Definition
An under-valued currency is one whose exchange rate relative to other currencies is lower than what is necessary for achieving external balance. This situation can bolster a country’s balance of payments on the current account by making its exports cheaper and more competitive internationally while making imports more expensive. This often improves the country’s trade surplus and can potentially make borrowing easier if the market anticipates a rise in the currency’s value.
Historical Context
Historically, countries have occasionally pursued policies to undervalue their currencies for strategic economic advantages. This has often led to conflicts and competitive devaluations, also known as “currency wars.”
Key Historical Events
- The Bretton Woods Agreement (1944-1971): This system of fixed exchange rates led to occasional imbalances and necessitated currency interventions.
- Asian Financial Crisis (1997): Many Asian currencies were devalued, causing widespread economic turmoil but eventually leading to improved export competitiveness.
- China’s Currency Policy: Persistent allegations have been made against China for keeping the yuan undervalued to benefit from export-led growth.
Economic Impacts
Improved Balance of Payments
An under-valued currency can lead to an improved balance of payments by enhancing the competitiveness of exports.
Inflation and Cost-Push Effects
However, undervaluation can lead to imported inflation as imported goods become more expensive.
Models and Formulas
The Purchasing Power Parity (PPP) Model
PPP suggests that in the long run, exchange rates should move towards rates that equalize the prices of an identical basket of goods in any two countries.
where \( E \) is the exchange rate, \( P_{\text{domestic}} \) is the domestic price level, and \( P_{\text{foreign}} \) is the foreign price level.
Diagrams in Mermaid
graph TD
A[Domestic Currency] -->|Under-Valued| B[Increased Exports]
B --> C[Improved Current Account Balance]
D[Foreign Goods] -->|More Expensive| E[Decreased Imports]
E --> C
Applicability and Examples
Modern Examples
- China (2000s): Accusations of maintaining an under-valued yuan to boost export growth.
- Japan (1980s): Implemented policies to keep the yen undervalued to support its manufacturing sector.
Considerations
Determining Undervaluation
It is often challenging to precisely determine if a currency is under-valued due to dynamic and complex global economic factors.
Policy Implications
Persistent undervaluation can lead to international tensions and retaliatory trade measures.
Related Terms
- Over-Valued Currency: A currency whose exchange rate is higher than necessary for external balance.
- Exchange Rate Manipulation: The deliberate intervention in currency markets to influence the exchange rate.
Comparisons
| Aspect | Under-Valued Currency | Over-Valued Currency |
|---|---|---|
| Export Competitiveness | High | Low |
| Import Prices | High | Low |
| Current Account Balance | Surplus | Deficit |
Interesting Facts
- The Big Mac Index: An informal way of measuring the purchasing power parity between two currencies and provides a test of whether currencies are at their “correct” level.
Inspirational Stories
- Germany Post-WWII: Despite the destruction, currency reforms and undervaluation strategies in the early years helped Germany rebuild its economy rapidly.
Famous Quotes
- “Currency depreciation is nothing but the taxation of imports.” – Unknown Economist
Proverbs and Clichés
- “The cheapest currency wins the export race.”
Jargon and Slang
- Currency War: A situation where countries compete against each other to achieve a relatively low exchange rate for their currency to boost exports.
FAQs
Q: Why would a country want an under-valued currency?
Q: How can one determine if a currency is under-valued?
References
- International Monetary Fund (IMF)
- World Bank Reports
- “Exchange Rate Determination” by Jeff Madura
- Historical data from the Federal Reserve
Summary
Understanding an under-valued currency involves grasping the economic dynamics and strategic motivations behind currency policies. While under-valuation can boost export competitiveness and improve a country’s balance of payments, it comes with complications such as imported inflation and potential international trade conflicts. Accurately determining undervaluation requires complex models and thorough economic analyses.
This comprehensive examination of under-valued currencies highlights their significance in global economics and provides an insightful resource for further study.
Remember to validate and cite specific sources when referencing historical data and real-world examples.
