How does a country devalue its currency under a floating exchange rate?
This seems simple to do under a gold standard: simply declare that
you have reduced the amount of gold your government will trade for the
paper money.
But in a floating exchange-rate situation, how does this work? For
example, I hear that before adopting the euro, the Italian government
would regularly devalue the lira to get it out of economic scrapes
(that's why there were so many zeros in the lira).
Consider this sentence, from today's NYT: "The Italian economy is in
recession. Before the advent of the eruo, Italy could always devalue
the lirra in order to spur growth by making its exports cheaper and,
in that way, more attractive."
But I've also heard it said the U.S. government might be forced to
devalue the dollar as a way of escaping our twin trade and budget
deficits.
But if the price of the dollar on the foreign exchange market is
determined by supply and demand, it's not clear how such a plan is
actually carried out.
The only answer I can think of is that the government simply prints
more money, which would of course quickly and effectively devalue the
currency.
Is there another way this is done . . . ?
In my view, it is as follows:
1) Under a *floating* exchange rate, countries do not devaluate their
currency - the exchange rate is determined by the market, i.e. demand
for and supply of the currency.
- Countries do devaluate under a *fixed* exchange rate regime. In that
case, the monetary authority (i.e. the central bank, the government,
the Ministry of Finance) simply declared that it will by foreign
currency at an exchange rate of x [domestic/foreign currency]. The
exchange x can be changed at any time. Note, however, that a "wrong"
exchange rate implies that the monetary authority either rapidly
accumulates international reserves - i.e. it is forced to buy a lot of
foreign money - or its international reserves shrink rapidly. This is
because citizens (and speculators) realise that they can make a profit
by engaging in a currency transaction.
Coming back to Italy: Italy had a "quasi-fixed" exchange rate prior to
the adoption of the euro - i.e. it was part of the European Monetary
System EMS, under which exchange rates were kept fixed (or better:
were floating within a narow band). While several currencies were not
revalued for various years, the Italian lira was repeatedly
devaluated, in order to restore competitiveness.
It's good to see you're back around, gnossie. I hope the answers to
your earlier Qs were satisfactory.
Oroblram is basically correct. Think of a spectrum of different
exhange rate regimes: the most liberal is a freely-floating rate
determined only by the market... the most conservative is a hard peg
(like China... ~8.28 rmb/$).
Under the more liberal systems, the country can "jawbone" its currency
downward. Generally, when someone in government says "we would like to
see our currency fall", it will do so. The country can also practice
stealth intervention in the market, where it transacts in forex to
lower its currency without officially declaring.
Under the more conservative systems, the country can either move the
bottom end of its trading band downward, move the midpoint of its
trading band downward, or move its fixed peg downward.
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