Causes of Devaluation

The free-market value of a national currency is determined by the interaction of supply and demand. If the quantity of the currency demanded is greater than the quantity supplied, a nation's currency will appreciate, or increase in value. A nation's currency will depreciate, or decrease in value, when the quantity of currency supplied is greater than that demanded.

The demand for a nation's currency depends on the amount of its exports, domestic investments, and assets held in domestic currency. A nation's currency supply on world markets depends partly on the amount of imports, investments abroad, and assets held in foreign countries. Ultimately, the supply of a currency depends on national monetary policy; if a country prints too much money, causing inflation domestically, a balance of payments deficit results.

Under a system of fixed exchange rates a country can adjust its exchange rate by trading its national currency for foreign currency or gold. If a balance of trade surplus persists, the government may decide to buy more foreign currency or gold in order to move back into equilibrium. Conversely, if a deficit exists, the government may sell some of its reserves of foreign currency or gold in order to bolster the value of its own currency.



Because a nation's reserves of other currencies and gold are limited, the government may choose to correct an imbalance by officially readjusting the value of its currency. Such a devaluation will usually be achieved through a legislative or administrative order. Under a flexible exchange-rate system, alterations in the exchange rate can be made to help a nation achieve equilibrium in its balance of payments.