DEVALUATION

A deliberate downward adjustment to the value of a country's currency, relative to another

currency, group of currencies or standard. Devaluation is a monetary policy tool of countries
that have a fixed exchange rate or semi-fixed exchange rate. It is often confused with
depreciation, and is in contrast to revaluation.
Devaluating a currency is decided by the government issuing the currency, and unlike
depreciation, is not the result of non-governmental activities. One reason a country may
devaluate its currency is to combat trade imbalances. Devaluation causes a country's exports
to become less expensive, making them more competitive on the global market. This in turn
means that imports are more expensive, making domestic consumers less likely to purchase
them.
While devaluating a currency can seem like an attractive option, it can have negative
consequences. By making imports more expensive, it protects domestic industries who may
then become less efficient without the pressure of competition. Higher exports relative to
imports can also increase aggregate demand, which can lead to inflation.
Effects of a devaluation

1. Exports cheaper. A devaluation of the exchange rate will make exports more competitive
and appear cheaper to foreigners. This will increase demand for exports
2. Imports more expensive. A devaluation means imports will become more expensive. This
will reduce demand for imports.
3. Increased AD. A devaluation could cause higher economic growth. Part of AD is (X-M)
therefore higher exports and lower imports should increase AD (assuming demand is
relatively elastic). Higher AD is likely to cause higher Real GDP and inflation.
4. Inflation is likely to occur because:

Imports are more expensive causing cost push inflation.

AD is increasing causing demand pull inflation
With exports becoming cheaper manufacturers may have less incentive to cut costs and
become more efficient. Therefore over time, costs may increase.

5. Improvement in the current account. With exports more competitive and imports more
expensive, we should see higher exports and lower imports, which will reduce the current
account deficit.

APPRECIATION
Impact of an appreciation on the current account

Assuming demand is relatively elastic, we would expect an appreciation to worsen the current
account position. Exports are more expensive, so we get a fall in eXports. Imports are
cheaper and so we see an increase in iMports. This will cause a bigger deficit on the current
account.
However, the impact on the current account is not certain:
1. An appreciation will tend to reduce inflation. This can make UK goods more competitive,
leading to stronger exports in the long term, therefore, this could help improve the current
account.
2. The impact on the current account depends on the elasticity of demand. If demand for
imports and exports is inelastic, they the current account could even improve. Exports are
more expensive, but if demand is inelastic, there will only be a small fall in demand. The
value of exports will increase. If demand for exports is price elastic, there will be a
proportionately greater fall in export demand, and there will be a fall in the value of exports.

Evaluation of a Devaluation

The effect of a devaluation depends on:

1. Elasticity of demand for exports and imports. If demand is price inelastic, the a fall in
the price of exports will lead to only a small rise in quantity. Therefore, the value of exports
may actually fall. An improvement in the current account on the Balance of Payments
depends upon the Marshall Lerner condition and the elasticity of demand for exports and
imports

If PEDx + PEDm > 1 then a devaluation will improve the current account
The impact of a devaluation may take time to have effect. In the short term, demand may be
inelastic, but over time demand may become more price elastic and have a bigger effect.

2. State of the global economy. If the global economy is in recession, then a devaluation
may be insufficient to boost export demand. If growth is strong, then there will be a greater
increase in demand. However, in a boom, a devaluation is likely to exacerbate inflation.
3.Inflation The effect on inflation will depend on other factors such as:

Spare capacity in the economy. E.g. in a recession, a devaluation is unlikely to cause

inflation.
Do firms pass increased import costs onto consumers? Firms may reduce their profit
margins, at least in the short run.

Import prices are not the only determinant of inflation. Other factors affecting inflation such
as wage increases may be important.

4. It depends why the currency is being devalued. If it is due to a loss of competitiveness,

then a devaluation can help to restore competitiveness and economic growth. If the
devaluation is aiming to meet a certain exchange rate target, it may be inappropriate for the
economy.

APPRECIATION
Current and Financial Account Surpluses and Deficits
Current account deficits (or surpluses) and financial deficits (or surpluses) do not directly
affect an economy. In fact, these deficits (surpluses) are actually the result of what is
occurring in an economy, instead of being the cause. Trade deficits often occur when a

nation's economy is growing faster than the economies of its trading partners. Rapid domestic
growth increases the demand for imports, while slow or no growth with foreign economies
can cause a decline in demand for the country's exports.
Trade balances are also affected by capital flows. If a nation's economy offers investment
opportunities that are relatively better than other nations, then capital will flow into the
country. With flexible exchange rates, this capital inflow will tend to increase the value of the
nation's currency.
Economic statistics support the hypothesis that trade deficits are associated with investment
opportunities and economic growth. Between 1973 and 1982, which was a time of stagnant
economic growth for the U.S., trade deficits and net foreign investment were fairly small. As
the U.S. economy grew rapidly after the 1982 recession, net foreign investment greatly
increased. During the recession of the early 1990s, capital inflow greatly decreased and the
current account was actually slightly positive during one of those years. The time between
1993 and 2000 was one of substantial economic growth; net capital inflows greatly increased,
which caused the U.S. dollar to appreciate and the current account ran large deficits.
Budget deficits and trade deficits tend to be linked
An increase in the U.S. government budget deficit will cause an increase in the real interest
rate, which causes additional foreign capital to flow into the country. The inflow of foreign
currencies will cause the value of the U.S. dollar to increase in relation to other currencies.
The increase in value of the U.S. dollar will make U.S. exports relatively less attractive to
foreigners and imports into the U.S. will be relatively less expensive; therefore, net exports
will go down. The increase in the budget deficit leads to an increase in the trade deficit.
Causes of a Nation's Currency Appreciation or Depreciation
Factors that can cause a nation's currency to appreciate or depreciate include:
Relative Product Prices - If a country's goods are relatively cheap, foreigners will want to
buy those goods. In order to buy those goods, they will need to buy the nation's currency.
Countries with the lowest price levels will tend to have the strongest currencies (those
currencies will be appreciating).
Monetary Policy - Countries with expansionary (easy) monetary policies will be increasing
the supply of their currencies, which will cause the currency to depreciate. Those countries
with restrictive (hard) monetary policies will be decreasing the supply of their currency and
the currency should appreciate. Note that exchange rates involve the currencies of two
countries. If a nation's central bank is pursuing an expansionary monetary policy while its
trading partners are pursuing monetary policies that are even more expansionary, the
currency of that nation is expected to appreciate relative to the currencies of its trading
partners.
Inflation Rate Differences - Inflation (deflation) is associated with currency depreciation
(appreciation). Suppose the price level increases by 40% in the U.S., while the price levels of
its trading partners remain relatively stable. U.S. goods will seem very expensive to
foreigners, while U.S. citizens will increase their purchase of relatively cheap foreign goods.
The U.S. dollar will depreciate as a result. If the U.S. inflation rate is lower than that of its
trading partners, the U.S. dollar is expected to appreciate. Note that exchange rate
adjustments permit nations with relatively high inflation rates to maintain trade relations with

countries that have low inflation rates.

Income Changes - Suppose that the income of a major trading partner with the U.S., such as
Great Britain, greatly increases. Greater domestic income is associated with an increased
consumption of imported goods. As British consumers purchase more U.S. goods, the
quantity of U.S. dollars demanded will exceed the quantity supplied and the U.S. dollar will
appreciate.

LITERATURE REVIEW
1. Grey literature is abundant in newspapers and magazine but it seems that academic
community is not willing to study electronic currency or the editors of the top
journals are not willing to publish electronic currency research. The few identified
articles are on the advantages, disadvantages and the functioning of the electronic

2.

3.

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5.

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7.

8.

currencies. The literature identifies two conceptually distinct but empirically

overlapping customers: the buyers who purchase products/services and the holders
who store value with electronic currencies.
To achieve the goal, other factors have to be considered such as the extent of the risk
and/or exchange rate exposure of the firms. The results add new evidence to the
current literature that have reported conflicting empirical findings from prior
research.
Fashions in the Contracts that have changed through time are noted. Modal, average,
maximum and minimum USA contract parameters for various features are used to
establish realistic and representative convertible bond contracts. The motivation for
analyzing the ISMA data is determine which contracts features are important before
investigating model errors.
The implications of this research would have been much stronger, had there been
stronger support for the hypotheses. Some of the following propositions can be made.
Firstly, it had been debated whether the US should pursue a policy of strengthening
the USD. The negative relationship that I found suggests that such a policy would also
be beneficial for the stock market. However, if the country targets exchange rate
appreciation in a time of rising stock prices, the policy could remain ineffective.
Secondly, multinational companies interested in exchange rate forecasting may
consider the stock market as a forecasting indicatorwhen it rises, the currency is
expected to depreciate. There is an interesting implication for portfolio managers,
namely that currency and equity have ambiguous correlation. It is positive when
equity prices are the first to fluctuate and negative when currency prices are shocked
first.
When the spot exchange rate is below the currency option strike price the price of the
currency call option is statistically zero and the price of the currency put option is
positive as a holder of the put option would gain from exercising them hence high
demand and price subsequently. On the other hand when the spot exchange rate is
above the strike price the price of the currency put option is statistically zero and the
price of the currency call option is positive as the holders of the currency options
would gain by exercising the call options and hence high demand and price of the
currency call options. Hence the further the spot exchange rate is from the strike price
the higher the price of the foreign currency calls and put option.
After a struggle to nd common ground, the gap between theory and empirics is being
closed from both directions. After early disappointments with dynamic general
equilibrium models, recent applications with nominal price rigidities show how
monetary shocks may have large and long-lasting effects on the real exchange rate.
When the firm is larger and the volume of foreign activity is sufficiently large to
justify the costs, the implementation of hedging programs appears to be strongly
facilitated. Further, our results lend support to the argument that the existence and
extent of tax loss carry forwards play a significant role in explaining firms use of
financial derivative instruments. The positive relationship between the percentage of
foreign denominated debt and the disclosure of FCDs reveals moreover that both
types of instruments are complements in hedging foreign currency risk.
Corporate governance plays an important role when investors assess the reason
behind the use of FCDs and its potential value for the firm. We find a significant
premium for FCD use only for firms with strong internal or strong external corporate
governance, while we find no premium for firms with weak corporate governance.
Finally, we find that the relation between the use of foreign currency derivatives and

firm value is most pronounced when both the internal firm level governance and
external country level governance environment are strong.
9. Empirical results confirm that short-run effects can exist, but their size and
persistence over time are not consistent across different studies. In the short-run, when
some prices in the economy can be sticky, movements in nominal exchange rates can
alter relative prices and affect international trade flows. These short-run trade effects,
however, are not straightforward, as they are likely to depend on specific
characteristics of the economy, including the currency in which domestic producers
invoice their products and the structure of trade.
10. To begin with, absolute values of data were converted to log normal forms and
checked for normality. Application of test yielded statistics that affirmed non-normal
distribution of both the variables. This posed questions on the stationarity of the two
series. Hence subsequently, stationarity of the two series was checked with ADF test
and the results showed stationarity at level forms for both the series.