Devaluation is a reduction in the value of a currency with respect to those goods, services or other monetary units with which that currency can be exchanged.
In common modern usage, it specifically implies an official lowering of the value of a country's currency within a fixed exchange rate system, by which the monetary authority formally sets a new fixed rate with respect to a foreign reference currency. In contrast, depreciation is used for the unofficial decrease in the exchange rate in a floating exchange rate system. The opposite of devaluation is called revaluation.
Depreciation and devaluation are sometimes incorrectly used interchangeably, but they always refer to values in terms of other currencies. Inflation, on the other hand, refers to the value of the currency in goods and services (related to its purchasing power). Altering the face value of a currency without reducing its exchange rate is a redenomination, not a devaluation or revaluation.
Devaluation is most often used in situation where a currency has a defined value relative to the baseline. Historically, early currencies were typically coins struck from gold or silver by an issuing authority which certified the weight and purity of the precious metal. A government in need of money and short on precious metal might abruptly lower the weight or purity of the coins without announcing this, or else decree that the new coins had equal value to the old, thus devaluing the currency.
Later, paper currencies were issued, and governments decreed them to be redeemable for gold or silver (a gold standard). Again, a government short on gold or silver might devalue by abruptly decreeing a reduction in the currency's redemption value, reducing the value of everyone's holdings.
Devaluation in modern economies
Present day currencies are usually fiat currencies with insignificant inherent value. When the U.S. dollar was fully disassociated from the gold standard in 1971, the value of any fiat currency became solely determined by the willingness of its issuing State to accept it as payment for taxes. Some countries hold floating exchange rates while others maintain fixed exchange rate policies against the United States dollar or other major currencies. These fixed rates are usually maintained by a combination of legally enforced capital controls or through government trading of foreign currency reserves to manipulate the money supply. Under fixed exchange rates, persistent capital outflows or trade deficits may lead countries to lower or abandon their fixed rate policy, resulting in a devaluation (as persistent surpluses and capital inflows may lead them towards revaluation).
In an open market, the perception that a devaluation is imminent may lead speculators to sell the currency in exchange for the country's foreign reserves, increasing pressure on the issuing country to make an actual devaluation. When speculators buy out all of the foreign reserves, a balance of payments crisis occurs. Economists Paul Krugman and Maurice Obstfeld present a theoretical model in which they state that the balance of payments crisis occurs when the real exchange rate (exchange rate adjusted for relative price differences between countries) is equal to the nominal exchange rate (the stated rate) (Krugman, Paul and Maurice Obstfeld. International Economics (2000), Chapter 17 [Appendix II]). In practice, the onset of crisis has typically occurred after the real exchange rate has depreciated below the nominal rate. The reason for this is that speculators do not have perfect information; they sometimes find out that a country is low on foreign reserves well after the real exchange rate has fallen. In these circumstances, the currency value will fall very far very rapidly. This is what occurred during the 1994 economic crisis in Mexico.
Generally, a steady process of inflation is not considered a devaluation, although if a currency has a high level of inflation, its value will naturally fall against gold or foreign currencies. Especially where a country deliberately prints money (a usual cause of hyperinflation) to cover a persistent budget deficit without borrowing, this may be considered a devaluation.
In some cases, a country may revalue its currency higher (the opposite of devaluation) in response to positive economic conditions, to lower inflation, or to please investors and trading partners. This would imply that existing currency increased in value, as opposed to the case with redenomination where a country issues a new currency to replace an old currency that had declined excessively in value (such as Turkey and Romania in 2005, Argentina in 2002, Russia in 1998, or Germany in 1923).
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