Devaluation, an official reduction in the value of the domestic currency in terms of foreign currencies or exchange rate adjustments, is a common thing. For example, between1985-87 the US engineered a 50 per cent fall in the external value of dollar through the Group of Seven. Many of India’s other trade partners have also made substantial exchange rate adjustments over the past few years. Over the period end December 1980 to end December 1989, China depreciated the currency by 68 per cent and Indonesia by 65 per cent while India depreciated by only 54 per cent against the US dollar, where as increase in consumer process in China and Indonesia were lower (at 100 per cent and 111 per cent respectively) against India’s 114 per cent over the same period.
Devaluation is resorted to help correct the balance of payments disequilibrium by increasing exports and decreasing imports. To illustrate, let us take the example of the devaluation of Indian rupee in 1966. Just before the devaluation of the Rupee with effect from 6-6-1966, the exchange rate was $1 = Rs 4.76. The devaluation of the rupee by 36.5 per cent changed the exchange rate to $1 = Rs 7.50. Before devaluation the price of an imported commodity which cost $1 abroad Rs 4.76 (assuming costless free trade). But after devaluation the same commodity which cost $1 abroad would cost Rs 7.50 when imported because of the change in the exchange rate. Thus, devaluation makes foreign goods costlier in terms of domestic currency and this is supposed to discourage imports. On the other hand, devaluation makes exports from the country that has devalued the currency cheaper in foreign markets. Taking the above example, before devaluation, a commodity which cost Rs 4.76 in India was sold abroad at $1 (assuming costless free trade), but after devaluation the landed cost abroad of the same commodity was only $0.64. This comparative cheapness of the Indian goods in the foreign markets was expected to stimulate demand for Indian exports.
It may appear that devaluation can help solve the problem of trade deficit by stimulating exports and curtailing imports. But in actual practice, the effect of devaluation depends on a number of intricate and, often, interdependent factors. Depending on these factors the net effect of devaluation may be favorable or unfavorable. If factors are, by and large unfavorable, exports may not increase sufficiently enough to improve the trade position or the high cost of imports and certain other developments resulting from devaluation may cause inflation and nullify the initial effect of devaluation on export prices.
A basic assumption related to devaluation is that the demand for the country’s exports and imports is price elastic, i.e. a fall in export prices will substantially increase the demand or export and an increase in the process of imports will significantly reduce imports. However, these things need not necessarily happen.
The demand for many exports of the developing countries, lie in the primary commodities, is regarded as relatively price inelastic that is, a fall in the price will not significantly increase the demand. On the other hand, the demand for many of the imports of the developing countries, like essential consumer goods, capital goods, technology etc. is also relatively price inelastic i.e. an increase in the import prices will not considerably reduce the imports.
It should be noted that devaluation may lead to a fall in the unit value of exports and hence the total earnings will increase only if the quantum of exports increase more than the rate of fall in the net value of exports following the devaluation. If the quantum of exports does not increase to the extent of the rate of fall in the unit value of exports following the devaluation. If the quantum of exports does not increase to the extent of the rate of fall in the unit value of exports, there will be fall in the total export earnings. However, as trade balance is a function of both export and imports, we have to consider the effect of devaluation on both exports and imports. In other words, devaluation will improve a country’s trade balance only if the sum of elasticity’s of demand for exports and of its demand for imports is greater than one.