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Exchange Rate Devaluation and Balance of Payments Essay

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Updated: Aug 14th, 2021

Devaluation of the exchange rate for a country is done when the country is not able to meet its foreign exchange payment obligations. Such a problem is termed a balance of payment (BOP) crisis (Callier, 1975). The paper will argue the thesis statement that a move to devalue the currency has only a temporary impact on the BOP. Various theories and models with regards to the BOP and the exchange rate are discussed.

The exchange rate is the rate at which domestic currency is exchanged for foreign currency. It is set in the market for foreign exchange either by market forces – floating exchange rates or by different foreign exchange authorities – fixed exchange rates (Obstfeld, 1983). Devaluation is an increase in the official price of foreign currency undertaken by the foreign exchange authority. Frequently, devaluation is undertaken to eliminate a deficit in the balance of payments. Devaluation should only be taken when there are real and quantifiable reasons and the effects of the devaluation should be real and not notional.

BOP is an account that summarizes all of the transactions between the domestic economy and the rest of the world. The simplest version of the BOP will have a current account, capital account, and the official settlements or change in reserves (Snowdon, 2003). BOP summarizes all of the transactions between the domestic economy and the rest of the world. As an accounting statement, it must balance (Mammen, 1999). The paper would use this statement as the basis to argue the thesis statement. The real effects of devaluation must describe which components of the BOP are affected by the devaluation and how they are affected (Thirlwall, 2004).

Please refer to the following table that shows a simple balance of payment statement. The table represents the aggregate economic transactions undertaken by the members of a country and the rest of the world. Entries on the left are positive and represent economic activities that generate foreign exchange and entries on the right are negative and represent economic activities that use the foreign exchange.

Sample BOP Statement.
Table 1. Sample BOP Statement (Charusheela, 2004).

In the above statement, the sum of all transactions under ‘sources of foreign exchange should be equal to the sum for all items under ‘Balances’. The account is said to balance when So total foreign exchange inflows = total foreign exchange uses. If the inflow is greater then there is a surplus of foreign exchange and if it is lesser, then there is a deficit (Charusheela, 2004).

The thesis statement ‘A devaluation of the exchange rate has only a temporary impact on the Balance of Payments” can now be examined with reference to the above table. As discussed by Callier (1975) if there is a deficit in the BOP, then the condition arises that outflows are more than inflows. If the government decides to devaluate the currency to meet the shortfall, it has actually not increased its income but only stretched the currency so that it is inflated and in return for a unit of foreign currency, more units of the local currency would be given out. Charusheela (2004) argues that the devaluation or reduction of currency is artificial and would not actually affect the balance of payment in real terms.

To make up for the shortfall, the nation increases its borrowings as shown for items short term and long term borrowings, 6 and 7 in the table and this would cause the deficit to further increase. A nation is caught in this vicious circle and ultimately; the balance of payment would show a very huge deficit and make the country go into recession.

Thus the statement “A devaluation of the exchange rate has only a temporary impact on the Balance of Payments” has been proved. Obstfeld (1983) has suggested that to get over the problem of BOP and deficits, some countries install remedial measures such as tariffs, trade barriers, taxes, debt instruments, and others.

References

Callier Philippe. 1975. Devaluation, capital flows and the balance of payments: A respecification. Review of World Economics. Volume 111. Number 1. pp: 159-161

Charusheela S. 2004. Structuralism and Individualism in Economic Analysis: The Contradictory Devaluation Debate in Development Economics. Routledge; 1 edition.

Mammen Thampy. 1999. India’s Economic Prospects: A Macroeconomic and Econometric Analysis. World Scientific Publishing Company.

Obstfeld, Maurice. 1983. Balance-of-Payments Crises and Devaluation. NBER Working Paper No. W1103.

Snowdon Brian. 2003. An Encyclopedia of Macroeconomics. Edward Elgar Publishing.

Thirlwall A. 2004. Essays on Balance of Payments Constrained Growth: Theory and Evidence. Routledge; 1 edition.

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