An overvalued currency is defined as a currency whose value is artificially higher than its market value due to governmental interventions and support. This often occurs through mechanisms such as currency pegs, foreign exchange controls, or deliberate economic policies. When a currency is overvalued, it can lead to various economic consequences, including impacts on trade balances, inflation, and national competitiveness.
Mechanisms Leading to Overvaluation
Currency Pegs
A common method for overvaluing a currency is a currency peg, where a country fixes its currency’s value to another major currency, such as the US dollar, at a higher rate than the market would normally determine.
Foreign Exchange Controls
Foreign exchange controls are another tool. Governments might restrict the amount of currency bought and sold, manipulating the value.
Economic Policies
Certain economic policies and interventions from central banks, like buying or selling large amounts of currency, can also lead to an artificial valuation.
Examples of Overvalued Currencies
Venezuelan Bolívar
Historically, the Venezuelan Bolívar has been overvalued due to strict currency controls and government intervention, leading to significant economic distortions.
Chinese Yuan (Renminbi)
China has periodically faced accusations of overvaluing (or undervaluing) its currency, the Yuan, through central bank interventions and foreign exchange reserves management.
Impact of Overvalued Currency
Trade Deficits
An overvalued currency can make a country’s exports more expensive and imports cheaper, often leading to trade deficits.
Inflationary Pressures
Attempting to maintain an overvalued currency can lead to inflationary pressures, as domestic products become less competitive globally.
Loss of Competitiveness
Countries with overvalued currencies might lose global market share because their goods become too expensive for international markets.
Types of Currency Valuation Related Terms
Undervalued Currency
An undervalued currency is a currency that is valued lower than its market value. This is the opposite scenario of an overvalued currency and often aims at boosting exports.
Floating Exchange Rate
A floating exchange rate ensures that the currency value is determined by market forces without direct governmental intervention.
Purchasing Power Parity (PPP)
Purchasing Power Parity (PPP) is a theory that states that in the long run, exchange rates should move towards the rate that equalizes the price of identical goods and services in any two countries.
FAQs
Why do governments overvalue their currencies?
Can overvalued currencies lead to economic crises?
How can countries correct an overvalued currency?
References
- Dornbusch, R. (1980). Exchange Rate Economics: Where Do We Stand? Brookings Papers on Economic Activity.
- Krugman, P., & Obstfeld, M. (2006). International Economics: Theory and Policy. Addison-Wesley.
Summary
An overvalued currency refers to a currency priced higher than its market-determined value due to government intervention. While this can help control inflation and stabilize the economy, it often results in trade deficits, inflationary issues, and loss of competitiveness. Understanding the mechanisms and impacts of overvalued currencies is crucial for navigating international finance and economic policy.
