Effects of a one-time devaluation
Devaluation is the official change of the value of a country’s currency in relation to other foreign currencies. The main aim of devaluation is to create a stable international economy by creating a fixed and stable exchange rate system thus increasing the foreign exchange reserve of a country. Devaluation normally result to low currency value making the currency less expensive to the devaluing country and more expensive to foreigners who may want to use that currency.
The stakeholders of foreign exchange market normally expect subsequent devaluations in the future as a result of the first devaluation. The main aim of initial devaluation is to replenish foreign reserve of a given country that is normally measured in terms of gold normally $35 an ounce. The initial devaluation normally increases the central bank’s reserves for a short period of time normally one to two and a half years and then the long- term effects of devaluation are felt negatively.
The initial devaluation makes a country’s currency to be cheaper as compared to other international currencies. This leads to imports becoming expensive for domestic consumers thus cutting down on the imported products in the country. The ultimate result is the increase of a country’s exports and decrease of imports thus increasing the central bank’s reserve. On the other hand, devaluation makes the country to rely more on domestic products thus aggravating inflation. To control inflation, the government is forced to raise the interest rate leading to slow economic growth and depletion of foreign exchange reserves. Initial devaluation has a psychological effect where investors perceive it to be economic weakness damping their confidence making it difficult for a country to secure foreign investment. Investors also fear for the security of their exporting industries which complicates the matter further to the country’s foreign reserves.
Monetary Policy Effect on the Country’s Exchange Rate
Monetary policy aims at promoting a country’s economic growth and stability by controlling the supply of money by targeting interest rates. The change of a country’s government comes with a lot of hopes and expectations especially in the area of monetary policy which at times may affect a country’s exchange rate. A new government may be forced to enact monetary policy in times of deflation by reducing the current interest rates. Such policy is expected to boost investment improving the economy and bringing the country out of recession. Economic recovery may eventually lead to hyperinflation whereby interest rates rise as if the country is under deflation. Increased interests rates pass the burden to the businesses leading to laying off of workers by the businesses to recover their profits and this has a negative impact on the country’s exchange rate.
The monetary policies steered by the people’s expectations may cause a government to conduct devaluation or revaluation of its currency that aggravates imports or exports depending on the measures taken. These two policies have direct impact on the country’s exchange rate whereby devaluation will discourage imports thus boosting the country’s exchange rate. The future policies expectations may alter the response of foreign exchange in the market. This is a result of the surprise caused in the market by such policies leading to speculations among the investors both local and foreigners thus affecting the exchange rate either upwards or downwards.
The government might also decide to adopt a fixed exchange rate in that the rate is controlled by non-convertibility measures such as imports/exports, capital controls and the general demand and supply. In this case, a unit of local currency is backed by a unit of foreign currency thus eliminating the worry of deficit of local currency value. In conclusion the major forces that affect the value of a country’s foreign exchange rate are the government policies and the psychological perception by all economy stakeholders pertaining to the country’s currency.