dollar, its foreign price is 20 dollars.
At ₹100 per dollar, the same product costs 10 dollars.
Devaluation therefore improves the price competitiveness of domestic exports in foreign markets. The actual increase in exports will, however, also depend on production capacity, quality, foreign demand and domestic inflation.
Statement 2 is incorrect.
Devaluation, by definition, reduces the official foreign value of the domestic currency. It does not increase that value.
For example, a movement from ₹50 to ₹100 per dollar means that the rupee has lost value against the dollar.
Statement 3 is incorrect.
Devaluation does not necessarily improve the trade balance. The outcome depends upon the price elasticity of demand for both exports and imports.
Immediately after devaluation, imports become more expensive, but the quantity of essential imports such as petroleum and machinery may not decline quickly. Consequently, the trade deficit may initially worsen. This is described as the J-curve effect.
An improvement in the trade balance is more likely when the sum of the price elasticities of demand for exports and imports exceeds one. This is known as the Marshall-Lerner Condition. Improvement is therefore possible, but not automatic.