AP_Krugman_Textbook

A reduction in the value of a currency that is set under a fixed exchange rate regime

is called devaluation.As we’ve already learned, a depreciationis a downward move in a

currency. A devaluation is a depreciation that is due to a revision in a fixed exchange

rate target. An increase in the value of a currency that is set under a fixed exchange rate

regime is called a revaluation.

A devaluation, like any depreciation, makes domestic goods cheaper in terms

of foreign currency, which leads to higher exports. At the same time, it makes for-

eign goods more expensive in terms of domestic currency, which reduces imports.

The effect is to increase the balance of payments on the current account. Similarly, a

revaluation makes domestic goods more expensive in terms of foreign currency,

which reduces exports, and makes foreign goods cheaper in domestic currency,

which increases imports. So a revaluation reduces the balance of payments on the

current account.

Devaluations and revaluations serve two purposes under a fixed exchange rate

regime. First, they can be used to eliminate shortages or surpluses in the foreign ex-

change market. For example, in 2010, some economists were urging China to revalue

438 section 8 The Open Economy: International Trade and Finance

From Bretton Woods to the Euro

In 1944, while World War II was still raging,

representatives of the Allied nations met in

Bretton Woods, New Hampshire, to establish

a postwar international monetary system of

fixed exchange rates among major currencies.

The system was highly successful at first, but

it broke down in 1971. After a confusing inter-

val during which policy makers tried unsuc-

cessfully to establish a new fixed exchange

rate system, by 1973 most economically ad-

vanced countries had moved to floating ex-

change rates.

In Europe, however, many policy makers

were unhappy with floating exchange rates,

which they believed created too much uncer-

tainty for business. From the late 1970s on-

ward they tried several times to create a

system of more or less fixed exchange rates

in Europe, culminating in an arrangement

known as the Exchange Rate Mechanism. (The

Exchange Rate Mechanism was, strictly speak-

ing, a “target zone” system—exchange rates

were free to move within a narrow band, but

not outside it.) And in 1991 they agreed to

move to the ultimate in fixed exchange rates: a

common European currency, the euro. To the

surprise of many analysts, they pulled it off:

today most of Europe has abandoned national

currencies for euros.

The accompanying figure

illustrates the history of

European exchange rate

arrangements. It shows the

exchange rate between the

French franc and the Ger-

man mark, measured as

francs per mark, since

1971. The exchange rate
      fluctuated widely at first.
      The “plateaus” you can see
      in the data—eras when the
      exchange rate fluctuated
      only modestly—are periods
      when attempts to restore
      fixed exchange rates were
      in process. The Exchange
      Rate Mechanism, after a
      couple of false starts, became effective in 1987,
      stabilizing the exchange rate at about 3.4 francs
      per mark. (The wobbles in the early 1990s re-
      flect two currency crises—episodes in which
      widespread expectations of imminent devalua-
      tions led to large but temporary capital flows.)
      In 1999 the exchange rate was “locked”—no
      further fluctuations were allowed as the coun-
      tries prepared to switch from francs and marks
      to euros. At the end of 2001, the franc and the
      mark ceased to exist.

fyi

FF4.0

3.5

3.0

2.5

2.0

1.5

Exchange

rate

(francs

per mark)

Year

1971 1975 1980 1985 1990 1995 2002

Exchange rate

mechanism

Exchange

rates locked

before euro

Attempts to

stabilize rates

The transition to the euro has not been with-

out costs. With most of Europe sharing the

same currency, it must also share the same

monetary policy. Yet economic conditions in the

different countries aren’t always the same.

Indeed, as this book went to press, there

were serious stresses within the eurozone be-

cause the world financial crisis was hitting

some countries, such as Greece, Portugal, Spain

and Ireland, much more severely than it was

hitting others, notably Germany.

Adevaluationis a reduction in the value of
a currency that is set under a fixed exchange
rate regime.

Arevaluationis an increase in the value of
a currency that is set under a fixed exchange
rate regime.