Devaluation is when a country makes a conscious decision to lower the value of its currency relative to other countries. So, when Mexico lowered the value of the Peso in 1995 it was devaluation. It’s not quite the same thing as devaluation that refers to the value of a floating exchange rate falling in value owing to the actions of the foreign exchange markets (that is, the interaction between demand and supply).

Why would a country devalue its currency? Say Mexico is in a situation where 1$ = 5 Pesos. This would mean the Peso might be too strong, which of course benefits people living in Mexico – They only need to supply 5 Pesos to get 1$, and this means imports might be increasing.

GDP (Aggregate Demand or National Income) = G (Government Spending) + I (Investment) + C (Consumer Spending) + (X (Exports) – M (Imports)).

So, if M, imports, increases this decreases GDP and thus growth slows. Why? Because money is leaving the country to buy what my economics teacher calls ‘naughty foreign products.’ Now that isn’t necessarily a bad thing. After all, imports benefit a society in terms of their value – consider the amount of BMWs and Mercedes sold outside Germany. Yet having too many imports also harms the current account, creating a current account surplus which is a barrier to achieving a healthy balance of payments.

In addition, if the Peso is too strong this means an American has to supply 1$ for 5 Pesos, say. This means that Mexico’s exports become expensive and thus the value of exports will fall, further harming GDP and the current account. Basically, by having too strong a currency, you lose competitiveness.

By devaluing your currency you restore competitiveness and give the domestic manufacturing sector a boost. Of course, devaluations must be done properly to have the desired effect. Mexico managed to mess up its devaluation. A successful devaluation requires this:

  • The devaluation is sufficiently large so that people stop speculating against the currency in question, and it holds its value.
  • The country devaluing the currency is certain that it has devalued the currency the right amount, and makes this clear publicly. It must “give off all the right signs,” writes Paul Krugman. If not, it just makes speculators think that another devaluation might be on the horizon.

In Mexico, they didn’t devalue enough, and they didn’t seem confident enough after the devaluation which simply made investors shaky and encouraged further speculation that made the Peso plummet.

Argentina recently devalued its currency, after years of pegging it to the Dollar. This was disastrous for people who had incomes in Pesos but liabilities in Dollars, whose debts exploded in value. Think about it:

Say $1 = 1 Peso. Your debts are in the region of $100. You need to supply 100 Pesos to pay off the debt.

Now, say the Peso is devalued and $1 = 10 Pesos. The Dollar value of your debt is still $100, but you now need to supply (10X100=) 1000 Pesos to pay off the debt.

Your income hasn’t changed (why should it?), meaning that you now owe ten times as much as before. Bankruptcy may ensue. Of course, this is inevitable, and probably it’s best for a currency to suffer the short-term pain because it will eventually reap the benefits of devaluation – increased investment, a boom in the export markets of your country and massive benefits for those whose incomes are in Dollars but liabilities in Pesos.

During the Asian Currency Crisis many Asian currencies like Thailand’s Baht were devalued, and two years later, in 1999 the Brazilian real was devalued (although it was also natural depreciation, as there was heavy speculation against it) and this sparked off real trouble In Argentina.

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