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Devaluation is reduction in the value of a currency. Typically it refers to the value of the currency relative to some specific baseline, such as foreign currencies or gold, rather than prevailing wages and prices.

The term inflation is generally used differently from the term currency devaluation. The former applies to the value of the currency within the national region of use, whereas the latter applies to the external value on international markets. The extent to which these two phenomena are related is open to economic debate.

The term is most often used when a currency has a defined value relative to the baseline. Historically, early currencies were typically coins stamped from gold or silver by an issuing authority which certified the weight and purity of the precious metal. A government in need of money and short on precious metal might abruptly lower the weight or purity of the coins without announcing this, or else decree that the new coins had equal value to the old, thus devaluing the currency. This gave rise to Gresham's Law, which stated that "bad money drives out good", i.e., if pure gold coins and false coins are decreed to have equal value, people will use the false coins for currency and hide the good coins or melt them down into gold.

Later, paper currencies were issued, and governments decreed them to be redeemable for gold or silver (a gold standard). Again, a government short on gold or silver might devalue by abruptly decreeing a reduction in the currency's redemption value, reducing the value of everyone's holdings. Naturally, a government which made a habit of doing this would lead its citizens to hold gold or silver in place of the government's notes, so such governments would often outlaw private hoarding of precious metal in order to prevent Gresham's Law from taking effect.

Present day currencies are usually fiat currencies with insignificant inherent value and no redemption policy. However, many countries maintain a fixed exchange rate policy against the United States dollar or other major currencies in order to provide investors and exporters with a sense of security. These fixed rates are usually maintained either by legally enforced capital controls or by maintaining a large reserve of foreign currency in order to intervene in the currency markets. For these currencies, a capital outflow or a persistent trade deficit may lead them to lower or abandon their fixed rate policy, resulting in a devaluation. In an open market, the perception that a devaluation may be imminent may lead speculators to sell the currency, increasing pressure on the issuing country to make an actual devaluation. An unusual example of a devaluation might be the 1985 Plaza Accord, in which the United States lowered its free floating currency dramatically by negotiating with its trading partners to stop them from artificially lowering their own currencies for competitiveness reasons.

Generally, a steady process of inflation is not considered a devaluation, although if a currency has a high level of inflation, its value will naturally fall against gold or foreign currencies. Especially where a country deliberately prints money (a usual cause of hyperinflation) to cover a persistent budget deficit without borrowing, this may be considered a devaluation.

In some cases, a country may revalue its currency higher (the opposite of devaluation) in response to positive economic conditions, to lower inflation, or to please investors and trading partners. This would imply that existing currency increased in value, as opposed to the case where a country issues a new currency to replace an old currency that had declined excessively in value. (such as Romania in 2005, Russia in 1997, or Germany in 1923)

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Last updated: 02-10-2005 16:37:20
Last updated: 05-03-2005 17:50:55