A country’s currency may decline in value relative to other currencies. This can make exports cheaper on the global market and boost domestic demand. However, devaluation also makes imports more expensive and could lead to inflation.
Devaluation is most commonly used as a tool to promote economic growth or to address a trade imbalance. The country’s monetary authority (usually its central bank) sets the exchange rate. It can do this on its own, or in cooperation with other countries and institutions. Changing the currency’s value makes its goods less expensive on foreign markets, which can help stimulate exports and reduce the country’s trade deficit.
However, devaluation can also make its imports more expensive and discourage residents from purchasing foreign goods. This can slow the country’s economy and stifle productivity over time. Additionally, it can cause the value of any outstanding loans in that country to be devalued.
Historically, early currencies were coins made of precious metals, with issuing authorities certified as to their weight and purity. Governments short on these metals would simply decrease the weight and purity, thereby devaluing their currency without making an official announcement. Later, when paper money replaced these coins, governments could devalue by simply lowering interest rates, which encourages people and businesses to move their savings to other countries with higher returns.
A country can also try to manipulate its currency through open market operations, a process known as “currency wars.” However, this can backfire if it is too aggressive and causes higher-than-expected inflation or more outflows of capital.
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