Under a system of fixed exchange rates a country can adjust its balance of payments by trading its national currency for foreign currency or gold. If a balance of payments surplus persists, the government may decide to buy more foreign currency or gold in order to move back into equilibrium. Conversely, if a deficit exists, the government may sell some of its reserves of foreign currency or gold in order to bolster the value of its own currency. Because a nation's reserves of other currencies and gold are limited, the government may choose to correct an imbalance by officially readjusting the value of its currency. Such a devaluation will usually be achieved through a legislative or administrative order. Under a flexible exchange-rate system, alterations in the exchange rate can be made to help a nation achieve equilibrium in its balance of payments.
Currency devaluation primarily affects a nation's trade balance, which is the difference between the value of its exports and that of its imports. Devaluation reduces the value of a nation's currency in terms of other currencies; thus, following a devaluation, a nation will have to exchange more of its own currency in order to obtain a given amount of foreign currency. This causes the price of imports to rise and makes domestic products more attractive to consumers at home. Because it takes less foreign currency to buy a given amount of a devalued currency, the price of the nation's exports declines, making them more desirable to foreign consumers.
Depending on consumer and producer responsiveness to price changes (known as supply and demand elasticities), an effective devaluation should reduce a nation's imports and raise world demand for its exports. Improvement in a country's balance of trade will cause an increase in the new inflow of foreign currency; this, in turn, may help strengthen a country's overall balance of payments account.
The total effect of a currency devaluation depends on the actual elasticities of the supply and demand for traded goods. The more elastic the demand for imports and exports, the greater the effect of the devaluation will be on the country's trade deficits and, therefore, on its balance of payments; the less elastic the demand, the greater the necessary devaluation will be to eliminate a given imbalance.
Devaluation often is criticized as an inflationary monetary policy because it raises the domestic price of exports and imports. The underlying cause of inflation is not devaluation, however, but rather excess money creation. Nonetheless, devaluation is an unpopular policy, especially in small countries that are extremely dependent on imports as a source of food and other necessities.
In 1944 the major world powers met at the Bretton Woods Conference to organize an international monetary system that would alleviate many of the foreign-exchange problems created by World War II. The International Monetary Fund, or IMF, was established at the conference primarily to promote currency stabilization, thereby facilitating the growth of world trade. The participating nations agreed to tie the values of major world currencies to the value of the United States dollar, which was determined by the amount of gold the dollar could buy. An agreement was also reached to set upper and lower limits within which exchange-rate fluctuations were permitted in response to market conditions. At the time of the conference this limit was set by the IMF at 1 per cent in either direction. If a country chose to adjust the value of its currency beyond 1 per cent, the nation would have to change its currency value officially in terms of US dollars. Although the Bretton Woods agreement enabled countries to raise their currency values, in practice almost all currency changes since then have been devaluations. The British pound sterling, for example, was devalued in 1949 and again in 1967.
In the years following the Bretton Woods agreement, the US dollar emerged as the world's leading currency. It was used as an alternative to gold when handling international payment imbalances. In a sense the US dollar functioned as the world's money because it served as a unit of account, a medium of exchange, and a store of value. Other nations kept large proportions of their international monetary reserves in dollars.
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***** This essay is excellent as far as it goes. Fixed exchange rates are unlikely to return in the forseeable future so I would have preferred to see more discussion of the floating exchange rate situation.