What is a devaluation? Definition and examples
A devaluation occurs when the official value of a currency declines in relation to other currencies. We use the term when the decline is forced. In other words, the authorities planned it. A devaluation is also the underestimation or reduction of the importance or worth of something.
The verb ‘to devalue‘ means to reduce the official value of a currency in relation to a basket of currencies. The verb also means to underestimate or reduce the importance or worth of something. For example, somebody might say: “Jenny resented the way Tom seemed to devalue her achievement.”
This article focuses on the meaning of the term when we use it in a financial context. In other words, when we are talking about currencies.
The Financial Times glossary, ft.com/lexicon, has the following definition of the term:
“Official lowering by monetary authorities of the value of a country’s currency in relationship to the currencies of one or more other countries.”
“For this to occur, the currency being devalued would have to have a fixed exchange rate against another currency or a basket of currencies.”
The opposite of a devaluation is a revaluation.
Devaluation vs. depreciation
Do not confuse the term with depreciation. Depreciation refers to a decline in a currency’s market value without any formal adjustments of its exchange rate. In other words, the government did not force it to happen.
If a country has a free-floating currency, it cannot devalue. Instead, it appreciates and depreciates.
Depreciation occurs when market forces, i.e., the forces of supply and demand, cause a free-floating currency to decline in value.
Devaluation can only occur if the government makes it happen, i.e., sets the currency to a new, lower value. You can only devalue a currency that has a fixed exchange rate – one that does not ‘float.’
The British pound, US dollar, Japanese yen, and euro are floating currencies. Market forces determine their value.
The Saudi riyal and Venezuelan Bolivar, on the other hand, are fixed currencies. The Saudi or Venezuelan governments set their value.
Therefore, a devaluation of the pound, dollar, or euro is not possible. However, it is possible for the riyal and bolivar.
Effects of a devaluation
Following a devaluation, the currency’s new lower value will make exports cheaper for foreign purchasers. Conversely, imports will become more expensive for citizens of the country whose currency devalued.
If the government mishandles the devaluation of its currency, it could end up with hyperinflation, i.e., an extremely high inflation rate.