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Foreign Exchange Markets: Devaluation and Revaluation

We are re-posting this popular article about the foreign currency and the devaluation and revaluation systems. After all, what’s the point of trying to predict foreign exchange markets (FOREX) if you don’t even know how the market moves and reacts to change? The world’s largest market that is open 24 hours does react to certain changes and you need to know how to watch and interpret these movements. Why let some third-party web application make predictions for you when you can do the work yourself?

Devaluation and Revaluation of Currencies

For all of our examples we will use the comparison between $ (dollar) and € (Euro). To depict what occurs in the economy we will use a model (economists like models). The model employed is called the AA–DD model.

Here is a quick summary of the model. The AA curve represents the asset market and the DD curve represents the output market (goods and services). The X-axis represents production (or GDP (Y)), and the Y-axis depicts the appreciation or depreciation between the domestic currency ($) and foreign currency (€ in this example). For more information on how these models are derived please visit the international economics study web site.

What happens to the domestic economy when currencies are devalued or revalued?

First devaluation:
An announcement to Increase (depreciate) $ with respect to € will lead to the following in domestic markets: Increase of exports (since goods are cheaper), decrease of imports (more expensive to buy); the current account will increase which all leads to increase of Y.

What about the opposite? What happens to the domestic economy when the currency is revaluated?
Quite simply the opposite. An announcement to decrease the exchange rate (appreciate the currency) means decrease in exports, a possibility their will be an increase in imports, and a decrease of the current account. This almost means that Y decreases and C (consumption). You will have a stronger currency at the expense of lower consumption, loss of jobs, etc. This is why China is not in favor of revaluating.

The US on the other hand would like China to revaluate their currency. This would do a few things, namely, decrease the trade deficit for the US. It’s also in the interest of China to revaluate as it would slow a heated economy. The idea is if you build to fast then you’ll have too much capacity and note enough work to go around (which could deflate the economy when nobody has work). Of course, the flip side to that threat is there’s no end in sight for China’s growth….

There you have some basic examples of what happens to the economy upon devaluation or revaluation announcements.

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