Consider the following statements: The effect of devaluation of a currency is that it necessarily:im

Question

Consider the following statements: 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?

Accepted Answer

Devaluation means the official lowering of the value of a country's currency within a fixed exchange rate system. Devaluation of a currency happens in countries with a fixed exchange rate (or also where it is managed floating rate).Example: Let us assume that the prevailing exchange rate of $1 is 10 rs. So currently 1 rs is worth $0.1. If devaluation of currency is done and now the exchange rate of $1 is 20 rs, this means 1 rs is worth $0.05. So the value of domestic currency (rs) is decreased in terms of the value of foreign currency ($). Hence, statement 2 is not correct.Let us take another example to understand statement 1: If a shirt costs $8 in the US and Rs 400 in India, the rupee-dollar exchange rate should be Rs 50. To see why, at any rate higher than Rs 50, say Rs 60, it costs Rs 480 per shirt in the US but only Rs 400 in India. In that case, all foreign customers would buy shirts from India. So devaluation of currency improves the competitiveness of the domestic exports (India) in the foreign markets. Hence, statement 1 is correct.Balance of Trade (BOT) is the difference between the value of exports and the value of imports of goods of a country in a given period of time. Regarding third statement, with the devaluation of currency competitiveness of the export improves, but trade balance depends upon both export as well as imports and it is not necessarily true that devaluation of currency improves trade balance. (Let us take a possibility in the Indian economy, our economy is heavily dependent upon the import of crude oil, and at the time of devaluation of currency, export increases but for the same period, demand for crude oil also increases due to increased growth in the economy, and the value of this increase in import is more than the value of increase in export. So, in this scenario again we have a deficit trade balance). Hence statement 3 is not correct.Source Citation:Vision Ias Economy Study Material Part-INCERT: Introductory Macroeconomics Chapter 6