There is a causal association between devaluation and inflation. There are evidences of this association in economic literature.Before that, we need to know the significance of these two words for finding answers for this economics question.Devaluation of a currency means that the currency is losing its purchasing power. If we compare any currency to dollar over a period, then we can see the exchange rate fluctuations.If the currency is cheaper than the dollar, then the exchange rate will be greater than one.Now, if that exchange rate goes up, then we can call it as the devaluation of that currency. It means that the currency will be able to buy a less amount of dollar.Now, let us look at the inflation. Inflation signifies rise in the general price level of an economy. It means that to buy any product, you will have to spend more.
So far, we have discussed the meanings of devaluation and inflation.Now, we will discuss about the association between them.It may seem to be possible that devaluation causes inflation. But, this may not be the case in reality. This association is dependent on several conditions.Inflation means general price level, and it is dependent on“Aggregate Demand”. This demand function comprises of consumption expenditure, investment, export and import.Now, devaluation cannot impact all these factors in equal manner.The causal association between devaluation and inflation is dependent on these factors.
FACTOR-BASED ANALYSIS OF DEVALUATION AND INFLATION
The aggregate demand function takes the following form:
AD = CE + IN + EX – IM
Where, AD = Aggregate demand
CE = Consumption expenditure
IN = Investment
EX = Export
IM = Import
Now, if the economy is at full employment, then rise in aggregate demand can cause inflation. But, even at full employment, inflation may not arise because of several factors.In this section, we will discuss about those factors.
BLOCKING THE DEVALUATION EFFECT
Devaluation effects import and export in two different ways. When the value of currency decreases, export becomes cheaper and import becomes costlier. So, devaluation of domestic currency will boost up an export-oriented economy.It will increase the inflow of foreign currency in the domestic economy.
Yet, for an import-oriented economy, the situation will be different.As import becomes costly, production cost will rise. Firms can respond to this situation in two different ways.They can either increase the price or they do not.If they increase the price, then the consumers will have to take the burden of devaluation. In this way the general price level will rise, but the demand will fall.This is because the real wage rate will not rise with the inflation. If the firms go for the second option, then they will bear the increase in production cost.They will reduce the profit margin, and the general price level will not rise. In this case, devaluation will not lead to inflation.
Let us begin with the previous example of export-oriented economy. If a firm earns more profit without any effort, then the firm will have less incentive to reduce costs. In this case, with the same production cost, the firm will earn more profit. This is because of more earning through exports. In such a condition, a firm will be reluctant to reduce the costs. If this continues, then the general price level will reflect the higher production cost.It will lead towards inflation.
Proper organizational management can handle this situation. If management perceives this situation as an opportunity, then cost-cutting will give more leverage.This will reduce the price in an intrinsic way.This will not let the general price level rise, and thus restrict the inflation to take place.This is how cost-cutting can stop inflation.
PSYCHOLOGY OF PEOPLE
Let us take two countries, i.e. India and the United States. The economic structures of these two countries are different from each other. Indian economy is saving-based and US economy is consumption-based. So, devaluation of domestic currency will have different effects on them. For the US, devaluation will lead to more consumption and less saving. For India, the case will be reverse. As a result, the inflationary pressure will be less in India. This is only possible because of the psychology of people. In other words, cumulative utility function of a nation decides the effect of devaluation.
By far, we have analyzed the effects of devaluation on inflation.Let us summarize our findings in short.
• If economy is in full employment, devaluation causes inflation.
• If firms reduce profit margins, the price level will not rise. This is for an import-oriented economy.
• If firms reduce operating costs, the price level will not rise. This is for an export-oriented economy.
• If people tend to save more, inflationary pressure will be less.