The Temptation of Competitive Devaluations

For our A2 macroeconomics teaching, we are moving into a study of exchange rate economics and the impact that currency movements have on key variables such as real output, profits, jobs, trade balances and living standards.

The decisions that countries make about exchange rate regimes can have a lasting effect on their macroeconomic performance. One topic in the news at the moment is the issue of whether individual countries - facing severe and painful downturns - will opt to use the exchange rate more aggressively as a tool of economic management. Today’s Independent has an interesting paragraph:

“Sterling has lost 8.1 per cent versus the dollar and 5 per cent against the euro this week alone, and is one-third down on its international value of a year ago. The G7 is said to be ready to discuss the pound’s precipitous decline, amid fears that the world could fall into a series of competitive devaluations”

Competitive devaluations occur when a country deliberately intervenes in foreign exchange markets to drive down the external value of the currency to provide a competitive boost to their international trade industries. For nations with persistent trade deficits and rising unemployment this can become an attractive option - but there are risks. I recommend that A2 economists read “What’s really wrong with Sterling? - The pound is suffering its worst ever fall in value. Why is it happening and what are the implications? Edmund Conway, Telegraph Economics Editor, has the answers.

Jeremy Warner’s comment piece in the Independent on exchange rates and the risks of protectionism is also worth a look.