UPSC Prelims 2021 Q8: Currency Devaluation and Trade — Explained
Consider the following statements:
The effect of devaluation of a currency is that it necessarily
1. improves the competitiveness of the domestic exports in the foreign markets
2. increases the foreign value of domestic currency
3. improves the trade balance
Which of the above statements is/are correct?
- 1 only
- 1 and 2
- 3 only
- 2 and 3
Answer: (a) 1 only
Statement-wise explanation
- 1: correct — Devaluation cuts the official value of the domestic currency against foreign currencies. A good priced at ₹100 now costs a foreign buyer fewer dollars, so its price abroad falls. Britannica describes this as the direct effect: devaluation lowers the price of the home country's exports in the importing country's currency. This price advantage follows from the definition, so the official key treats it as a necessary effect.
- 2: incorrect — This is the reverse of devaluation. Devaluation lowers the foreign value of the domestic currency, so one rupee buys fewer dollars. A rise in the foreign value of the currency would be revaluation under a fixed rate, or appreciation under a floating rate.
- 3: incorrect — Cheaper exports and dearer imports improve the trade balance only if export and import volumes respond enough to the price change. This is the Marshall-Lerner condition: the sum of the price elasticities of demand for exports and imports must exceed one. In the short run the balance often gets worse first (the J-curve), because import bills rise in domestic currency before volumes adjust. Britannica also notes that devaluation does not work when the deficit comes from structural weaknesses in the economy. So the trade balance does not necessarily improve.
How to eliminate
The word 'necessarily' settles this question. Ask which effect follows from the definition and which depends on other conditions. Statement 2 is false from basic knowledge, because devaluation by definition lowers the currency's foreign value. That removes the two options that include Statement 2, leaving '1 only' and '3 only'. Now compare 1 and 3. Statement 1 is a direct price effect: when the rupee is cut, foreign buyers pay less in their own currency for Indian goods. Statement 3 is an outcome that depends on how much export and import volumes respond, so it is not guaranteed. Fact to remember: devaluation makes exports cheaper and imports dearer at once, but whether the trade balance improves depends on the Marshall-Lerner condition, and it may first worsen (the J-curve).
Know more
Devaluation vs depreciation. Both mean the domestic currency buys less foreign currency. The difference is who makes the change.
| Term | Exchange-rate system | Who changes the value | Direction |
|---|---|---|---|
| Devaluation | Fixed / pegged | Government or central bank, by decision | Value falls |
| Revaluation | Fixed / pegged | Government or central bank | Value rises |
| Depreciation | Floating / market | Demand and supply in the forex market | Value falls |
| Appreciation | Floating / market | Demand and supply in the forex market | Value rises |
Channels of effect.
- Exports: cheaper in foreign currency, so their price competitiveness improves.
- Imports: dearer in domestic currency, which raises costs for oil, inputs and machinery. This can cause cost-push inflation.
- Trade balance: improves only if the Marshall-Lerner condition holds, meaning the sum of the price elasticities of export and import demand is greater than 1. Because contracts and volumes adjust slowly, the balance often worsens before it improves. This is the J-curve.
- Real exchange rate: if domestic inflation rises after devaluation, part of the price advantage is lost over time.
Indian milestones.
- June 1966: a large devaluation of the rupee, around 57%.
- July 1 and 3, 1991: a two-step downward adjustment of about 18–19% during the balance-of-payments crisis (RBI).
- March 1992: LERMS, a dual-rate system. 40% of foreign-exchange earnings were surrendered at the official rate and 60% were converted at market rates.
- March 1, 1993: a unified, market-determined rate. Since then the rupee has followed a managed float, so 'depreciation' is the correct term for the rupee today.
Competitive devaluation happens when several countries weaken their currencies on purpose to gain export share. Each country's gain cancels out the others', which is why it is called a 'currency war'.
NCERT Concepts to Revise
- Devaluation: The question asks what devaluation 'necessarily' does, so start from its exact definition.
- Currency depreciation: Depreciation is the floating-rate counterpart of devaluation. Students often confuse the two terms.
- Fixed exchange rate: Devaluation can only happen under a fixed or pegged rate, the system this concept describes.
- Real exchange rate: Export competitiveness depends on relative prices as well as the nominal rate. The real exchange rate captures both.
- Foreign exchange rate: Reading Statement 2 correctly needs a clear idea of what a currency's 'foreign value' means.
- Competitive devaluation: Shows why countries deliberately devalue and what they expect it to do for their exports.