Devaluationis a reduction in the value of acurrencywith respect to those goods, services or other monetary units with which that

currency can be exchanged. A substantial drop in the value of a currency, relative to the price of gold or the currencies of other countries.

 The natural result of market forces (FLOATING EXCHANGE RATES) The result of government intervention (FIXED EXCHANGE RATES)

When exchange rate falls in floating exchange rate system due to free interaction of market forces, it is called depreciation In simple words demand and supply of a currency in international market affect the currency rates. This could be in two ways: When supply increases. When demand

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D D S S

r a t e

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Demand/Supply of currency

The active decision of a government to reduce thevalueof its owncurrencyvis a vis other currencies. Devaluation occurs exclusively in fixed currencies, when the currency in question is pegged to another

BOP On current account Surplus

Time

Deficit

 Overvaluation of currency associated with import substitution for industrialization as opposed to the export promotion policies. The risk of loosing competitiveness To relieve an unfavorable balance of trade. Economic stabilization. Correcting the price distortions. To increase competitiveness in foreign markets. To raise national income per capita. Achieve higher standards of living for their population Close the development gap. Government policies of high tariffs on imports fails. A cycle of competitive devaluations.

POSSITIVE EFFECTS: Industrial Growth Increase in Exports Decrease in Imports Improve trade balance and BOP Accordingly expand output and employment Economic Development

Import reduces

Improved trade balance

Local output increases

Positive balance of payments ROI

Reduce of Smuggling

ECONOMIC STABILIZATION Employment improves Expansion of industries Production Increases Higher standards of living

Govt. taxes improves

Per capita income Increase in increase Foreign investment

Rise in Govt. exp

Export Increases Consumption increase Profit improves

Price fall

Reduction in purchasing power. Inflation. Debt crises. Retaliation. Terms of Trade. Increase in import bill. Temporary help. Shortage of goods at home market. Inelastic exports.

 Devaluation is likely to be contractionary in the very short run (within the same year devaluation occurs), expansionary in the medium run (the year following devaluation) and neutral in the long run, i.e. negative and positive effects offset each other over time. The results appear to be valid for both manufacturing exporters and agricultural and primary exporters. Fiscal expansion (increasing the relative size of government expenditures) has a significant positive effect on output growth for all countries regardless of their export composition. Similarly, unexpected monetary expansion also positively affects output growth. The effect of terms of trade changes on output is generally negative for agricultural and primary exporters, but fluctuating for manufacturing exporters.

 Current account deficit of over Rs 290 crore due to SECOND five year plan (Capital goods import) Inflation had caused Indian prices to become much higher than world prices Budget deficit due to Defense spending in 1965/1966 was 24.06% of total expenditure due to Indo-pak war. Money supply increased, depleting foreign reserves. The drought of 1965/1966

Budget Deficit as Percentage of Total Government Expenditure

 To avert a financial crisis. The trade deficit in 1990 was $9.44 billion. The current account deficit was $9.7 billion. The gulf war led to much higher imports due to rise in oil prices. Cost pull inflation. Political and economical instability Higher inflation rate. Depleting foreign exchange reserve and gold pledged to IMF by govt.